What is insolvency?
Insolvency describes a situation in which an organisation (or individual) cannot pay debts as and when they fall due (the cash flow test) or if there is an actual or anticipated deficiency of assets over liabilities (the balance sheet test).
When an organisation is insolvent, there are several processes which can be followed to wind up the organisation and distribute funds – cash and money from disposing of any other assets – to the people and organisations who are owed money.
If a charity, voluntary group or organisation is incorporated and the trustees recognise that it is, or will become, insolvent, then they can work with a specialist insolvency practitioner to put the organisation into voluntary liquidation.
If the charity is failing to pay its debts, then a creditor may petition the court for the organisation to be placed into compulsory liquidation.
If the charity has a reasonable prospect of being able to trade out of its difficulties, or restructure its financing, then it may go through voluntary arrangement, administration or receivership, again using the services of a specialist insolvency practitioner.
In Scotland, there is a slightly different route, known as sequestration, which is supervised by the Accountant in Bankruptcy (AiB), an agency of the Scottish Government. This is similar to compulsory liquidation in the rest of the UK. Voluntary arrangement, administration and receivership are also options available to charities in Scotland, as they are in the rest of the UK.
Why does insolvency matter?
There are two different ways in which insolvency can be relevant to charities:
- If the charity itself is insolvent
- If the charity is a creditor of an individual or organisation which becomes insolvent.
Charities are not treated differently from businesses if they become insolvent. The impact on the trustees individually will depend on the legal structure of the charity.
If it is a company limited by guarantee, then there is usually no or very little personal liability for the trustees. However, if the charity is unincorporated then trustees can be held personally liable for the debts of the charity, if these cannot be met from funds and assets of the charity.
Trustees and senior members of staff must be mindful of the charity’s financial position, the state of the cashflow and the risk of insolvency. Legislation sets out conditions which give rise to various offences including fraudulent trading, which could lead to trustees and senior staff being subject to criminal prosecution. This covers both deliberate acts intended to defraud creditors, and negligence, where trustees and senior staff ‘knew or ought to have known’ that the organisation was insolvent.
If the charity is owed money, for whatever reason, by a person or organisation that becomes subject to insolvency proceedings, then the charity is known as a creditor. In the vast majority of cases, the charity will be an ordinary/unsecured creditor.
The distribution of the insolvent body’s assets follows a legally-fixed hierarchy, with ordinary/unsecured creditor at the end of the queue. Having a realistic understanding of if the debt is likely to be repaid, and whether that will be in full or only in part, will help trustees and senior members of staff to assess the potential impact on the charity.
Who needs to know about insolvency?
Trustees and senior members of staff should understand the conditions which give rise to insolvency. There should be procedures in place to share accurate information about the charity’s finances regularly.
Where do we start?
The Charity Commission says:
'provided there are proper financial controls in place, trustees should be able to identify financial risks and plan for their management at an early stage, despite changes in the economic environment in which the charity is operating. The overall responsibility for effective governance and the implementation of proper financial management rests with the trustees, but may well involve all staff members whether paid or volunteers.'
Managing a charity’s finances: planning, managing difficulties and insolvency (CC12)
The Office of the Scottish Charity Regulator also provides some information about charities and insolvency.
If your charity becomes insolvent, or if you are affected by an insolvency which has a serious impact on your charity’s ability to operate, you should report this to the Charity Commission as a serious incident.
In more detail
Charities and Insolvency, Crowe and CFG, 2020
Managing Charity Finances, Charity Commission
How to report a serious incident in your charity, Charity Commission
Charity Commission CC12
OSCR (Scottish Charity Regulator) Good Governance Guide
Build your skills and knowledge
Advanced Charity Finance, one-day CFG course, 23 September 2022
Foundation Charity Finance, one-day CFG course, 6 October 2022
Inspiring Financial Leadership 2022/23, CFG's flagship training course in partnership with Centre for Charity Effectiveness and Sayer Vincent
Sharing is caring!
Have you found any resources you think our other small charity members will find helpful? Let us know!
Please send details, including the web link, and we might feature them here.
Have you seen our other CFG Guides for Small Charities? Head back to our main page.