In the Companies Act, the legality of the distribution of assets is on one hand connected to the distributable profits shown in the balance sheet and on the other hand to the solvency of the company. In addition, the distribution of assets should be based on validated and audited financial statements. This blog post will examine the solvency test, the definition and interpretation of which has proved to be particularly difficult, because the wording of the section, the government bill and case law do not directly provide clarity on what the solvency test means and how it should be carried out.
According to chapter 13, section 2, of the Companies Act, assets shall not be distributed if it is known or should be known at the time of the distribution decision that the company is insolvent or that the distribution will cause insolvency of the company. This section is commonly referred to as the solvency test. In the section, the distribution of assets is tied to the continued solvency of the company, that is, the company must be able to meet its obligations even after the distribution of assets.
The solvency test applies to any distribution of assets, not only to the distribution of dividends or assets from reserves of unrestricted equity. This provision is applicable, for example, when the company acquires or redeems its own shares or reduces its share capital. However, the provision does not apply when the company is being dissolved.
When should the solvency test be done and how?
According to the government bill of the Companies Act, solvency should be assessed at the time of the distribution decision, or at least as soon as possible after this. It’s common for the board to conduct the solvency test in connection with the presentation of its proposal for the distribution of assets in the annual general meeting (AGM). It's important to note that after the AGM, the board must always ensure that the decision is implemented in accordance with the Companies Act. If the board, for example, notices that the solvency of the company has significantly deteriorated after the AGM and there is a risk that the company may become insolvent, the board may not distribute assets of the company even if a distribution decision had been made in the AGM. The board may be regarded as having a continuing duty to review and update its own evaluation of the solvency of the company as it implements decisions of the AGM.
How can solvency be assessed?
The solvency assessment should be based on all of the company’s available financial information.
This does not mean just the latest validated and audited financial statements, but all information describing and measuring the financial position of the company. A recently validated and audited financial statement does, however, have a very important role in this assessment. It shows the amount of unrestricted equity that can be distributed by the company as well as tranches relating to solvency.
Why are solvency tests needed?
The solvency test has primarily been set to protect creditors. In accordance with the general principles of Corporate law shareholders’ claims are always the last priority in relation to claims of creditors. This principle does not occur if the shareholders could distribute company assets freely for themselves and at the same time cause the company to become insolvent and bankrupt.
Distributing assets in violation of the solvency test is illegal distribution of assets. This infringement results in an obligation to refund received assets under chapter 13, section 4, of the Companies Act. In addition to this, provisions of the Limited Liability Companies Act on damages and, in the worst case, provisions of the Criminal Code may become applicable.
It's up to the management of the company to decide how it ensures that the solvency test is carried out. It's essential that the management is aware of its obligation to conduct the solvency test and understands the risks associated with failure to do so or its careless execution. Rather than only being seen as administrative burden set by the legislator, the solvency test can at its best be part of the company’s financial planning and monitoring.