Charity trustees' duties in financial crises: lessons from recent cases

Insight

26.07.2024

Trustees of charities will already be aware that if a charity starts to experience financial difficulties the trustees need to start to consider not just the interests of the charity but also the interests of the charities’ creditors.

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 at first instance in the BHS case.

Whilst both these cases concerned for-profit companies (and in this note we therefore refer in places to the duties of directors rather than trustees), the legal duties and practical guidance are equally applicable to charities incorporated as companies. It is important that trustees are mindful of these developments. These judgments may also have some application to other incorporated charities including Royal Charter bodies and charitable incorporated organisations.

Sequana, wrongful trading and the Creditor Duty

Once a charity starts to experience financial difficulties, trustees must comply with the wrongful trading test. This requires a board to continually consider whether the charity has a reasonable prospect of avoiding insolvent liquidation and if at any time that test cannot 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 generally thought that in addition to wrongful trading, once a charity started 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 also to start to consider the interests of creditors.

In Sequana the Supreme Court confirmed:

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.
This Creditor Duty arises once a company is insolvent or bordering on insolvency.
The Creditor Duty is distinct from the Wrongful Trading test and could apply at an earlier point in time.
Once the Creditor Duty applies, a board must begin to consider the interests of its creditors.

The Supreme Court left open a number of points and the BHS decision provides some helpful further guidance to boards.

BHS decision, the Creditor Duty and Trading Misfeasance

The BHS case received a lot of publicity as it arose out of the collapse of the British Home Stores group and the reporting focussed on the application of the wrongful trading test.

The decision did, however, also provide guidance on the Creditor Duty and its enforcement and started to use an alternative term: Trading Misfeasance.

Trustees should be aware of some 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.
When applying Trading Misfeasance, the Court focussed on the fact that at the relevant time the board knew that the company was cashflow insolvent. Whilst there was still some prospect of a turnaround plan being implemented (and hence there was at that time no liability for Wrongful Trading) 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 at certain times:
- 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.

Key points to note

The key takeaway from these two decisions 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.

It is important to take professional advice at an early stage and for that advice to be considered by all board members. These cases are also a timely reminder of the importance of holding and attending regular board meetings, and of maintaining accurate minutes that, when appropriate, evidence that the interests of creditors have been duly considered.

Charity trustees should also consider whether to file a report of a serious incident with the Charity Commission if financial difficulties are threatening the charity's continuation or its ability to maintain core services.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.