UK: Charitable Companies Facing Financial Difficulties: A Refresher

Last Updated: 4 September 2014
Article by Michael Arnott

There had been much talk of an economic recovery since the start of 2014.  GDP is up; property prices keep rising; and there's even a chance that interest rates may increase for the first time in nearly five years.  Sadly, the reality for a lot of charities is that donations remain low and costs have already been cut as much as possible.  For some charitable companies, the spectre of insolvency has yet to be dispelled.

In times of financial difficulty it can be hard for trustees to know what to do when.  It is important to remember that in insolvency trustees, as directors of charitable companies, will be judged by the same standards as those that apply outside the charitable sector.  They can be found personally liable in certain cases.

Avoiding financial difficulties

Insolvency is obviously something best avoided and on paper this can be achieved, simply, by either increasing revenue or cutting costs.

Reinvigorating fundraising initiatives, making fresh appeals, and attracting high value  donors can all turn around the fortunes of a flagging charity; but for many charities there is little more that can be done that has not already been tried.  In some cases, only a significant investment in fundraising is likely to be successful, and if the funds are absent to start with, options are limited. 

Borrowing money for this purpose should not be done lightly.  If loans are taken out and the charity is still unable to avoid insolvency then the trustees could possibly be (personally) liable for wrongful trading (see below).  Charities, like any business, must have a very clear, rational and plausible plan for recovery before they borrow to implement it.

If revenue cannot be increased, then perhaps costs can be cut.  The extent to which costs savings can be made will vary from case to case.  At the extreme end of the scale, some small charities have been able to eliminate their costs entirely for a period whilst fresh funding was sought – all their remaining staff agreed to work for free, and from home.  Clearly, however, few charities will be able to reduce costs to zero, and when there are ongoing costs the trustees need to pay particular attention to their duties and the risks which come with insolvency.

When is a charitable company insolvent?

Charitable companies are judged no differently from non-charitable companies.  Insolvency is not a simple concept, and it is not easy to identify the exact point in time at which a charity becomes insolvent.  There is, for example, no statutory definition of "insolvency". 

Instead, the Insolvency Act 1986 refers to a company being "unable to pay debts".  This occurs when:

  • it is unable to pay its debts as they fall due (the cashflow test);

     OR

  • the value of its assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities (the balance sheet test).

As we summarised in our Autumn 2013 edition of this Bulletin, the cashflow test is probably the more comprehensible of the two.  Simply, if the company cannot pay its debts as they fall due, then the test is failed.  If the Court is satisfied of this, then a creditor will be allowed to put the company into liquidation or administration.  The cashflow test is also prospective in nature, considering debts which fall due in the "reasonably near" future.  How far into the future will depend upon the specific circumstances.

The balance sheet test is less palpable:  to what extent should contingent and prospective liabilities be "taken into account" when assessing assets against liabilities?

In a recent decision, the Supreme Court ruled that whenever the balance sheet test is applied there needs to be an analysis of whether or not, on the balance of probabilities, each future or contingent liability is ever likely to fall due and, if so, when. That decision means that the line marking the edge of solvency becomes even more blurred.

Response to potential insolvency

In reality many companies continue to trade when they fail one or both tests by stretching credit terms to obtain time to collect in the required cash.  If that strategy works and insolvency is avoided, then the directors' conduct is not scrutinized as it is in a formal insolvency process.  The directors are also not subject to Court action taken by a liquidator or administrator on behalf of the company's creditors:  no liquidator or administrator is ever appointed, and many of the statutory provisions giving rise to liability for the directors will not take effect. 

In this example, the simple fact that insolvency is avoided does not mean that the directors acted properly.  A more plausible analysis is that they did in fact breach their duties in order to try to rescue the company, but that the consequences of those breaches are minimised because insolvency is avoided.  This is a risky strategy and not one that a well-advised trustee should adopt. 

If this strategy fails, there are potentially serious consequences for the directors.  In insolvency, what applies to companies and their directors also applies to charitable companies and their trustees. The consequences of taking this approach and failing can be much worse for the trustees than if they had simply acknowledged insolvency early and appointed an administrator or liquidator.  That way, the trustees' duties are not breached and they are consequently not likely to suffer any risk of personal liability.  It is much better to put the charity into a formal insolvency process, than to try to trade out and fail.

Consequences of insolvency

A formal insolvency will oblige the liquidator or administrator to investigate the causes of the charitable company's insolvency.  It will also give rise to a number of insolvency-specific offences which trustees may have committed in the run up to the insolvency.  The one which usually concerns trustees the most is "wrongful trading". 

Wrongful trading, confusingly, has little to do with the trading of the charity.  A trustee who knew or should have known that the charitable company had no reasonable prospect of avoiding insolvent liquidation is liable for wrongful trading simply by virtue of being a director (or shadow director) at the time.  However, if the trustee takes every step with a view to minimising potential loss to the charitable company's creditors, he/she has a defence to a wrongful trading claim. 

If a charitable company might be insolvent – ie might fail one or both of the cashflow or balance sheet tests – the trustees need to consider carefully (taking into account all the relevant factors) whether or not they have a plan which gives the company a reasonable prospect of being restored to financial health.  That analysis is a difficult one and should be taken with the benefit of legal advice and guidance from an insolvency practitioner.  These professional advisers can objectively assess the trustees' opinion that there is a reasonable prospect of avoiding insolvency.  If there is a subsequent insolvency, then the endorsement of independent professionals prior to the insolvency will be useful evidence in defence of a claim for wrongful trading against the trustees. 

In addition to wrongful trading, there are a number of other potential consequences of insolvency that should inform the conduct of the trustees when the charity is in financial difficulty:

  • Transactions entered into by the charitable company where it gave significantly more value than it received can be overturned.  An example would be selling a property for less than it is worth.  Trustees should ensure that anything they sell is sold for market value, and they should not otherwise dissipate the assets of the charity. 
  • No creditor should be put into a better position than they would otherwise be in on insolvency, without good reason.  In other words, the charity should not do anything with the intention of preferring a creditor, such as paying them off first or giving them assets in payment of their debt. 
  • New credit and liabilities should not be incurred.  This is likely to prejudice the existing creditors and in a subsequent insolvency could eliminate the defence to wrongful trading.

In insolvency trustees may be ordered by the court to make a contribution to the assets of the charity if their conduct falls foul of any of these obligations.  They can also face directors' disqualification proceedings for serious breaches, which, if upheld, could have serious consequences for their business or professional lives.

Summary

Trustees should remember that if their charity is a charitable company, then they will be judged to the same standards as directors of non-charitable companies on insolvency.

Where a charitable company is in serious financial difficulty, the interests of the charity's creditors become paramount.  All action which the trustees carry out should prioritise the interests of the charity's creditors above all other considerations.

Finally, the temptation to trade through difficult times should be resisted unless there is a viable plan to avoid insolvency which has been reviewed and approved by independent advisers.

This article was first published in the Summer 2014 issue of RECOVERY. It is reproduced with the permission of R3 and GTI Media.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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