When a company experiences financial distress, three common options are available to them. Firstly, an attempt to trade out of the tough times. Secondly, enter business rescue. Thirdly, cut the losses and put the company into liquidation. The first option comes with great risk if an immediate solution is not available. An example of this risk is the exposure of the company’s directors to charges or penalties for reckless trading. If the first option is not feasible, then the clear choice is between business rescue or liquidation. Business rescue is ultimately a creditor driven process and, since creditors will ultimately be the decision makers as to whether a distressed company enters business rescue or liquidation (by virtue of voting on the business rescue plan), it is of vital importance for creditors to understand their position to enable them to make informed decisions in their best interests.
The ranking of creditors in liquidation
Liquidation is the proverbial death of a company with its affairs being wound up and its assets sold to be distributed to creditors as per the statutory hierarchy governed primarily by the Insolvency Act 24 of 1936, read with section 339 of the Companies Act 61 of 1973. Due to the distribution being statutorily defined, it is rigid and relatively quantifiable at an early stage, depending on the complexity of the liquidation and the estate. The Insolvency Act establishes the order of priority between secured, preferent and concurrent creditors, as well as the costs incurred in the liquidation. The image below displays the order of priority:
Liquidation costs
Before any creditor receives a distribution in liquidation, the first payments are made with regard to the costs of liquidation. These costs speak to the liquidator’s remuneration, legal costs incurred to put the company into liquidation, and the reasonable expenses incurred in realising assets to be sold.
Secured creditors
Secured creditors are the first in line of creditors to receive a distribution. Secured creditors possess some manner of recognised and realised security interest against the company’s assets. Examples include notarial (general and special) bond holders, mortgage bond holders and pledgees. The presence of many secured creditors will greatly impact the remaining distribution to the “lower” levels on the waterfall.
Preferent creditors
Preferent creditors are given their status by operation of law. Preferent creditors do not hold security but are ranked before concurrent creditors, purely because the law says they are. Broadly speaking, preferent creditors in liquidation are generally the South African Reserve Bank, South African Revenue Services, and amounts owing to employees for their salaries, limited to an amount not exceeding three months’ pay. Only preferent creditors will receive payment in full, should the asset pool be sufficient, otherwise they will be paid a proportionate amount of the full amount owing to them, relative to the other preferent creditors.
Concurrent and Unsecured creditors
These creditors do not possess any security and are not given any statutory preferential status. It is rare for concurrent creditors to receive any distribution in liquidations since they will only share in the residue of whatever remains, once the costs of the liquidation, secured and preferent creditors have been paid in full. It is often in the best interest of concurrent creditors to support the business rescue, as one of the requirements of business rescue is for creditors to receive a better return than they would in the scenario of an immediate liquidation of the company (even if the amount received is marginal). Business rescue affords the distressed company the opportunity to be placed under moratorium, to get temporary new management (i.e. the business rescue practitioner) and to rise from its financial woes, potentially enabling it to settle its “lower-ranking” creditors.
Creditors often know what to expect from liquidation, but it seldom brings fruitful returns (unless the creditor possesses handsome security in the company), especially where the company is in a particularly bad way by the time it is liquidated. This marks the end of Part 1 of the guide to creditors, with Part 2 turning to the ranking of creditors in business rescue.
