When does a commercial dispute become an insolvency problem?

By Wessel Robertson | Director 

An unpaid account usually begins as a dispute between two businesses. The creditor believes payment is due, while the debtor questions the work, disputes the amount or promises to pay once a temporary cash-flow problem has been resolved.

A letter of demand, summons and ordinary debt collection proceedings may be the appropriate response. However, the position changes when the unpaid debt is no longer an isolated contractual issue and becomes one indication of a broader financial collapse.

Creditors who fail to recognise that change can spend considerable time and money obtaining a judgment, only to discover that there are no assets available to satisfy it.

Disputed debt or inability to pay?

The first distinction is between a debtor that will not pay and one that cannot pay.

A commercial dispute concerns whether the debt exists, how much is owed or whether payment has become due. Insolvency concerns the debtor’s ability to meet its financial obligations in the ordinary course of business. South African law recognises that a company may be commercially insolvent because it cannot pay its debts as they fall due, even when the apparent value of its assets exceeds its liabilities.

Liquidation is not simply a more forceful form of debt collection. Under the principle commonly known as the Badenhorst rule, winding-up proceedings should not be used to enforce a debt that is genuinely disputed on reasonable grounds. A creditor that approaches liquidation as leverage in an unresolved contractual dispute may therefore find that the application is dismissed, potentially with an adverse costs order.

The relevant question is consequently not only whether an account remains unpaid. A creditor must consider whether the debt is due and sufficiently established, and whether the continued failure to pay points to financial incapacity rather than a genuine disagreement about liability.

Recognising the broader financial problem

Financial distress is seldom announced formally. It tends to emerge through a pattern of conduct.

A debtor may repeatedly request extensions, miss agreed payment dates or propose payment plans that are abandoned almost immediately. Management may become unwilling to provide credible financial information, while suppliers begin withdrawing credit or requiring cash in advance. The creditor may also become aware of judgments, execution attempts, unpaid employees, tax arrears, rental defaults or proceedings brought by other creditors.

Selective payment can be another important warning. A debtor may keep certain strategic suppliers satisfied while older or less commercially important creditors remain unpaid. Although this may allow the business to continue operating for a time, it can indicate that the debtor no longer has sufficient liquidity to meet all its obligations as they fall due.

No single warning sign necessarily proves insolvency. Taken together, however, these developments may show that the creditor is no longer dealing with a delayed payment or an ordinary breach of contract. It is competing with a growing body of creditors for access to a diminishing pool of assets.

Appropriate recovery routes

Ordinary litigation generally remains appropriate where liability must still be determined, the debtor appears financially stable or there are identifiable assets against which a judgment can be executed. It may also be preferable where the creditor holds effective security or can pursue a surety independently.

Liquidation may require serious consideration where the debt is established and due, there is no genuine defence and the available evidence indicates that the company cannot pay its debts in the ordinary course. In those circumstances, the purpose is no longer merely to enforce one creditor’s claim. It is to place the debtor’s assets under the control of a liquidator so that they can be investigated, preserved and distributed through a collective insolvency process.

That does not mean liquidation will always produce the best financial result. Before proceeding, the creditor should consider the value and location of the debtor’s assets, existing security over those assets, the creditor’s likely ranking, other pending claims and the probable costs of the process. A creditor that begins as the only party pursuing payment may ultimately receive only a proportionate dividend alongside other creditors.

Business rescue may also enter the assessment where the underlying business remains viable and there is a reasonable prospect of rehabilitation or a better return for creditors than immediate liquidation. A creditor qualifies as an affected person and may, in appropriate circumstances, apply to place a financially distressed company into business rescue. The existence of financial distress does not, on its own, establish that rescue will succeed; there must be a reasonable prospect of achieving one of the statutory rescue outcomes.

Reassess before the options narrow

A creditor that continues with ordinary proceedings for too long may eventually obtain judgment against an empty company. A creditor that moves prematurely for liquidation may discover that the debt first needs to be resolved through trial proceedings.

The recovery strategy should therefore be reassessed as soon as the debtor’s conduct suggests that non-payment forms part of a wider financial problem. This requires more than escalating the tone of correspondence. It calls for an investigation into the debtor’s financial position, other creditor activity, available security and the practical value of each available remedy.

The point at which a commercial dispute becomes an insolvency problem is not determined by the age or size of the unpaid invoice. It is reached when the evidence indicates that the creditor is no longer pursuing payment from a functioning business but attempting to recover value from a business that may no longer be able to meet its obligations.