The Solvency Regime - A Critical Evaluation of the Legal Framework in Sri Lanka

Abstract

Introduction The new Companies Act No. 7 of 2007 brought into existence the solvency test into the legal framework of Sri Lanka. This is to be met in a variety of corporate procedures and requires companies to satisfy two tests to be classed as being solvent; the first is the "cash IORZ WHVWRUWUDGLQJVROYHQF\ 7KHVHFRQGWHVWLV µDVVHWVWHVW¶RUEDODQFHVKHHWVROYHQF\ namely that the assets of a company must be greater than its liabilities. The test plays an important role in the management of companies and presents challenges to the board of directors of a company as to how a company enhances its solvency position. During last three decades, Sri Lanka witnessed number of cases of corporate failures, especially in finance companies. Such failures can have huge impact on the economy which can set a country several years back in its path to development. Because today a company cannot stand in isolation, its actions and behaviour affects society, the lives of people it transact with and the nation at large. The recent plight of the Golden Key Credit Card Company and the major corporate scandals such as Sakvithi created a severe umbrage amongst the investors in Sri Lanka. The mismanagement of the corporate sector, the lack of a proper regulatory/legal regime to monitor the internal management and administration of companies, the manipulation of financial reporting standards to promote unethical practises by the directors, auditors and senior officials of the companies and oversight and the lack of timely action by the Central Bank of Sri Lanka to prevent such collapses in relation to financial institutions have been some of the main attributes for the financial instability created in the recent past in Sri Lanka. Sri Lanka until the 2007 Act, like most other jurisdictions through a capital maintenance approach protected the creditors of a company. The intention was to prevent companies returning funds to shareholders by way of distribution or providing financial assistance for 161 the purchase of its own shares or reducing its capital etc. in order to ensure that there was a pool of money on which creditors could rely. However it was questionable as to the extent the capital maintenance rule provided the protection to the creditors. The paper identifies deficiencies in the previous framework which proved very detrimental for creditors, reviewing the evolution in shareholder and creditor protection that has taken place in Sri Lanka under the 2007 Act. Also explores and evaluates the practical impact, importance and the drawbacks of the solvency test as a mechanism to provide effective protection to stakeholders of a company with special reference to the position of the creditors of a company. The paper is based on the hypothesis that the solvency regime is a major step in ensuring the integrity of the corporate sector and it provides a better protection to stakeholders of a company, as opposed to the protection afforded by capital maintenance rules. The effectivness of the test is analysed with a comparision of New Zealand and UK jurisdictions