Opinion

We are technically insolvent

Governance | 1 Mar 2009

The Charity Commission responds to an insomniac chair, wracked with worry about trading while insolvent.

Dear editor,

In late 2006, with ever-increasing rents being charged for office space and with mortgages readily available, we decided after very careful thought and having vigilantly scrutinised the business plan, to purchase our own building. Although we were stretching ourselves financially, we were very much a ‘going concern' and the future looked good.

The credit crunch happened. The property market has nose-dived. Voluntary income has already shown signs of dropping and the value of our investments (endowed funds) has slumped. We now find that technically the charity is insolvent because our liabilities amount to more than our assets. If we can hold on until the stock market and property market recover, we will be fine.

However, I am concerned that if we continue to trade while ‘insolvent', we might be personally liable. We are also worried that if the bank that provided our mortgage hears about the situation, it might recall its loan.

What do you advise?

Yours sincerely,

A chair who can hardly sleep at night

Dear chair,

It's possible that some charities may see their balance sheets go into deficit if the value of a property or their investment portfolios decline. There are two tests of insolvency that apply to company charities - the balance sheet test (positive net assets) and the cash flow test (ability of a charity to pay its debts as and when they fall due).

When a charity has net liabilities then it is important that the trustees assess whether continuing their activities will make the position worse. If activities continue when the trustees ought to have known there was no reasonable prospect of avoiding insolvent liquidation then the risk of wrongful trading arises.

However, despite failing one of the solvency ‘tests' and appearing insolvent an organisation may often be able continue as a going concern and not have to wind up - particularly if liabilities can still be met as they fall due and there is a reasonable plan for the way forward. Cash flow is vital, for example, a decline in the value of a property occupied for functional purposes may have no effect on cash flow - but the ability to meet any mortgage payment would be vitally important. Property should be funded on a long-term basis and the risk of loans being recalled will often arise where payment schedules are missed - again, if they are doubts about the ability to meet the repayments, that is a sign that professional advice is needed.

What trustees must do is take a careful look at their forward budgets and satisfy themselves they can ‘trade out' of the position they are in. They need to monitor how they are performing against budgets on a regular basis and if the position worsens or they have any doubts about meeting the budget then they should talk to their professional advisers who may recommend talking to an insolvency practitioner. Charities also need to understand the different funds they control and manage - for example, there will be limitations on how the funds of a special trust can be used.

Communication within the charity becomes more important than ever and it's vital that all trustees understand the position and the steps being taken to address it. It's likely that trustees will need to meet more frequently and that management gives them the information they need to monitor the financial position.

What trustees cannot do is ignore a worsening position or give preference to particular creditors. The term ‘insolvency' only strictly applies to company charities but the same principles apply to non-company charities if trustees want to ensure they avoid personal liabilities. Our guidance Managing Financial Difficulties and Insolvency in Charities (CC12) is a good place to start. But if trustees are unsure or simply worried then that is often the time to at least have a word with your auditors or professional advisers.

Yours sincerely,

The Charity Commission

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