What every director must check before acting

Corporate actions are a common feature of business, but their success depends on a company’s readiness to undertake them responsibly and sustainably. Their implications for its shareholders and other stakeholders can be significant, whether the action is undertaken to boost confidence in the company’s financial position, such as through a share buyback or reduction of share capital, or in response to exceptional circumstances, such as a solvent winding up. 

The key question now is: Has the company carefully considered the most critical factor before proceeding? 

That factor is solvency. 

One wrong assessment can expose the company and its directors to significant legal and commercial consequences. 

On the one hand, the Companies Act 2016 (“CA 2016”) aims to facilitate business activities and make it easier for entrepreneurs to operate. On the other hand, it also safeguards the interests of stakeholders such as suppliers, creditors, and customers by introducing the solvency assessment as a key requirement. The regulations were designed based on the fundamental principle that maintaining solvency is essential. 

What does it mean to be a solvent company?

A company is considered solvent when it can meet its debt obligations as they come due and when its total assets—excluding contingent assets for prudence—exceed its total liabilities, including any contingent liabilities. In essence, a solvent company not only has sufficient financial resources to cover its debts but also maintains a healthy position net asset value, ensuring its ongoing financial stability and confidence for stakeholders.

When considering a corporate transaction, ask yourself these two questions:

1. Can the company pay its debts on time?
2. Will the company still have more assets than liabilities after the transaction? 

The solvency assessment was introduced in CA 2016—by making it a formal legal requirement, this represents a more structured approach to how companies evaluate their financial position before undertaking corporate actions, building on the 1965 Act it precedes. Designed to protect those who rely on the company’s financial stability, the responsibility to ensure that the company passes the assessment sits squarely with the board.

While the concept of solvency may seem straightforward in principle, the law doesn’t leave it to instinct or broad judgement alone. The CA 2016 gives legal structure to this consideration through the solvency test: a set of criteria that determines when and how a company’s financial position must be assessed before a corporate transaction. 

Understanding the solvency test: What it is and how companies meet the criteria

At its core, the solvency test assesses whether a company will remain financially sound immediately after a transaction and for a defined period thereafter. Different corporate exercises are subject to different criteria to satisfy the solvency test. 

The table below provides a simple overview.

Solvency statement: The basics

Meeting the solvency test alone is not enough. A formal solvency statement is also required. A written declaration signed by the directors confirming that, after making proper inquiry and considering all liabilities (including contingent liabilities), they have reasonable grounds to believe the company can pay its debts as they fall due and will remain solvent after the proposed transaction.

This is not just a procedural formality. A director who makes a solvency statement without reasonable grounds commits an offence and may be exposed to serious consequences, including imprisonment for up to five years, a fine of up to RM500,000, or both.

While a solvency statement is not mandatory for dividend distribution, it does not remove the need to consider solvency. A company may only distribute dividends out of its available profits if it is solvent. Failure to comply with this requirement constitutes an offence, and any company officer or individual involved may, upon conviction, face imprisonment for up to five years, a fine up to RM3 million or both. 

Solvency test across methods: Similarities and differences

Sometimes it’s not that simple and straightforward—different corporate exercises have different criteria.

What stays the same?

The bottom line never changes: the company must be able to pay its debt on time. Directors should carefully assess both current and future debts and be confident the business will remain financially resilient after the deal, particularly in terms of cash flow, liquidity, and commitments. Statements should be based on reasonable grounds, such as up-to-date management accounts, prudent monthly cash flow forecasts, monthly debt maturity schedules, evidence of available financing, and a review of contingent liabilities. As these expose directors to regulatory risk and potential penalties, keep proper records of how the decision was made.

What changes? 

• Who signs: Some need not be signed off; some need all directors to sign; whilst others may proceed with a majority. For example, dividend distribution does not require a statutory solvency statement to be signed; however, capital reductions for returning surplus/restructuring and the redemption of preference shares require all directors to sign the statutory solvency statement. In contrast, share buybacks and provision of financial assistance may be proceeded with a majority.

• How long you must stay solvent: Certain exercises impose ongoing solvency requirements. For share buybacks, you must stay solvent for six months after each one, and it shall not reduce the capital below a safe threshold.

• Extra steps and timing: Some methods involve specific filing requirements, procedural steps, or statutory timelines, especially capital reductions and redemptions, so plan for those.

Conclusion

Solvency is one of those things that only becomes visible when it’s absent, by which point the options are limited, and the consequences become significant. The CA 2016 doesn’t ask directors to predict the future with certainty; it demands diligence. Before committing a company to a transaction that alters its capital structure, those responsible should pause long enough to ask whether the company can bear it, and honest enough to document the answer properly. Most of the time, the answer is straightforward. The discipline lies in making sure the question is always asked.

Speak to us today to keep your transaction compliant and on track.