As financial pressures loom large, school governors need to carefully scrutinise their school’s position. In this article, we explore what school governors should be considering in particularly straitened times and provide suggestions to help school governors mitigate the risk of any personal liability.
While this article is primarily aimed at governors of schools operating as charitable companies, the general principles are applicable across a wide variety of entities and may also be of use for those involved with finance and governance of schools generally. For the purposes of this article, we will assume that school governors are also directors of the charitable company in question and the term “school governor” may be used interchangeably with the term “director”.
Test for insolvency
Over the past decade terms such as “liquidation”, “administration”, and “CVA” have entered the public consciousness as a number of high-profile businesses have entered into these processes. These terms are used to describe different types of insolvency processes.
While there is no one definition of the term “insolvency”, in England and Wales there are two tests used to determine whether a business is insolvent: the “cash flow test” and the “balance sheet test”. A school will be considered “insolvent” if it fails one or both of these tests.
The cash flow test is whether a business can pay its debts as and when they fall due. The balance sheet test is whether a businesses’ liabilities (including prospective and contingent liabilities) exceed its assets.
Duties of school governors
Many independent schools have charitable status, and as such its governors owe a number of duties as charity trustees. As set out in the Charity Commission’s guidance, there are six “core” duties owed by charity trustees. For school governors, these duties include the duty to promote the school’s charitable purpose, acting in the best interests of the school and its beneficiaries, acting in good faith, and a duty to act in a prudent manner.
In addition to their duties as charity trustees, governors of schools operating as charitable companies also have duties as directors which are codified in the Companies Act 2006. The most prominent of these duties is the duty to promote the success of the company pursuant to s.172 of the Companies Act 2006 (or in this context, the success of the school).
When a school is trading well, the school governors’ main objective will be to promote the success of the school and in doing so, their primary consideration will be to act in the best interests of the school’s beneficiaries. By contrast, when a school is insolvent, or is facing serious financial difficulties and on the verge of insolvency, school governors have a duty to act in the best interests of the school’s creditors (otherwise known as the Creditor Duty). The Creditor Duty is engaged when the school is insolvent or bordering on insolvency (based on the tests for insolvency set out above) or when an insolvent liquidation or administration is probable. This will override the duty to act in the best interests of the school’s beneficiaries.
Insolvency processes for schools
Depending on the type of legal structure under which a school is operating, there are a variety of informal and formal insolvency processes available.
For schools operating as charitable companies, they can enter into administration and liquidation in the same way that a company would.
An administration is a process whereby an administrator (a qualified insolvency practitioner) is appointed in respect of a company’s business and assets. When a company is in administration, it has the benefit of a moratorium to protect it from any creditor action. The administrator’s objective is to achieve one of the following three statutory purposes set out in the Insolvency Act 1986:
- To rescue the company as a going concern,
- Achieving a better result for the company’s creditors as a whole than if the company were to be wound up, or
- To realise the company’s assets in order to make a distribution to one or more of the company’s secured or preferential creditors.
In reality, many administrations will result in the sale of assets to another entity.
A liquidation is a process whereby a liquidator is appointed to control the school and its assets, and to wind down the affairs of the school in an orderly manner. There are three types of liquidation:
- A compulsory liquidation (where the school is insolvent): a winding up petition is presented to the High Court (typically by a creditor).
- A creditors’ voluntary liquidation (again where the school is insolvent): similarly, directors may voluntarily resolve to put the school into liquidation.
- A members’ voluntary liquidation (where the school is still solvent): the directors may voluntarily resolve to put the school into liquidation even though it is solvent. This involves the directors swearing a statutory declaration to the effect that the school is able to settle its liabilities in full over a period of 12 months.
In any of the above three processes, a liquidator will be appointed and will seek to sell the school’s assets for the benefit of the school’s creditors as a whole.
Risks for governors in insolvency
If a school does enter into an insolvency process and it is found that the governors have not acted in accordance with their statutory duties as set out in the Companies Act 2006, it may be the case that an office-holder (being an administrator or a liquidator) may pursue claims against the school governors under the Insolvency Act 1986.
School governors may be liable under s.214 of the Insolvency Act 1986 if:
- The school continues to operate beyond the point that the governors knew or ought to have concluded that the school had no reasonable prospect of avoiding an insolvent liquidation, and
- The effect of the school continuing to operate is to cause an increase in the deficit owed to the school’s creditors.
If a school governor is found to have committed wrongful trading, a court may order that a school governor is personally liable for the increase in the overall deficit to the school’s creditors.
It is worth noting that there is a defence against wrongful trading for directors who have taken every step with a view to minimising the loss to a company’s creditors.
A liquidator may bring a misfeasance claim pursuant to s.212 of the Insolvency Act 1986 against a school governor if it can be proved that a school governor has breached their statutory duties (being those set out in the Companies Act 2006) or common law duties (including any fiduciary duties). The court has a wide discretion to make a variety of orders against directors guilty of misfeasance, including orders compelling directors to account for any losses to the company in question.
If an office-holder is appointed in respect of a school, they have the power to review and bring proceedings to unwind certain transactions entered into by the school in the period preceding its entry into an insolvency procedure.
The two most common types of antecedent transactions are (1) transactions at an undervalue; and (2) preferences.
A transaction at an undervalue takes place if, at any point in the two years preceding the company entering into liquidation or administration:
- A company makes a gift or enters into a transaction whereby it receives significantly less consideration than the value of the consideration it has provided, and
- The company was either insolvent at the time of the transaction or as a result of the transaction.
A court can make an order restoring the position to what it was prior to the transaction. Allowing a company to enter into a transaction at an undervalue can be evidence that a director has been misfeasant. It is therefore critical for school governors to ensure that they have up-to-date valuations and to carefully consider any disposal of school owned assets (and whether the transaction represents good value for the assets).
A company gives a preference if, at any point in the six months (or two years in cases where the preference is given to a connected party) prior to the company entering liquidation or administration:
- It does anything which has the effect of putting a creditor in a better position (compared to other creditors) than had that thing not been done, and
- In doing so, the company was influenced by a desire to prefer that creditor.
When a school is in financial distress, school governors should therefore think carefully before repaying any creditors in preference to others and document the reasons for making any payments to specific creditors (for example, critical suppliers) in board minutes.
Disqualification and Charity Commission
When a school enters an insolvency process, the appointed office-holder is obliged to send a report to the Insolvency Service on the conduct of directors. If a school governor is suspected to have been guilty of wrongful trading, been misfeasant, is suspected of having engaged in fraudulent conduct, or has caused the school to enter into an antecedent transaction, the Insolvency Service may seek to commence disqualification proceedings in respect of the director in question pursuant to the Company Directors Disqualification Act 1986 (CDDA). Orders made under the CDDA can last for a duration of up to 15 years and results in a prohibition from being a director of a company in England and Wales, as well as being involved in the formation, marketing, or management of a company. A disqualification order also means that an individual is prohibited from being a trustee of a charity.
In addition to the Insolvency Service’s ability to bring disqualification proceedings against a director under the CDDA, the Charity Commission also has broad powers to intervene in the management of a school. These powers include the ability to remove a trustee or employee of a charity and to make its own disqualification order in respect of such an individual.
Tips for governors of schools in financial distress
Identifying financial issues at an early stage and exploring the options available to a school while it remains solvent are critical for school governors.
Below we set out a number of practical suggestions for school governors seeking to mitigate the risk of personal liability arising out of a school’s insolvency:
- Regularly reviewing up-to-date management accounts to have an up-to-date understanding of the school’s financial position and to identify issues at the earliest possibility,
- Ensuring that cash flow is reviewed regularly and discussed at meetings of governors,
- Monitoring the position regarding cash reserves,
- Discussing the possibility of commissioning an independent business review to understand where the school has weaknesses and inefficiencies,
- Carefully considering any new items of expenditure and carefully documenting the reasons for them, specifically the impact it will have on the schools’ creditors,
- Not disposing of any valuable assets at an undervalue or to connected parties,
- Instructing professionals at an early stage to assist in putting together the options for the school with a view to putting the school into an insolvency process if necessary,
- Reviewing the extent to which the school has insurance for school governors (and in particular whether any such insurance provides coverage in the event of insolvency, as well as the duration of any run-off cover),
- Considering whether any advance payments made to the school should be ring-fenced and held in separate accounts to avoid potential claims by creditors.
If you require further information about anything covered in this briefing, please contact Zaid Dadah or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, April 2023