Summary: The Public Administration and Constitutional Affairs Committee's findings in relation to Kids Company serve as a reminder of the risks of insolvency to large charities. The inherent weaknesses in the demand-led 'self-referral' operating model resulted in little to no reserves, and ultimately led to the trustees being required to file a petition to wind up the charity. Trustees of large charities must always be mindful of reserve levels.
Keeping Kids Company (commonly known as 'Kids Company') was a well-known and well-loved charity set up for the purpose of supporting and advocating on behalf of exceptionally vulnerable children. In the years leading up to its collapse, Kids Company purported to support 36,000 children, young people and vulnerable adults, principally through its 12 support centres and by working in partnership with 40 schools across Bristol and London.
However, in July 2015, despite having a number of extremely high profile donors, an income of £23,104,012 and receiving an estimated £42m of government grants over a nine-year period, the charity was seeking emergency fundraising in the face of financial collapse. With a combination of acute financial difficulties and the emergence of allegations of sexual misconduct, the trustees filed a petition to wind up the charity. Within days of the petition having being presented, a winding up order was made and the charity was shut down.
Investigations into the failure of the Kids Company by the Official Receiver and the Charity Commission are ongoing. However, on 21 January 2016, the Public Administration and Constitutional Affairs Committee (PACAC) released its report into the collapse of Kids Company to provide lessons for charity trustees, professional firms, the Charity Commission and Whitehall.
This article will focus on the PACAC's findings in relation to the inherent weaknesses in the charity's demand-led operating model, the charity's lack of financial reserves, and will provide some guidance for trustees of charities in financial difficulty.
One of the founding principles of Kids Company was that no child in need should ever be turned away. Any child, young person or vulnerable adult could self-refer themselves to one of its centres or programmes and they would always be accepted. This was to address the perceived gap between the number of vulnerable children that were in need of help and those that were actually receiving it.
However, the result of this self-referral model was that the Kids Company was never able to predict with any real certainty the number of children that would be in need of help, or the scale of resources that would be required to provide it. In its last published annual accounts, the charity recognised that this left it reliant on exceptional grants from the government to bridge funding gaps.
The PACAC report states that the self-referral model 'carried the constant risk that the charity would not be able to ensure that its commitments would be matched by its resources. The charity's trustees failed to address this risk.'
A search on the Charity Commission's website identifies that the income of Kids Company in 2014 was £23,104,102 and the total resources expended was £22,963,671. The charity was spending all of the money which it had raised. It is easy to see how this would have been looked upon as favourable by the charity's donors and sponsors. Those donating might welcome the fact that the money is reaching those who need it and is not being kept in a back account ' just in case'.
The Charity Commission has recognised this dichotomy as a problem facing the whole charity sector. All charities are encouraged by the Commission to spend their money, but at the same time are advised that they must have adequate reserves. This was clearly a very real problem for Kids Company, partly because of the sheer scale and size of the operation, but also because the self-referral model lead to a 'hand-to-mouth' existence.
The charity recognised, in its list of principal risks, that there was a need for sufficient reserves and balancing fixed costs against the security of its income. However, when stating how to manage this risk, the accounts state, rather weakly, 'our business model is to spend money according to need, which is consistently growing. We aspire to build up our reserves when circumstances allow.'
Trustees and financial reserves
While there is at all times a need to ensure that any money that is raised is given to those who need it most, the trustees of any charity also owe a duty of care to the charity's clients, employees and donors not to expose the charity to undue financial risk. Ms Michelle Russell, Director of Investigations, Monitoring and Enforcement at the Charity Commission, stated that: 'Trustees have a higher duty of care to make sure that their financial planning and business model is much more robust and the safeguards are there.'
While this will be a consideration for trustees of all charities, this is particularly pertinent in the case of charities of a larger scale. Some charities will have few overheads and will be able to apply donations however and to whomever they choose without the need for robust financial planning. Others will need to be run more like a business. They may have very significant and regular overheads including rent, payroll, taxes and pension contributions, therefore it is absolutely vital that trustees are mindful to ensure that a charity is and will remain solvent. Accurate and reliable information, cashflow forecasts and budgets are essential in the same way that these things are essential in the running of any business. Of course, charities often rely on the generosity of others, which makes estimating its annual income very difficult to predict. However, this makes the need for reserves even more essential. The larger the charity, the larger the overheads. The larger the overheads, the more crucial it will be to accurately estimate the required level of reserves.
Mr Nick Brooks, a partner of Kingston Smith, who audited Kids Company between 2011 and 2015, told the PACAC that the trustees should have calculated the charity's necessary level of reserves on the basis of a 'number of months'. He suggested that an appropriate level for a charity the size of Kids Company, and taking in account the self-referral model, would have been around six months' spending, so approximately £12m. In reality, in the 2014 accounts, the free reserves position throughout 2013 was stated to be £434,282. This was the highest level of reserves that the charity had ever had. In fact, between 2003 and 2006, and again between 2009 and 2011, the charity had no reserves at all and carried a deficit.
Mr Brooks' comments were made with the benefit of hindsight. Prior to the collapse of Kids Company, the auditors each year signed off on the charity as a going concern. They recognised that the charity had no endowed funds, and that the level of activities in the financial year starting 1 January 2014 would depend almost entirely on its ability to secure continuing grant income. It stated that the organisation continued to have low reserves relative to its size and that this was putting a strain on the charity's cash flow. However, they suggested that 'the trustees were confident sufficient funding would be secured'.
How did the trustees have the confidence that sufficient funding would be secured? The PACAC report suggests that there should have been significant concern about the financial resilience of Kids Company going back several years. While the trustees have suggested that this was only a very recent issue for the charity, the report states:
"Given the charity's historic hand-to-mouth existence its continual failure to build up reserves, significant periods on the brink of insolvency and its inability to meet its obligations to HMRC, this is an inaccurate and alarming interpretation…"
It would appear that, in some respects, the auditors and the trustees were in a 'chicken and egg' situation whereby the auditors were relying on the confidence of the trustees that sufficient funding would be secured to sign off the charity as a going concern, while the trustees were relying on the auditors sign-off to continue to trade. However, as with directors of a business, in order to fulfil their duties as trustees, the trustees should not simply be relying on a line in their audited accounts, but should be consistently monitoring the viability of the business. It will not be enough to 'rely upon wishful thinking and false optimism and become inured to the precariousness of [a] charity's financial situation'.
The case of Kids Company serves as a timely reminder of the need for trustees of charities to consider carefully their duties to the charity, including the need to adequately build a charity's reserves. It is essential for a trustee body that it has a sound knowledge and understanding of the charity, its operating structure and its finances, so that, as far as possible, the continued viability of the charity and its charitable activities can be assured. This understanding will be a vital part of a trustee's compliance with their legal duties to:
- act in the interest of their charity and its beneficiaries;
- protect and safeguard the assets of their charity; and
- act with reasonable care and skill.
If effective financial management and controls are in place, then insolvency may be prevented or foreseen in its early stages. This is important, first and foremost, for the protection of the vulnerable people that are often the clients of a charity, but also for a wide range of stakeholders, from the charity's employees through to the charity's creditors. Advice to trustees should be the same advice given to directors of companies in financial difficulty - as soon as a trustee becomes aware that there may be some solvency or cash flow issues, they should raise the problem with the board and the board should seek independent professional advice.
In 2010, the Charity Commission provided detailed guidance for trustees on building financial resilience. It states that trustees should develop a reserves policy that:
- fully justifies and clearly explains keeping, or not keeping, reserves;
- identifies and plans for maintenance of essential services for beneficiaries;
- reflects the risks of unplanned closure associated with the charity's business model, spending commitments, potential liabilities and financial forecasts; and
- helps to address the risks of unplanned closure on their beneficiaries (in particular, vulnerable beneficiaries, staff and volunteers).
It is likely that this guidance will need to be revisited, if not bolstered, to provide charities with further guidance about financial management of charities and the risks of insolvency. The PACAC report highlights a large number of failings on the part of a large number of interested parties, ranging from the trustees, to the Charity Commission to some of the charity's professional advisers. It remains to be seen what the longer term's response will be. However, in the light of all of the issues highlighted above, it is likely that increasing scrutiny will be placed on all of these parties in the future.
This article first appeared in Corporate Rescue & Insolvency journal (2016) 2 CRI 68.