Winding up of companies by court
File pic: Some garment factories have wound up
‘Winding up’ or ‘Liquidation’ is the process that prepares the company for dissolution, whereby, the assets of a company are collected and realized, the proceeds of such realization are utilized to settle the debts and liabilities of the company and, any balance that remains after meeting the costs and expenses of the winding up and settlement of such debts and liabilities is distributed among the members of the company or distributed as the constitution of the company directs. However, when an insolvent company is being wound up there will be no assets left for distribution among the members of the company.
Since the companies are legal personalities, their winding up is regulated by law. In Sri Lanka, winding up of companies is regulated by the Companies Act No.07 of 2007 and the Winding up Rules of 1939. In the case where the winding up of a company commenced prior to the introduction of the new Companies Act and the completion of which is still pending, the applicable laws are the Companies Act No.17 of 1982 and the Winding up Rules of 1939.
Winding up of companies could be carried out voluntarily or by court or under the supervision of court, on various grounds. It could be done voluntarily by the company when it is solvent. When a company is insolvent, its winding up could be initiated by the company itself through court or by its creditors – voluntarily or through court. It could also be initiated by the Registrar General of Companies or by the Official Receiver of court/ Liquidator of the company, under voluntary winding up or winding up under court supervision, when such winding up cannot be continued with due regard to the interests of the creditors or contributories.
In this article, we consider the relevant provisions of the new Companies Act No.07 of 2007 in respect of the winding up of an insolvent company by court, initiated either by the company or by a creditor. All Sections referred to in this article are that of the new Companies Act No.07 of 2007.
When insolvent
A Director of a company who believes that the company is unable to pay its debts as they fall due shall forthwith call for a Board Meeting to consider whether the Board should apply to court for the winding up of the company and the appointment of a Liquidator or an Administrator or carry on further business of the company, as required under Section 219 of the Act.
The failure to comply with this provision will render the Directors, other than those Directors who attended the meeting and voted in favour of applying to court for the winding up of the company and for the appointment of a Liquidator or an Administrator, personally liable for the losses suffered by the creditors of the company as a result of the company continuing to carry on the business. This situation is termed Trading in Insolvency. In recent times, there has been a noticeable increase in creditors bringing personal liability claims against Company Directors in a number of winding up cases and the courts are also entertaining such applications in favour of such creditors.
Petition for winding up
When a company is making continuous losses and is unable to pay its debts as they fall due, the company could adopt a Special Resolution for winding up in compliance with Section 219 and make an application to court to wind up the company under Section 270 of the Act. After an inquiry, if the court is satisfied with the application and is of the opinion that it is just and equitable that the company should be wound up, it will make the Winding up Order and appoint a Liquidator.
When a company is unable to pay its debts as they fall due, a creditor of the said company could bring an application to wind up the company by court by proving the company’s inability to pay its debts. According to Section 271, a company’s inability to pay its debt is proved, when a creditor to whom the company owes a sum exceeding Rs. 50,000 serves a letter of demand in writing on the company, requiring the company to pay the sum due, and the company fails to settle the said sum within three weeks from the date of serving such letter of demand.
Under these circumstances, a creditor could make an application to court to wind up the company on the grounds that the company is unable to pay its debt, and the court, after an inquiry, if satisfied with the application and is of the opinion that it is just and equitable that the company should be wound up, will make the Winding up Order under Section 270 of the Act and appoint a Liquidator as provided under Section 285.
The date of commencement of winding up by court is the date of presentation of the Petition for Winding up in Court, as provided under Section 277 of the Act.
Provisional liquidator
Court may appoint a Provisional Liquidator, on or after receiving the Petition for Winding up filed either by the company or by a creditor, for the management and protection of the assets owned by the company, until such time the court makes the Order on the Application for Winding up.
According to Section 279 (1), when a winding up order is made or a provisional liquidator is appointed by court, no action or proceeding shall be proceeded with or commenced against the company except by leave of court, and subject to such terms as the court may impose.
Section 279 (2) states that the execution process or attachment against any property owned by the company, by or for the benefit of a creditor who is entitled to a duly registered charge against such property, will not be affected by the said provision under Section 279 (1).
Example: Parate execution against mortgaged property by a bank will be immune to Section 279 (1), provided such mortgage is duly registered as a charge under Section 103.
Where a winding up order has been made or a provisional liquidator has been appointed by court, the liquidator or the provisional liquidator shall take into his custody or under his control, all the property and the things in action which are owned by the company or appears to be entitled to the company.
Connected person
Section 373 (3) identifies the following parties as connected persons: (a) A director of the company at the time of transaction or a nominee or a relative or a nominee of a relative of a Director or a trustee or a trustee of a relative of a director, (b) a person or a relative of a person, who at the time of transaction, had control of the company, (c) another company that was controlled by any one of the under mentioned persons of the company under winding up at the time of transaction, a nominee or a relative of a director, a trustee for a director, a trustee for a relative of a director or another company that was a related company at the time of transaction.
Under these provisions, the new Act has widened the scope of the safeguards available for a creditor in case the net realization of the remaining assets of the company is insufficient to meet his claim.
Fraud in anticipation of winding up
When a company is wound up, a person who is a past or present officer of the company is deemed to have committed an offence under Section 374, if, within the two years preceding the commencement of the winding up, he has committed the following: (a) Concealed or fraudulently removed any part of the company’s property worth Rs.10,000 or more and concealed any debt or (b) concealed, destroyed, mutilated, falsified or made any false entry in any book or document relating to company property or (c) made or caused to be made any gift or transfer of or charge on, or has caused or connived at the execution against the company’s property with the intent of defrauding the company’s creditors.
A person who commits such an offence shall be liable, on conviction, to a fine not exceeding Rs.1 million or, to imprisonment for a term not exceeding 5 years or, to both fine and imprisonment.
Fraudulent trading
Where any business of a company that has been wound up, has been carried on with the intention to defraud the creditors of the company or for any fraudulent purpose, every person who was knowingly a party to such activity shall be deemed to have committed an offence and shall be liable, on conviction, to a fine not exceeding Rs.1million or, to imprisonment for period not exceeding 5 years or, for both fine and imprisonment.
These provisions enable any unsettled creditor of a company under winding up, to recover his claim from the Directors of the company who carried on the business under the said circumstances.
Settling claims
When the notice of winding up of a company is published, the creditors of the company could submit their claims to the liquidator in the form of Proof of Debt, in the format specified by the Companies Act No.07 of 2007. Statutory claims are mostly submitted by way of Orders or Statements or by way of Statutory Bills. According to their nature, these claims are classified as Secured claims, Preferential claims and Unsecured claims. Secured claims are those supported by a security/ charge on the assets of the Company. Preferential claims are generally statutory claims such as liquidators fees, costs and expenses, labour dues, Tax payable etc, as specified in the 9th Schedule of the Act. The liquidator will verify these claims with the supporting documents and the Statement of Affairs of the company furnished by the officers of the company, and inform the court the details of the claims received by him andthose admitted by him.
Ranking of claims
Generally, the admitted claims are settled in the following order of priority, depending on the net realization of the company assets available with the liquidator; Secured claims, Preferential claims and Unsecured / all other claims.
Secured claims: a secured creditor has three options to realize his security as provided under Section 358 (1). These options are as follows; to seize, attach and realize or issue an execution or appoint a receiver in respect of a property subject to a charge/ mortgage, if entitled to do so, or to value the property subject to the charge and claim in liquidation, as a secured creditor, an amount up to the value of the security and, claim the balance due, if any, as an unsecured creditor, or to surrender the charge to the Liquidator for the general benefit of all the creditors and claim in the liquidation, as an unsecured creditor, for the whole debt. If he realizes the asset subject to such charge, he shall account to the Liquidator for any surplus after settling his debt and other charge holders on the said asset. However, in practice, a secured creditor generally chooses the 2nd option and releases his security on receipt of the net realization of the asset subject to such security, from the liquidator.
Under these provisions the rights of the secured Creditor are protected. Thus, the licensed banks in Sri Lanka could either exercise their power under the Recovery of Loans by Banks (Special Provisions) Act No.04 of 1990, popularly known as Parate Execution, against the Company properties subject to their mortgages or, to value the security and submit their claims to the Liquidator and get their settlement in priority as stated above. However, this is subject to the condition that such mortgages are duly registered as charges at the ROC, as required under the new Act, since an unregistered charge over a company property is void against the Liquidator and any other creditor of the company, as provided under Section 103 of the new Act. A charge includes a mortgage as provided under Section 102 (13). In general, the claims secured by a duly registered charge/ mortgage over any specific property of the company, other than a floating charge, shall have priority of settlement out of the net realization of the said property.
Exceptions
In respect of properties (buildings) owned by BOI registered companies, located within the BOI Export Promotion Zones, which are subject to mortgages in favour of any approved Credit Agency, the net asset realization of such properties is first applied to settle the arrears of EPF, ETF, gratuity and any dues to BOI, prior to settling the charge/ mortgage holder, as provided under the BOI Law (by virtue of Tripartite Agreements). Therefore, it is advisable for such approved Credit Agencies, mostly Licensed Banks, to devise a mechanism to monitor the timely settlement of the said labour dues etc, by the company, in order to ensure maximum realization for settlement of their loans. A fine imposed on the company for an offence and a monetary penalty payable to the State as imposed by court for the breach of any enactment, whether imposed before or after the commencement of winding up and the costs ordered to be paid by the company in such proceedings. All provident fund dues, trust fund dues and gratuity payments due which existed prior to the securing of any asset, from the sale proceeds of such secured asset. Therefore, a creditor or a bank, when executing a mortgage or a charge over a specific company property as security for the facility granted by them, shall ensure prior to the grant of such facility, that the above labour dues and fines are not in existence.
Preferential Claims
According to Section 365, the net realization of all unencumbered assets (which are not subject to any fixed charge/ mortgage) shall first be applied to settle the preferential claims in the order of priority as specified in the 9th Schedule of the new Act. As per the 9th Schedule, the liquidator’s costs and fees rank first among the preferential claims, in addition to the reasonable costs incurred by the person who applies to court for winding up and the actual costs incurred by the Liquidation Committee. After settling the above claims, the liquidator shall pay the following claims; EPF, ETF and gratuity dues of any employee, Income Tax charged or chargeable for any one complete year prior to the commencement of the winding up, as selected by the Commissioner General of Inland Revenue, Turnover Tax charged or chargeable for one complete year prior to the commencement of the winding up, VAT charged or chargeable for four taxable periods prior to the commencement of the winding up, as selected by the Commissioner General of Inland Revenue, all rates or taxes (other than income tax) due from the company within a period of 12 months prior to the commencement of the winding up, all dues to the Government as recurring payments for any service given or rendered periodically (electricity, water supply etc.), Industrial court awards and other statutory dues payable to employees, unpaid salaries or wages of employees for the services rendered to the company during the last four months immediately preceding the commencement of the winding up, holiday pay payable to any employee, and any liability for compensation accrued prior to the commencement of the winding up under the Workmen’s Compensation Ordinance.
All these claims rank equally among themselves and shall be paid in full unless the assets of the company are insufficient to meet them, in which case they abate in equal proportion (of the shortfall). It is interesting to note that the priority enjoyed by ETF Claim on the assets of the company, over the other Preferential claims, as provided under Section 31 of the ETF Board Act No.46 of 1980, has now been removed by the new Companies Act, as the ETF claim now ranks equal to other preferential claims as specified in the said 9th Schedule.
Unsecured Claims
All other claims, including the unsettled balance due to the secured creditors and the Commissioner General of Inland Revenue on account of Income Tax and VAT, and the balance Turnover Tax, Rates and other taxes payable, are treated as unsecured claims. They rank equally among themselves and are settled in equal proportions, depending on the availability of funds on net asset realization, after settling the secured and preferential claims. It is unfortunate that in most instances of winding up of companies by court, the unsecured creditors do not get any settlement. Under these circumstances, they are likely to incur heavy losses.
The new Companies Act attempts to provide some relief to such creditors on grounds of Trading in Insolvency and Fraudulent Trading, as provided under Sections 219, 367,368, 369, 373, 375 and 376. As a result, in recent times there is an increase in the number of personal liability claims brought against the Directors of Companies by the unsecured creditors, in winding up cases that are mostly initiated by the companies themselves.
Conclusion
In this paper, the writer has tried to give an overview of some of the important provisions of the new Companies Act No.07 of 2007 that deal with the winding up of insolvent companies by court, the ranking and settlement of claims and the remedies available for unsettled creditors. The comments made herein are essentially that of the writer and do not represent the views of the firm to which the writer is attached.
(The writer is an Incorporated Valuer and Attorney-at-Law, and Director- Corporate Recovery & Valuation at SJMS Associates)
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