Mar 18,2010 / News / Legal Brief

The King III Code (first published in February 2009) is due to become effective on 1 March 2010.

The strong governance principles which have been aligned to King III, will certainly impact on directors and the manner in which they behave when sitting on companies’ boards across the country.

In particular, all directors need to understand the overarching applicable principle that companies must either apply the corporate governance principles of King III or explain non-compliance.

Clearly the aim is to ensure that all forms of business apply the basic principles of good governance when running companies in South Africa. King III will apply to all companies, public entities, private companies and all other forms of business.

With continued tough economic trading pressures placed on companies in South Africa, it is important for directors to consider the impact of King III and the manner in which their roles will now change in respect of reporting considerations to all stakeholders, especially creditors.

King III has specifically confirmed that the board and each individual director should have a working understanding of the effect of the applicable laws, rules, codes and standards applicable to the company and its business. Boards will now have to ensure that processes are put in place to ensure that the board is continually informed of relevant legislation as well as amendments to such legislation. Directors will need to familiarise themselves with the general content of the applicable laws so as to enhance their ability to adequately discharge their fiduciary duties in the best interests of the company.

Directors will particularly have to be aware of the penalties resulting from allowing their companies to trade in insolvent circumstances (both factually in that its liabilities exceed its assets or commercially in that the company cannot pay its debts to creditors as and when they fall due). Directors will be expected to have a working understanding of the applicable laws relevant to directors’ personal liability and particularly the consequences of continuing to incur credit while the company is trading in insolvent circumstances. Currently, section 424 of the Companies Act punishes directors when they conduct the business of the company recklessly, negligently with an intent to defraud creditors. In such circumstances, directors may be held personally liable for all the debts of the company, particularly once such company is placed into liquidation.

King III specifically states that a company’s board must, on a continuous basis, monitor whether the company is able to pay all of its debts as they fall due and payable, whether the company is solvent or is financially distressed.

In terms of the new Companies Act, No 71 of 2008 (not yet operational but expected to become operational later this year), the definition of “financial distress” is where it appears to be reasonably unlikely that the company will be able to pay all of its debts as they fall due and payable within the immediately ensuing six months, or it appears to be reasonably likely that the company will become insolvent within the immediately ensuing six months.

In circumstances of financial distress, directors will be expected to conduct investigations into whether or not a company should be placed under business rescue or whether such company should be placed into liquidation.

In terms of King III, the board of directors is responsible for the governance of risk. The board will be expected to apply good corporate governance and establish proper risk management processes, including the establishment of a risk management committee to attend to and address the levels of risk within the company. The consideration of risks as it affects income streams, critical business processes within a company, critical dependencies of the business and the sustainability of the business are all to be considered by directors.

Insofar as solvency or insolvency is concerned, the board will be expected to ensure that particular attention is focused on these risks and how they may negatively impact the long-term sustainability of the company.

The new Companies Act will include similar provisions to section 424 of the old Companies Act. Sections 76 and 77 of the new Act will direct that directors of companies be held liable in accordance with the principles of the common law and where breaches of section 76 of the new Companies Act occur.

In terms of section 76, a director of a company must exercise the powers and perform the functions of a director in good faith and for a proper purpose, in the best interests of the company and with the degree of care, skill and diligence that may reasonably be expected of a person carrying out the same functions in relation to the company as those carried out by that director and having the general knowledge, skill and experience of that director. The new Act particularly deals with reckless conduct and where actions are calculated to defraud a creditor by, for example, trading the company in insolvent circumstances. Section 22 of the new Act particularly prohibits a company from carrying on its business recklessly, with gross negligence, with intent to defraud any person or for any fraudulent purpose or trade under insolvent circumstances.

The critical timing for when to apply for a company’s winding-up or liquidation will be carefully looked at when one considers whether or not the King III Code has been applied, particularly where sustainability issues are involved. If a director is knowingly aware that a company is trading in insolvent circumstances he is obligated to place such company into liquidation.

King III specifically confirms that boards must continually monitor the risk levels and should do so together with management. The development of a risk management plan is essential to ensure that the company continues to trade in solvent circumstances and is sustainable in the long term.

All in all, the expectations on the part of creditors when it comes to the behaviour of directors will no doubt increase and reach levels which have never before been considered in South Africa. It is clear that directors are going to have to keep a careful watch on the financial status of their companies and monitor the manner in which they trade. No doubt, when it comes to personal liability, directors will have to update themselves in respect of the parameters of King III, the old Companies Act (while still applicable), as well as the provisions of the new Act, when it comes to them being held personally liable for the debts of a company once it goes into liquidation.