Financial distress & duties to creditors - a reminder to look beyond your charity's beneficiaries

As the charity sector continues to find itself under financial stress, it is important for trustees, and those involved in the governance and management of charities, to be aware of their fiduciary duties to ensure that they act properly in line with insolvency and charities legislation, and in compliance with the Charity Commission's requirements.

Trustees will be aware of the Charity Commission's guidance notes, and particularly CC12, which offers helpful practical advice on improving a charity's finances. However, we have found that when a charity is facing financial uncertainty, trustees often focus on safeguarding the interests of beneficiaries without much regard for creditors, which, as the Supreme Court found in the Sequana Judgment in 2022, is problematic.

The Sequana Judgment remains a key reference point for understanding how trustee's duties evolve when insolvency becomes a real risk. Its findings continue to provide valuable guidance for trustees, emphasising the importance of recognising when creditor interests take priority and the practical steps trustees should take to safeguard the charity’s financial position.

What is the Sequana Judgment?

In 2022, the UK Supreme Court handed down its decision in BTI 2014 LLC v Sequana SA [2022] UKSC 25. Whilst it was a case involving a company in the "for profit" sector, its principles are widely regarded as applicable to charitable companies and other not for profit organisations. The judgment confirmed that directors, and by extension trustees, have a duty to consider the interests of creditors when the charity is facing insolvency, or when insolvency is a real possibility. This duty does not necessarily replace the duty to beneficiaries (or in the case of companies, shareholders). Rather, the duty sits alongside it and, in certain circumstances, which we explore below, the interests of creditors will take precedence over other stakeholders.

Three key thresholds to understand

The judgment identifies three stages, in the lead up to formal insolvency, that trustees should be aware of:

Real risk of insolvency: Even before insolvency becomes likely, trustees must begin to give weight to creditors' interests when there is a genuine possibility (not merely a theoretical one) that the charity could become insolvent. In practice, the charity may still be solvent, but the risks of insolvency on the horizon must be acknowledged.
Probable insolvency: Where insolvency has become more likely than not, the duty to creditors becomes more pronounced. At this stage, trustees must actively balance the interests of creditors against those of beneficiaries and cannot simply press ahead with decisions that benefit beneficiaries at the expense of those owed money.
Inevitable insolvency: Where insolvency is unavoidable, creditors' interests must become the primary focus for the trustees. Decisions that would deplete assets or prejudice creditors are very difficult to justify at this stage, and trustees who proceed without appropriate care may face personal liability.

What should Trustees look out for?

The nuances of each of the above stages are often difficult to identify, and a charity could, very quickly, move from one stage to another. For this reason, it is important for trustees to have access to up to date and accurate financial information on a regular basis. Trustees should also be mindful of the status of funds and assets which are held on a restricted basis, and which cannot be used as part of the general funds (or to service the general liabilities) of a charity.

Recognising the warning signs of financial distress early is critical. Trustees should be alert to:

Contingent liabilities, for example, an ongoing legal dispute that could result in a significant financial judgment against the charity.
Cash flow difficulties, such as an inability to easily meet payroll, pay suppliers on time or seeking to extend credit terms, an inability to service existing debts or an extension of an overdraft facility.
Upcoming financial obligations that cannot be met from current reserves, including lease renewals, pension contributions, or grant repayment obligations.
Declining income trends (including reductions in grants and public funding) combined with static or rising costs, and particularly where reserves are being drawn down to cover recurring deficits.
Over-reliance on a single major funder whose continuation is uncertain.

None of these factors alone necessarily signals inevitable insolvency, but each warrants close attention and given the complexities involved, trustees should consider obtaining specialist professional advice.

Balancing duties: a practical tension

The challenge for trustees is that the duty to beneficiaries and the duty to creditors can pull in opposite directions. Consider a soup kitchen in financial distress - should it continue to order provisions and perishable goods to feed the community it aims to help when it knows that it can't pay its suppliers unless there is an increase in donations? Should a charity continue to accept online donations, via platforms such as JustGiving, if its financial future is uncertain? In such circumstances, there is not always an easy answer, and trustees may need to take urgent legal and financial advice.

Conclusion

The Sequana judgment is a reminder that trustee responsibilities extend beyond the immediate needs of beneficiaries and the duty to achieve a charity's objectives. In times of financial uncertainty, the interests of creditors must be factored into decision-making and the earlier this is done, the more options will be available.

If your charity is experiencing financial pressures, acting early can make all the difference. At VWV, our experienced team can provide tailored advice to help you navigate these challenges effectively. Whether you need guidance on governance, creditor obligations, or insolvency risks, we are here to support you.

We recommend seeking advice from trusted legal advisers, or a specialist insolvency practitioner as soon as concerns arise. Careful documentation of decisions, including the information available and the rationale behind them, is crucial to protecting your charity and its trustees should questions arise later.