However, the decision identified many issues that trustees of charities in financial difficulty need to be aware of, and the purpose of this article is to look at the lessons that can be learnt to mitigate the risk of personal liability against a charity trustee where finances are tight.
What legal principles should trustees of a charity in financial distress be aware of?
Trustees of a charity in financial distress need to be aware of certain key legal principles in both charity law and the insolvency legislation. In summary, these are as follows.
Although day-to-day management of a charity can be delegated to a senior management team (or teams), the charity trustees continue to have ultimate responsibility for its management.
They have a duty to act in the interests of their charity and its beneficiaries, protect and safeguard the assets of their charity, and act with reasonable care and skill. Understanding and managing the charity’s financial health is therefore crucial to complying with these duties.
The Charity Commission has published guidance on what trustees need to consider when facing financial difficulties or an “insolvency” scenario (this term is used loosely, and the Commission uses it to refer to all charities, regardless of legal structure). The guidance should be read in full by the trustees of any charity facing financial difficulties.
Where a charity has to close, the Commission’s guidance makes clear that it expects charity trustees to have planned for an orderly shutdown.
The guidance also sets out the role of the trustees, including:
- recognising that charities may have to wind up and planning for what will happen to the charity’s beneficiaries – especially if they are vulnerable – as well as staff and assets
- recognising at an early stage when the charity is facing financial difficulties - in particular, whether their charity is a ‘going concern’
- regularly receiving and considering up-to-date financial management information
- reviewing sources of income, planned and proposed expenditure and risk and reserve policies to see if there is anything that can be done to rectify the position
- taking rescue action when the charity cannot pay its debts as they fall due and/or the value of its liabilities is more than that of its assets and getting professional advice where there is a risk of potential insolvency
- recognising that once the charity has reached the stage of liquidation or winding up, their primary duty is to pay the charity’s debt
In an insolvency situation, payments to creditors are the trustees’ primary responsibility and should be scheduled in accordance with their priority. Every step necessary to minimise the potential loss to the charity’s creditors should be taken. This may involve cutting back or stopping some or all of the charity’s activities.
Paying professional fees for advice obtained is justifiable if incurred with a view to ensuring the best outcome for the charity’s creditors.
In the case of Kids Company, the charity was an incorporated company limited by guarantee, which meant that the Companies and Insolvency legislation applied, in addition to the Company Directors Disqualification Act 1986 (“CDDA”).
And in the case of Charitable Incorporated Organisations, the Insolvency legislation is largely implemented in the same way as for a company.
However, certain types of unincorporated charities – including those incorporated by Royal Charter or Act of Parliament, and unincorporated associations, but excepting charitable trusts – could still be wound up as an “unregistered company” under the Insolvency Act 1986 (the “Act”).
If this was to happen, then the provisions of the Act and the CDDA would apply and our advice and recommendation to charities in financial distress is therefore that the trustees proceed as if the Act applies and as if their charity were incorporated as a company.
In these circumstances, the main provisions of the Act that the Trustees need to bear in mind are:
- misfeasance – personal liability for a failure to act in the best interest of creditors
- wrongful trading: personal liability if the trustees continue trading beyond the time when they knew or ought to have known that there was no reasonable prospect of avoiding an insolvency process and did not take every step with a view to minimising the potential loss to the creditors
Unincorporated charities – trusts and associations
Neither a charitable trust nor a charitable association has a legal personality, and so the trustees themselves enter into contracts on behalf of their charity, and are personally liable for the liabilities of their charity.
While the charity has assets, the trustees are entitled to be indemnified out of those assets for all liabilities and debts properly incurred in the performance of their trustee duties.
When the charity has insufficient assets, the trustees have potentially unlimited liability for any of the charity’s liabilities that remain unpaid, and can face personal insolvency.
For this reason, even if the same Company and Insolvency legislation cannot apply to charitable trusts as it might for an unincorporated charitable association, it would still be prudent for trustees of charitable trusts to be alert to signs of their charity being in financial difficulty, follow the Commission guidance, and take into consideration the points made in the remainder of this article!
Management vs trustees: who’s in charge of the charity?
One of the areas that the judgment in the Kids Company decision focused on was that charity’s management structure.
Executive power and decisions rested with the trustees but, like many charities, the charity employed a CEO and a management team to run the charity day-to-day.
The issue was highlighted in the judgment because the Official Receiver bringing the proceedings alleged that the CEO was a “de facto” director (someone who was not an actual director, but acted as if they were).
Under the Companies and Insolvency legislation, de facto directors and “shadow” directors (those who direct the directors how to act even though they are not themselves directors) are dealt with in the same way as actual directors and can be personally liable for their actions and the actions of the other directors, even though they are not directors themselves.
In the Kids Company decision, the Official Receiver argued that the CEO was, in effect, a director and could therefore be disqualified as if she were an actual director. The Judge disagreed, on the facts of the case, and refused to find that the CEO was a director.
However, the fact that the argument was pursued to trial demonstrates how important it is for charities to have a clear management structure and for everyone to know and understand their role and their liability, particularly if a charity gets into financial difficulty and ends up in an insolvency process, as Kids Company did.
In a non-charitable corporate, those with executive power in the company would normally be directors and the company may employ, depending on its size, people to run the day-to-day operations. However, those people would usually report to the directors, who would make the executive decisions on the most important issues.
In times of financial distress, we advise and encourage directors to have an even more detailed view of the day to day operations of the company and to take decisions on all aspects as it is not known which decision could give rise to personal liability if the company fails.
With charities, we often find the inverse is happening – the management team are making the executive decisions about the running of the charity and simply asking the trustees, who sometimes consider themselves to be “non-executive”, to approve what the management team propose.
However, should the charity get into financial difficulty and ultimately fail, you could have a situation where:
- the ultimate decision makers, the trustees, are personally liable for the executive decisions made when they did not consider themselves to be the decision makers, and
- the management team are found to be de facto directors and personally liable for their actions as such, when they believed that they were not the ultimate decision makers.
That is the essence of many of the allegations made against the trustees in the Kids Company decision. So how is it avoided?
Ways to avoid confusion over roles and liability
- All decision makers, whether they are trustees or not, should make sure they are aware of the risks and consequences of their actions, and proper structures should be put in place to best protect everyone concerned
- Management can continue to bring matters to the trustees to decide on, but it should be made clear that management are making the recommendations, but the trustees are making the decisions
- The trustees should properly understand their duties and responsibilities, in the circumstances, and scrutinise the recommendations and discuss the issues before making the decisions. The trustees should meet as regularly as is required, which may necessitate more frequent meetings whilst a charity steers a path through financial uncertainty
- The trustees should also fully record their decisions and the reasons behind those decisions so those dealing with any subsequent insolvency process, with the benefit of hindsight, can understand what was done and why
- Lastly, the board should take professional advice, legal and/or accountancy. That may seem a difficult decision to take when money is tight, but it is established case law for companies that the courts expect boards of directors to take advice in times of financial distress, and charity trustees should be no different. It is no coincidence that the Judge specifically referenced the legal and accountancy advice taken by the trustees in the Kids Company judgment before finding in favour of the trustees.
A “corporate” approach
Many charities are not companies, but if they get into financial difficulty, regardless of their size, the Kids Company decision has shown the importance of taking a “corporate” approach to structure and governance.
This should best mitigate against the personal liability that can visit on charity trustees, whether paid or unpaid, if their charities get into financial difficulty and eventually go into an insolvency process.
Very few do so, but if a charity trustee is unlucky enough to be involved in such a situation, they should be doing all they can not only to protect the charity but also to mitigate their own personal liability, particularly when they are not remunerated for what they do. Forewarned is forearmed.