Insolvency Litigation & Charity Law for NFPs

Introduction

For any not-for-profit (NFP) or religious institution, facing insolvency presents a unique and complex set of challenges that differ significantly from those in the commercial sector. The duties that board members of a charity owe are governed by a distinct framework of charity law, creating serious implications when financial distress arises. Failure to manage this situation correctly can expose the organisation to litigation and its directors to personal liability.

Understanding the legal landscape, including the key risks and responsibilities for a charity’s directors, is therefore critical for the responsible persons of a charity. This guide provides essential information on the compliance obligations and strategic options available when an NFP is facing insolvency. Consulting an experienced not-for-profit lawyer is a crucial step in protecting the organisation’s mission, its assets, and the individuals tasked with its governance.

Why NFP Insolvency Is Different for Your Charity

Complex Interplay of Trust Law & ACNC Obligations

For an NFP charity, assets are often held on trust for a specific charitable purpose. This creates duties that extend beyond standard corporate obligations. The property is impressed with a trust for the charity’s religious or community goals, rather than for the benefit of individual members.

This principle applies even to unincorporated associations without a formal trust deed. Courts can recognise that property was acquired and held for the organisation’s purposes.

The case of Chaina v Presbyterian Church Property Trust illustrates this point. The NSW Supreme Court found that land purchased for a church remained dedicated to its charitable purpose, even after trustees wrongfully transferred and mortgaged it for personal gain. The court held that this was a breach of trustee duties and ordered the property to be restored to the church. This demonstrates how trust law protects a charity’s assets from being misapplied.

In addition to trust law, registered charities must adhere to the Australian Charities and Not-for-profits Commission (ACNC) Governance Standards. Specifically, Governance Standard 5 outlines the duties of a charity’s ‘Responsible People,’ which include:

• Acting with reasonable care and diligence.
• Acting honestly and fairly in the best interests of the charity.
• Ensuring responsible financial management.
• Not allowing the charity to operate while it is insolvent.

This creates a dual compliance burden, a core aspect of NFP governance and ACNC compliance, where leaders of a charity owe duties under both trust law and ACNC regulations. Given these overlapping responsibilities, it is crucial to seek advice from a not-for-profit lawyer to ensure all legal obligations are met, particularly when the organisation is facing insolvency.

Differences Between Commonwealth Corporations Act & NSW Associations Act

The legal framework governing a not-for-profit depends on its structure, which significantly impacts the duties of its leaders during insolvency. When you choose the right legal structure, it determines the governing legislation; for example, a charity structured as a company limited by guarantee (CLG) is regulated by the federal Corporations Act 2001 (Cth), whereas an incorporated association in New South Wales is governed by the Associations Incorporation Act 2009 (NSW).

Under the Corporations Act 2001 (Cth), directors of CLGs face stringent duties to prevent insolvent trading. A breach can lead to severe consequences, including:

• Civil penalties,
• Compensation orders, and
• Potential criminal charges.

Directors can be held personally liable for debts incurred while the company was insolvent. Ignorance of the organisation’s financial state is not considered a valid defence.

Conversely, the Associations Incorporation Act 2009 (NSW) sets out similar duties for the officeholders of incorporated associations. These include the duty to act with reasonable care and prevent the association from incurring debts that would cause it to become insolvent.

While breaches can still result in personal liability and monetary penalties, the specific rules and available defences may differ from those under the federal legislation. A key distinction under the Associations Incorporation Act 2009 (NSW) is the strict prohibition on distributing surplus assets to members during a winding up, ensuring property is directed toward charitable purposes.

Due to these critical differences, consulting a charity lawyer is essential to understand the specific legislation that applies to your NFP and to manage compliance and liability risks effectively.

Case Analysis of Chaina v Presbyterian Church Property Trust

Disputes Over Charitable Property & Trust Law in the NSW Supreme Court

The NSW Supreme Court plays a critical role in resolving disputes concerning property held on trust for religious and charitable purposes. The case of Chaina v Presbyterian Church Property Trust provides a clear example of the court’s function in upholding the integrity of charitable trusts, even for a small, unincorporated NFP body.

In this matter, a property was purchased by members of a church to be used for religious worship. The court found that, despite the church being an unincorporated association without a formal constitution, the property was impressed with a trust for the charitable and religious purposes of the organisation.

This finding confirms several important principles:

• Property dedicated to a charity does not lose its protected status simply because of a lack of formal documentation.
• The land remained dedicated to its original charitable purpose, even after it was wrongfully transferred.

Breach of Trustee Duties & Rights of Members

Trustees of a charity owe a significant duty to act in the best interests of the organisation, and a breach of this duty can lead to serious legal consequences and commercial litigation. In the Chaina case, a trustee transferred the church’s property into his own name and his sons’ names. He then mortgaged the property to secure a loan for his personal and business interests, which constituted a clear misappropriation of a charitable asset.

The court found this action to be a severe breach of the trustee’s obligations. Consequently, the members of the charity had the right to seek legal redress to protect the organisation’s assets.

The court ordered the defendants to:

• Restore the property to the church by transferring the title back to the rightful trustees.
• Indemnify the plaintiffs against any claims made by the mortgagee against the land.
• Pay the plaintiffs’ legal costs.

This case underscores that trustees must prioritise their duties to the trust over self-interest. The complexity of trust law and the potential for disputes highlight the importance of consulting a not-for-profit lawyer to ensure compliance and protect the charity’s assets from mismanagement.

Understanding the Personal Liability of Your Directors

Duty to Prevent Insolvent Trading Under ACNC Governance Standard 5

Responsible Persons, including directors and committee members, have a fundamental legal duty under ACNC Governance Standard 5 to act with reasonable care and diligence. A critical part of this obligation is ensuring the charity they govern does not operate while insolvent. This means the organisation must not incur debts if it is unable to pay existing ones as they become due.

Allowing an NFP to trade while insolvent is a serious breach of these duties and can expose directors to significant personal liability. The standard requires active oversight of the charity’s financial health to manage risks and maintain compliance.

Given the complexity of charity law, it is essential to consult an experienced not-for-profit lawyer when facing insolvency. This ensures directors fully understand their obligations and can take appropriate steps to protect themselves and the organisation.

Consequences of Breaching Duties Under the Commonwealth Corporations Act

For charities structured as companies, a breach of the duty to prevent insolvent trading can lead to severe penalties under the Corporations Act 2001 (Cth). Directors may face legal action from regulators, creditors, or the charity itself, resulting in serious personal consequences.

The potential penalties for directors include:

Penalty / Consequence	Description
Civil penalties	Courts can impose substantial fines on individual directors for breaches.
Compensation proceedings	Directors may be held personally liable to compensate the charity for losses resulting from debts incurred during insolvency.
Disqualification	A court can disqualify an individual from managing corporations for a specified period.
Criminal charges	In cases involving dishonesty, directors could face criminal charges, which may lead to large fines or even imprisonment.

Furthermore, the Australian Taxation Office (ATO) can issue a Director Penalty Notice, making directors personally liable for the charity’s unpaid tax and superannuation obligations.

These risks highlight why seeking early advice from a lawyer with expertise in charity law and insolvency is critical to protect both the organisation and its leaders.

Using Safe Harbour Provisions to Protect Your Board

How NFP Directors Can Use Safe Harbour to Avoid Liability

For an NFP or charity facing insolvency, the safe harbour provisions under section 588GA of the Corporations Act 2001 (Cth) offer crucial protection for directors. This regime shields directors from personal liability for insolvent trading, which can otherwise result in:

• civil penalties,
• compensation orders,
• or even criminal charges.

This protection allows the board to continue operating the charity while developing a plan to achieve a better outcome than immediate liquidation or administration.

The safe harbour protection is available if directors begin developing a course of action that is reasonably likely to lead to a more favourable result for the organisation. The protection begins as soon as the director suspects the charity may become insolvent and starts pursuing this turnaround strategy.

However, this protection ends if:

• the plan is not acted upon in a reasonable time,
• the plan is no longer likely to succeed,
• or if an administrator is appointed.

Developing a Course of Action for a Better Outcome

To qualify for safe harbour protection, directors of a charity must take proactive and documented steps to turn the organisation around. A critical first step is to promptly identify the signs of financial distress and engage qualified professional advisors to assist with developing and implementing a viable turnaround plan.

Consulting an experienced not-for-profit lawyer is essential to ensure compliance with all legal duties.

To effectively use the safe harbour provisions, directors should focus on several key actions:

Key Action	Rationale / Description
Engage qualified advisors	Seeking advice from legal and insolvency professionals is a key factor in determining whether a course of action is reasonably likely to succeed.
Maintain proper financial records	It is vital to document the turnaround plan, the reasoning behind it, and the progress achieved.
Ensure legal compliance	The charity must continue to meet its legal and regulatory obligations, including paying employee entitlements and tax liabilities.

A successful outcome often depends on the board’s ability to act quickly. For instance, one regional community services provider facing imminent insolvency was able to merge with a larger organisation, ensuring its long-term viability, because its directors promptly sought expert advice to guide them through the safe harbour process.

Determining Who Has First Claim to Assets in Litigation

Role of the NSW Supreme Court in Asset Distribution

The NSW Supreme Court holds significant authority in overseeing the assets of a charity, particularly during litigation or insolvency. Under the Charitable Trusts Act 1993 (NSW), the Court can intervene in cases of misconduct or mismanagement to protect trust property and ensure it is applied correctly for the organisation’s charitable purpose.

In proceedings, the Court has the power to make various orders, such as:

• Removing trustees
• Appointing a receiver to manage the charity’s property

As demonstrated in the case of Chaina v Presbyterian Church Property Trust, the Court can also order that misapplied assets be restored to the NFP.

Furthermore, under the Associations Incorporation Act 2009 (NSW), any person aggrieved by the distribution of surplus assets during a winding up can apply to the Supreme Court for a final determination.

Given the Court’s extensive powers, consulting a not-for-profit lawyer is essential to manage these complex legal proceedings effectively.

Strict Prohibition on Distributing Assets to Members Under NSW Law

A fundamental principle of charity law in New South Wales is that the assets of an NFP must be used for its charitable purposes, not for the private benefit of its members. This rule regarding asset distribution when ending a charity is strictly enforced during a winding up, whether the organisation is facing insolvency or is closing for other reasons.

Section 65 of the Associations Incorporation Act 2009 (NSW) explicitly prohibits the distribution of any surplus property to members or former members of the association. This ensures that all remaining assets, after debts and liabilities have been settled, are directed toward other charitable endeavours.

This prohibition is a critical compliance point for any charity, and a failure to adhere to it can lead to serious legal consequences and litigation.

Strategic Options for Your Board When Facing Insolvency

Voluntary Administration Under the Commonwealth Corporations Act

When an NFP organisation is insolvent or likely to become insolvent, voluntary administration offers a structured pathway to determine its future. Under the Corporations Act 2001 (Cth), this process involves appointing an independent and qualified administrator who takes full control of the charity.

The administrator’s primary role is to investigate the organisation’s affairs and provide a recommendation to creditors on the best course of action. This appointment provides the charity with a crucial “breathing space” by placing a temporary hold on claims from unsecured creditors, allowing the administrator to assess all available options without immediate pressure.

The administrator will then report to creditors on whether it is in their best interests to:

Recommended Course of Action	Description
Return control to directors	Return control of the organisation to its directors.
Approve a Deed of Company Arrangement (DOCA)	Restructure and pay off debts over time.
Wind up the organisation	Wind up the organisation and appoint a liquidator.

Orderly & Solvent Winding Up Under the Associations Incorporation Act

For an incorporated association that is solvent but needs to cease operations, a voluntary winding up provides an orderly method to finalise its affairs. This option is often suitable for a charity with a complex structure or significant assets that can still meet its financial obligations.

The process is initiated when members pass a special resolution to wind up the organisation and appoint a liquidator. The liquidator’s responsibilities include:

• Managing the sale of the association’s assets.
• Settling any outstanding debts and liabilities.
• Distributing any remaining surplus property.

A key compliance point under the Associations Incorporation Act 2009 (NSW) is that surplus assets are strictly prohibited from being distributed to members. This ensures that the charity’s property is directed toward other charitable purposes, upholding the core principles of charity law.

Importance of Consulting a Not-for-Profit Lawyer

When a charity is facing insolvency, it is critical for its board to seek immediate advice from a qualified not-for-profit lawyer. An experienced lawyer can provide essential guidance on the complex legal duties directors owe and help them understand the strategic options available, whether it be voluntary administration, liquidation, or utilising safe harbour protections.

Engaging a charity lawyer early in the process is vital for managing compliance and minimising the risk of personal liability for directors. A lawyer with expertise in charity law can assist the board in developing a course of action that is reasonably likely to lead to a better outcome, which is a key requirement for accessing the safe harbour provisions under the Corporations Act 2001 (Cth).

This professional support is indispensable for protecting the organisation, its mission, and the individuals responsible for its governance during a period of financial distress.

Conclusion

Facing insolvency presents unique challenges for an NFP or charity, governed by a complex mix of trust law, ACNC standards, and specific legislation that dictates director duties and asset distribution. Understanding these obligations, from preventing insolvent trading to exploring strategic options like safe harbour, is crucial for protecting the organisation and its leaders from personal liability and litigation.

To effectively manage these responsibilities and ensure full compliance with charity law, seeking specialised legal guidance is essential. Contact the expert not-for-profit lawyers at LawBridge today for trusted advice tailored to your organisation’s unique challenges when facing insolvency.

Frequently Asked Questions