Charities, trading subsidiaries and financial distress - what do you need to know?

Key features of a charity's trading subsidiary

A trading subsidiary of a charity is generally a private company limited by shares that is wholly owned by the charity.

The trading subsidiary will usually conduct non-charitable trading but occasionally is set up to carry out charitable activities while ring-fencing associated risks to protect the charity.

The subsidiary's directors sometimes include individuals who are also trustees of the charity or have been nominated by the charity.

A trading subsidiary is usually set up to generate income for its parent charity. It is often used as a solution if a charity is not allowed to trade in its own right or if doing so would seriously risk the charity's assets.

Can a parent charity provide funding to its trading subsidiary?

Trading companies are often funded by their parent charity. This is usually through a share capital investment in the trading subsidiary when it is set up, and subsequently, a parent charity may provide loans to its trading subsidiary during the course of its trade. However, it is important for this funding to be provided properly, in a considered manner, and in line with the charity's governance documents.

Trustees of charities who are considering whether to provide funding to trading subsidiaries should familiarise themselves with the Charities Commission's guidance in this regard, particularly CC14 and CC35.

Charity trustees should consider any funding provided to a subsidiary in the same way as they would consider an investment in an unrelated commercial entity with which the charity has no operational link. Funding the (non-charitable) trading subsidiary is an investment by the charity.  The charity trustees should therefore make sure that the aim of that investment is to secure the best level of financial return possible within a level of risk which is acceptable to the charity, in order that the charity can achieve its own charitable purposes.

As trading subsidiaries often pass a significant proportion of their profits on to their parent charity, the charity's trustees may find that investing in the subsidiary enables it to continue trading profitably, resulting in good returns to the charity. 

It is important for charities to be properly advised if they are considering setting up a subsidiary or providing funding to it. This will ensure that the charity has the correct investment and lending powers (or that the constitution is updated if necessary) and that any funding arrangement, loan, or investment is properly documented.

How to assess the trading subsidiary's financial circumstances

The trustees of the parent charity will need to regularly review their investment in the subsidiary over the course of the investment. The parent charity should monitor, to the extent it is able, the trading subsidiary's performance and financial position.

The parent charity should ensure that it has sufficient visibility of the trading subsidiary's finances in order to be able to assess how it is trading. Whilst being mindful of the conflict of interest concerns discussed further below, and the sharing of confidential information, trustees of the parent charity may find it helpful to include, within any investment or loan documentation, positive obligations on the trading subsidiary to disclose or deliver up financial information to the parent charity on a regular basis.

There are two tests for insolvency which trustees should be mindful of, as the trading subsidiary could be deemed insolvent if it meets the criteria for either of the tests:

• Cashflow test - an entity is deemed insolvent on a cashflow basis where it is unable to pay its debts as they fall due.
• Balance sheet test - an entity is deemed insolvent on a balance sheet basis where its net liabilities (including contingent liabilities) are greater than its net assets.

What if the trading subsidiary is in financial difficulty?

It is important for the parent charity and its trustees to understand the financial circumstances of the trading subsidiary; and to quickly identify situations of distress or doubtful solvency, for two main reasons:

1. The parent charity needs to establish whether it should continuing funding or supporting the distressed subsidiary and if so, the format of that support:

• The subsidiary's business plan and forecast for the future should be assessed to scope for financial viability and feasibility.
• In situations of a subsidiary's financial distress, a loan, potentially secured, may be a better use of charity funds than buying more share capital in the subsidiary.
• Repayment dates should be closely monitored and enforcement action considered where necessary.
• Restricted funds should not be used to bailout the charity as doing so would be a breach of trust.

2. The parent charity needs to understand the impact on its own (financial position) if the subsidiary ceased trading, or became insolvent and was no longer able to forward profits to the charity or failed to repay any existing loans:

• Trustees should regularly review management accounts and financial data for the charity and these should be updated to take into account the subsidiary's precarious situation.
• The charity's cash reserves should be monitored and its cashflow projections updated to take into account the subsidiary's inability to repay loans, or issue dividends.
• The charity trustees should take action to minimise any loss to the charity and to protect the charity's assets.
• Charities may also want to take into account any negative PR or reputational damage which may arise out of the trading subsidiary's failure and take pre-emptive steps to reduce the impact of that damage on the charity.
• If the subsidiary does enter a formal insolvency process, any appointed insolvency practitioner could review and challenge transactions and payments entered into between the charity and its subsidiary in the preceding time period - this could result in the insolvency practitioner taking "clawback action" and requiring the charity to repay amounts they have previously received from the subsidiary. We can assist charity trustees in assessing the risks of these types of claims, advise on the prospects of a claw back by the liquidator or administrator, and assist in defending the charity if any action was brought or threatened.
• If the charity finds itself in a precarious financial position its trustees ensure that they continue to act in accordance with their fiduciary duties and should take prompt steps to obtain specialist professional advice.

Can a trading subsidiary continue trading if its parent charity is in financial distress?

Whilst it is theoretically possible for a subsidiary to survive its parent charity's insolvency, in practice, this is not often the case, particularly where a trading subsidiary's operations complement the charity.

The parent charity will often provide office space, or trading premises for the subsidiary to use which will be impacted if the charity becomes insolvent. Similarly, if the charity ceases trading any management or administrative support (eg payroll, HR etc) it was providing the subsidiary may cease. The charity may allow the subsidiary to use its assets (eg the use of trademarks or other intellectual property) and those licences may be impacted by insolvency. If the subsidiary's activities are ancillary to the charity's objects (eg running a café or gift shop at a museum or arts centre), if there are no longer visitors to the site as the underlying charity has closed down, then there will be no custom for the subsidiary.

Accordingly, directors of a trading subsidiary will need to assess the subsidiary's own affairs and future viability if its parent is in a precarious position and to be considerate of their fiduciary duties in these circumstances.

Conflicts of interest, shadow directorships and other pitfalls to be aware of

Whilst directors of companies and trustees of charities must always act in accordance with their fiduciary duties, where trustees of a parent charity are also directors of the trading subsidiary, they must, in particular, be alert to possible conflicts of interest arising and mindful of their duty to avoid them.

This conflict of interest may be particularly apparent when making decisions as to whether or not to provide funding to the trading subsidiary (or vice versa).

The solvent parent charity's trustees must be mindful of their duty to act in the charity's best interest alone when deciding how to spend the charity's funds and ensure that the charity's assets are only used to support and carry out the charity's charitable objectives.

Both directors and trustees also need to be aware that when an entity is in a precarious financial position, they must take into account the interests of creditors as well as shareholders'/beneficiaries' interests. This can be difficult as their interests do not always align. This change in focus is on a sliding scale, and the closer an entity is to unavoidable insolvency the greater the focus must be on creditors' interests.

 Unfortunately, in practice, we often encounter scenarios where, despite having distinct boards of directors/trustees, a parent charity and its trading subsidiary's operations are so intermingled that they can appear to be run as one. This can often be because staff are shared across the group, and group finances and accounts are prepared jointly. Materials and records can be shared or stored by one on behalf of the other.

This can cause issues, not just because it can be harder to review distinct updated financial information to assess financial distress and apply insolvency tests, but also because if the subsidiary's board of directors is essentially accustomed to acting in accordance with instructions from the parent's trustees, then the trustees of the parent could be at risk of being considered shadow directors of the subsidiary as well.

Further support and guidance

The matters discussed in this article are complex and charity trustees and subsidiary directors will often benefit from additional professional support.

If you have any questions regarding the content of this article, please do not hesitate to contact Ambuja Bose on 020 7665 0990 or Shivaji Shiva on 0121 227 3724, in our Charities team. Alternatively, please complete the form below.