Hindsight is a wonderful thing: Trustees’ duties when insolvency is in prospect

Thankfully the Covid-19 pandemic has not led to the levels of charity insolvencies that were feared in March 2020. However, many charities do find themselves in a difficult financial position. This might be because of an unexpected liability or the loss of a major contract or source of funding. When a charity becomes insolvent, the trustees’ actions taken in the preceding days and months will come under scrutiny, and if their conduct is considered to have fallen below the standard expected, or made the charity’s financial position worse, then they could face personal liability. This note provides guidance on what trustees can do to ensure they properly oversee their charity’s operations and finances to protect against these risks.

Trustees’ duties

However a charity is formed, trustees will have a number of duties with which they are obliged to comply, including:

• fiduciary duties that place on trustees a higher standard of care
• a duty to promote the charitable purposes of their charity, usually set out in the charity’s governing document
• various statutory duties, for example under the Charities Act 2011, the Trustee Act 2000, and (if the charity is an incorporated company) the Companies Act 2006

This means in particular that charity trustees must:

• act in the best interests of their charity and its beneficiaries
• protect and safeguard the assets of their charity
• act with reasonable care and skill

Charity insolvency and the “twilight zone”

These considerations become more acute when insolvency is approaching, because at that stage creditors’ interests take priority, and trustees must do everything they can to minimise loss to creditors. Charities rely on various funding streams but nothing is certain forever, so there is always a risk of insolvency if future funding changes or costs suddenly increase. This is particularly important in a challenging economic climate.

However, the difficulty for trustees is that this pre-insolvency period (known as the “twilight zone”) is not defined anywhere. Instead, if and when a charity enters an insolvency process, the office-holder will review the charity’s financial history and determine when the trustees should have been aware of the impending insolvency. Therefore it is difficult to say precisely when the trustees’ focus should switch from the charity and its beneficiaries to creditors.

Some guidance can however be gleaned from the legislation. English insolvency law is governed by the Insolvency Act 1986, which essentially defines insolvency as an inability for a charity to pay its debts. This generally means either a) the charity cannot pay its debts as they fall due for payment (known as “cash flow insolvency”), or b) the value of its liabilities exceeds the value of its assets (known as “balance sheet” insolvency). Although everything is fact-specific, bearing these tests in mind may be a useful yardstick against which trustees can assess whether insolvency is approaching, and therefore when their focus should turn to creditors.

Risks to trustees

The reason why trustees’ duties come into sharp focus when insolvency becomes apparent is because of the potential risks to trustees personally if an insolvency office-holder subsequently considers they acted improperly and worsened (or even caused) the charity’s financial collapse. Claims that can be brought against trustees by insolvency office-holders include:

• Misfeasance, which is a deliberately broad type of claim that encompasses any conduct by a trustee that causes harm to the charity, and allows a liquidator to recover from the trustee any loss they have caused the charity. This type of claim is generally based on alleged breach of one or more of the above mentioned duties owed by a trustee.
• Wrongful trading, which concerns the situation where a trustee ought to have realised, during the twilight zone, that the charity could not avoid insolvency. If the trustee decided to carry on operating the charity, and this had the effect of worsening the creditors’ position, the trustee can be personally liable for the consequential increase in losses to creditors.

Risk management

So what can trustees do to protect themselves against the risk of claims being brought against them?

Insolvency office-holders apply hindsight when assessing trustees’ actions. Therefore, in order to reduce the risk to trustees, it is very important to take appropriate steps when insolvency is, or might be, on the horizon. These are likely to include trustees ensuring:

• key decisions are properly documented
• early professional advice is taken, including from insolvency practitioners who may be able to assist with restructuring the charity’s finances with a view to avoiding a formal insolvency process
• the charity’s finances are continually monitored, and regular accounts are prepared, and contingency / wind down strategies produced to prepare for the worst-case scenario
• they challenge their management and finance teams, and that their voice is heard in meetings, and keep clear minutes of discussions
• they remain fully committed and well-informed about the management of their charity

The Charity Commission’s website also has a very useful guide which sets out in detail the standards expected of trustees when their charity is experiencing financial difficulties.

Thinking ahead

There are a number of risks to trustees when a charity faces insolvency. However, with careful planning, taking professional advice, and properly documenting decisions and explaining why they were taken, trustees can minimise the risk of their actions and decisions being challenged by an insolvency office-holder in the future.

Russell-Cooke has a specialist insolvency team which regularly advises boards and trustees on their duties, both when insolvency is in prospect and otherwise. We also have a number of insolvency practitioner contacts with expertise in charity finances and restructurings who can assist charities with resolving their financial problems.