Stephen Claus – Charities: More to Know About Financial Difficulties

Not us?  Right?  Well, maybe not.  Charity Trustees are not exempt because Trustees are volunteers, or they do good work.

We have previously discussed the importance of Trustees taking appropriate independent advice in relation to investments. Given recent market volatility, drawing down on reserves during market contractions could materially affect a charity’s longer-term sustainability. This can lead to scrutiny on the policies adopted, leaving the Trustees exposed. Let’s look at another aspect concerning potential claims against Trustees when Charities are experiencing financial difficulties.

The cost-of-living crisis is everywhere, and we are not out of the woods yet. In fact, in some respects, it has become worse.  Donors have less money to donate, and Charity is finding it especially difficult to tighten its belt.  Look at foodbanks, donations halved as need doubles. So, what do you do?  Well, I suggest you must protect your own assets in these circumstances from a claim arising because you did not follow the law.

The law requires Trustees of Charities to be aware and note that, if you start to experience financial difficulties, then your obligations as a Trustee switch so that you must start to consider the position of creditors, also.  Once you reach the point when you do not believe you can meet your debts, or are in doubt, then you must no longer consider the interest of beneficiaries solely but must consider the interests of the Charities’ creditors.  Not to do so can result in very serious personal consequences for you as a Trustee. For example, you may have to use your own money to pay those debts in the event a claim is made.

Two recent court decisions have provided some important guidance on the application of this principle: the Supreme Court decision in a case called “Sequana” and a subsequent decision in a lower court of first instance, “the BHS case.”

Neither case concerned a Charity, but rather, a normal trading company, but note directors’ duties in a charitable company are no different to a standard company.  Therefore, prudent Trustees must be mindful of these developments. Those whose Charities are CIO’s (Charitable Incorporated Organisations) should also take note.

The Sequana Case

This case concerns wrongful trading and the Creditor Duty. Once you start to experience financial difficulties, the Board must look to comply with the wrongful trading test. This requires a Board to continually consider whether the Charity has a reasonable prospect of paying its debts and, therefore, avoiding insolvent liquidation.  If at any time you do not consider that test can be met, then the Board must take steps to minimise the loss to creditors. Failure to comply with this duty can result in the Trustee incurring personal liability.

Prior to Sequana, it was the case that you must also look to the wrongful trading issue, which is: once you began to experience financial difficulties, the Board had a separate duty to act in the best interests of, not just the Charity and its beneficiaries, but now also the interests of creditors.

In the Sequana case, the Court confirmed:

1. There is a separate statutory duty, which has been called the “Creditor Duty.” The Court, in particular, referred to the pre-existing duties contained in sections 171 to 177 of the Companies Act.
2. This Creditor Duty arises once a company is insolvent or bordering on insolvency.
3. The Creditor Duty is distinct from the Wrongful Trading test and could apply at an earlier point in time.
4. Once the Creditor Duty applies, a Board must begin to consider the interests of its creditors.

The Court has not answered all the questions in Sequana judgement, but the BHS decision provides some helpful further guidance to Boards.

The BHS Decision

This concerns the Creditor Duty and Trading Misfeasance. This decision did provide guidance on the Creditor Duty and its enforcement and started to use an alternative term: “Trading Misfeasance.” This is new to Charity people, and others!

Trustees note some of the key points:

• In reviewing the Creditor Duty test, the Court described the potential liability as a Trading Misfeasance Claim, partly because the method of enforcement was pursuant to a misfeasance claim under s.212 of the Insolvency Act.
• The Court confirmed that a Trading Misfeasance Claim could arise at an earlier point in time than the Wrongful Trading test, so you must start to take action once you identify there could be a problem.
• When applying Trading Misfeasance, the Court focussed on the fact that, at the relevant time, the Board knew that the company was cashflow insolvent. You should pay attention to management accounts and make sure you are comfortable that debts can be paid by looking at budget against spend and monitoring it carefully so that you know you can meet liabilities.

So, in this case, whilst there was still a prospect of a turnaround plan being implemented, (and hence there was at that time no liability for Wrongful Trading), the Court found the board knew, (or should have known), that insolvency was probable and, therefore, should have begun to consider the interests of creditors.  The Board members, therefore, incurred personal liability for Trading Misfeasance.

In considering the actions of the Board, the Court also noted that:

• The Board did not take appropriate professional advice before making key decisions.
• When advice was taken, the Board failed to act on that advice.
• The Board failed to convene Board meetings to consider some key decisions and, where Board meetings were held, there was a failure on some occasions to take proper minutes.
• Where minutes were kept, they did not evidence that the Board had considered their duty to act in the best interests of creditors.
• Certain directors failed to attend key meetings without any explanation.
• Some directors failed to exercise independent judgment and did not ask to see key legal advice to ensure they had access to all relevant financial information, allowing them to make informed decisions.

The key issue from these two cases is that, as soon as a Charity starts to experience financial difficulties, the Board needs to consider whether the Creditor Duty applies and whether the interests of creditors need to be considered. Careful minutes are important, and I suggest that early legal and financial advice is vital.

It is important to take professional advice at an early stage and for that advice to be considered by all Board members, and that must be in the minutes. Regular Board meetings should be held, and Trustees should attend!  Accurate minutes are essential.

There is no substitute for formal advice, and you should not seek to rely on this briefing which cannot apply to all cases.  You should take professional advice when the need arises.

Please Note

There is no substitute for taking specific legal advice in respect of issues, and this note is only meant to be a general summary of the law and not legal advice.

These are the views of Stephen Claus and therefore do not constitute individual legal or financial advice, this article is for information only. If you require guidance or advice, please get in touch.

Or, click here to go to our Charities and Trusts page to read about our approach when it comes to guiding and advising Trustees.

The Financial Conduct Authority does not regulate trusts.

Stephen Claus

September 2024.