Insolvency issues for directors of not-for-profit companies

The recent liquidation of a large college in Victoria which displaced over 1200 students, is a reminder to directors of not for profit (NFP) organisations of their duties. Even though directors in this sector are sometimes 'well meaning amateurs,' they play an important function and carry the burdens and responsibilities that accompany the office of a director.

In the current economic climate, NFPs face increasing demand for their services and a decreasing supply of funds from corporates and individual donors. They and their directors may face difficult times. In this context, the governance and accountability of the NFP board are significant issues that are worth revisiting.

Tania Mannello and Aaron Lane

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What NFP organisations are we talking about?

This article concerns NFPs operating as Australian companies under the Corporations Act 2001 (Cth) (Act). Like all NFPs, these companies:

• do not operate for the profit or gain of their individual members - even if they have significant business activities, high annual turnovers (and profits) and control significant assets; and
• have the key feature that any profits they make remain in the organisation for them to use to carry out their purposes - as set out in their constitutions.

Directors of these NFPs have additional duties as set out in the Act. These duties do not apply to trustees of charitable trusts or committee members of incorporated associations.

Why are insolvency issues, and directors' duties, important to focus on?

NFP companies, and other NFP organisations, are an essential part of the community and the number of different organisations, and the number of people involved in operating them, continues to grow. This proliferation continues despite the challenging economic times.

This means that:

• people are more likely to be asked to help operate these organisations, including by acting as directors;
• advisors are more likely to be helping:
  • to advise the growing number of NFPs as clients concerning their taxation and financial affairs; and
  • individual clients, who are involved with these NFPs in a variety of roles; and
• those NFPs face increasing competition for donations and revenue, combined with rising costs, meaning they face increased financial pressures.

Recent case study – liquidation of not for profit school

The circumstances surrounding the recent closure of an independent school in Melbourne's west reinforces the need for directors of NFPs to exercise their duties with care.

The school comprised 3 campuses and was operated by an NFP company. In late May 2012, the company was placed into voluntary administration. In July 2012, its creditors voted to place it into liquidation.

The school's liquidator has commented that the likely causes of the school's financial troubles were:

• overarching governance issues;
• high borrowings to fund capital expenditure;
• high operating costs;
• declining enrolments;
• slow payment of fees; and
• high turnover of directors and key staff.

The liquidator is investigating whether the directors were trading the company whilst it was insolvent or breached any of their other duties under the Act.

Equipping directors to properly discharge their duties (and protect themselves)

Knowledge For directors of NFPs to properly discharge their duties, they must understand:

• the range of duties they must fulfil as officers or directors of NFP organisations; and
• the financial governance and controls in place at their NFP - and how important these controls are in helping them meet their duties.

Advisors to these NFPs (and to clients considering taking board positions) should ensure directors understand these key duties and requirements.

Systems If there are gaps in those financial governance and controls, then directors need to ensure that good financial management policies and procedures are put in place to suit their organisation.

Also, directors should be educated on financial management, including the essential elements of income and expenditure, balance sheets and financial statements.

Inquire If a person plans to consent to act as a director of an NFP then, before they do so, they should ask the NFP for:

• key financial information such as profit and loss statements, cash flow statements and balance sheets; and
• evidence of its financial management policies and procedures.

These inquiries might include meeting with the NFP's treasurer or financial officer to get their view on the financial health of the organisation, including issues around the reliability of revenue streams (including access to government grants), costs management and how long the NFP's creditors are waiting to get paid.

Insurance Directors should check whether:

• the NFP has adequate Directors and Officers insurance, and require the company to take out this insurance if it is not in place; and
• the NFP's management policies and procedures ensure that insurance is monitored and renewed.

Advice If doubt exists about the organisation's financial governance and controls, or financial health, then boards should consult with appropriate professional advisors and take action swiftly.

Relevant duties of directors under the Act

To act with care and diligence

Directors of a company are required to exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise:

• if they were a director of that company in the same circumstances; and
• if they had the same office and responsibilities. [1]

Directors will have discharged this duty if they have:

• made the judgment in good faith for a proper purpose;
• do not have a material interest in the subject matter of the decision;
• have properly informed themselves about the subject matter of the decision; and
• rationally believe that the judgment is in the best interests of the company.

This 'reasonable person' standard means that it will not be an excuse for a director to say that they were an amateur, or that they did not properly understand the reports or the decisions the board was making. In particular, directors cannot avoid their responsibilities by:

• failing to read board papers;
• unreasonably relying on advice;
• being absent from meetings; or
• disagreeing with decisions.

Also, 'nominee' directors, who may be appointed to represent specific interests on the board, owe a broad duty to act in the best interests of the company as a whole – rather than just the interests of the members they represent. For example, an independent school may have a teacher that has been appointed to the board as a nominee director on behalf of the teachers of the school. In this case, the nominee director must make decisions and judgments that are in the best interests of the school as a whole, rather than the teachers' best interests.

To act in good faith, and not improperly use position or information

Directors must act in the best interests of the organisation for proper purposes and avoid conflicts of interest. [2] The Act prohibits directors from using their position, and information obtained from their position:

• to gain an advantage for themselves or someone else; or
• to cause detriment to the organisation.

This obligation not to use information for personal gain continues after a director has left the organisation.

Directors must disclose all conflicts of interest.[3] If a director has a conflict of interest and the company is a public company (NFP or otherwise), then the director's right to vote may be restricted.

To prevent insolvent trading

Many organisations in the NFP sector will be familiar with the obligation to avoid trading while insolvent.

A company will be insolvent where it is unable to pay all its debts, and as when they become due and payable.

Directors of a company must prevent the company from incurring a debt[4] if:

• the company is already insolvent at the time the debt is incurred; or
• by incurring that debt, or incurring a range of debts, the company becomes insolvent.

Again, the 'reasonable person' standard applies. A director will be in breach of the obligation to prevent insolvent trading if, at the time of incurring the debt, a reasonable person in the same circumstances would have had reasonable grounds to suspect that the company was already insolvent, or would have become insolvent by incurring the debt.

Accordingly, directors must ensure that their company maintains an adequate cash flow to continue their operations.

What are the possible penalties for directors?

The law provides civil and criminal penalties for directors who fail to discharge their duties under the Act. These penalties apply to a director of a NFP company in the same way that they apply to a director of a company operated for profit.

Currently, the maximum civil penalty for a contravention of a directors' duty is $200,000. Additionally, the Court may order a director to compensate the corporation for any loss or damage to the corporation resulting from breach of the duty.

Criminal penalties also apply to the duty to prevent insolvent trading if the breach is found to be dishonest. Currently, the maximum criminal penalty is a fine of $220,000 or 5 years imprisonment.

What impact might the proposed Australian charities and not for profits laws have?

While these laws are still in a draft form, the possible impacts may include:

• directors having to ensure that revenue from 'unrelated commercial activities' is properly identified and monitored by the NFP's financial governance and controls to ensure all related taxation is paid on that revenue;
• directors having to ensure that their financial governance and controls:
• correctly record and explain the financial position and performance of NFP; and
• facilitate compliance with revised financial reporting obligations; and
• the directors' duties under the Act being supplemented by additional duties on 'responsible individuals' (which would include directors, but also other persons in a position to influence the NFP's decision-making). The proposal at the moment is that these persons would be required to exercise 'the same degree of care, diligence and skill that a prudent individual would exercise in managing the affairs of others'.

A well organised and managed NFP, regulated under the Act, should be able to effect a smooth transition to these new regulatory arrangements. NFP directors should ensure they are monitoring these developments and preparing to seek advice on them when the laws are finalised.

More information from Maddocks

For questions or more information about the above article please contact Maddocks on (03) 9288 0555 and ask to speak to a member of the Maddocks Insolvency Team.

More Information on companies from Cleardocs

You can read other articles concerning companies and not-for-profits here.

Order Cleardocs company packages

Order the Cleardocs Company Registration package here.

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[1] Section 180 of the Act.

[2] Sections 181-184 of the Act.

[3] Section 191 of the Act.

[4] Section 588G of the Act.