Asset protection for leaders of non profit organisations

A paper presented to the Christian Management Australia Conference June 2008

It's fair to say that the liability of leaders of non-profits has, particularly since the 1990's, been trending upwards. Even for corporate bodies, which traditionally have been viewed as "safer options" for leaders and members, the corporate veil has gradually been lifted by courts. Courts are becoming more adventuristic in finding ways to make leaders of corporate entities responsible for the debts of the corporate entities, and to seek to look through asset protection structures.

Leading a non-profit organisation has many pressures, and it seems somewhat unfair that leaders who devote themselves to managing and guiding a non-profit organisation should have to be concerned about personal liability.

This is particularly the case when you are providing your time and services "free of charge" or for a salary well below market expectations.

Unfortunately, however, creditors, the Trustee in Bankruptcy and the Courts will not place much weight, if any, on your honorable intentions. Ultimately, when there is a liability or debt to be paid, the creditor will seek to utilise all measures at their disposal in order to satisfy the liability or debt. If that means attacking the personal assets of the leaders of the non-profit organisation, then so be it.

That's little comfort when litigation against you has commenced, proceedings have been served, and your personal home is now at risk. Litigation is stressful enough without also having to worry about losing your personal assets and home. However at this stage, it's too late to be thinking about "asset protection". The time for thinking about it is now, when there is no possible claim or litigation on the horizon.

For that reason it is timely to consider, if you are a leader of a non-profit entity, what protections are in place for your personal assets, and to further consider whether additional measures need to be put in place to properly protect those personal assets.

At the outset, we want to stress that this is a very general overview of the law and strategies for asset protection. We won't be delving into complex company and trust structures today. It is not possible to provide a thorough treatment of all the strategies that might be implemented, many of which will depend on the individual's own circumstances. Therefore, we recommend that you take legal advice regarding the options best suited to your circumstances. Taking that advice sooner, rather than later (when it might be too late), is crucial.

WHAT ARE THE RISKS FOR LEADERS OF NON-PROFIT ORGANISATIONS?

Before considering what steps should be taken to protect your personal assets, it's worthwhile to first consider the risks. A consideration of these risks will help you to decide if further steps to protect your personal assets are actually necessary.

The risks will vary depending on the type of structure that your non-profit organisation has chosen.

In this regard, there are three common structures chosen by non-profit organisations:

• The Unincorporated Association;
• The Company Limited by Guarantee (under the Commonwealth Corporations Act); or
• The Incorporated Association (under the relevant State of Territory Associations Incorporation Act).

There is also the Letters Patent entity, which is analogous to the Incorporated Association or Company Limited by Guarantee, but with less legislative obligations.

Entity A - The Unincorporated Association

Unincorporated associations have no separate legal capacity. They cannot be sued or sue in their own name, nor can they contract or hold property in their own name.

Many churches and smaller organisations are "unincorporated associations".

The leaders (and indeed potentially all of the members) of the organisation are personally (jointly and severally) liable for all the debts and liabilities of that entity. There is no corporate veil, and therefore there is no real protection for these leaders.

Of course, the leaders may have other forms of protection in place, such as a claim against the assets of the association, or relevant insurance policies to provide some degree of protection.

However, where those assets or insurance policies are inadequate, the shortfall will generally be borne by the leaders of the non-profit association.

Entity B - The Company limited by guarantee

A company limited by guarantee is also a separate legal entity, can sue or be sued in it's own name, and can contract or hold property in it's own name.

Many non-profit organisations choose this structure when incorporating.

The members of these companies have limited liability as provided in the Constitution of the Company, generally limited to $50.

However, the directors of the company will still carry some personal liability. We address some of these liabilities below.

Unremitted PAYG Group Tax

All company directors have a duty to ensure that the company meets its obligations to remit to the ATO amounts deducted from employee payments for PAYG Group Tax. If the company fails to remit the payments, the directors are personally liable to pay to the Commissioner of Taxation, by way of a penalty, an amount equal to the unpaid amount.

Trading whilst insolvent

Directors are personally liable for debts incurred as a result of the company trading whilst insolvent, or a debt that is incurred which would make the company insolvent.

Insolvency = unable to pay debts as and when they fall due.

In this regard, it is not uncommon for a non-profit entity to find itself trading "insolvent", given that the entity is often reliant on donations. Each director is personally liable for the entire loss or damage incurred by the creditor(s) while trading insolvently.

Liability generally extends to each director regardless of the level of involvement that the director has in the management of the company.

Criminal offences

It is becoming increasingly common for the legislature to extend criminal responsibility for certain offences to directors of companies.

For example, Directors will generally be responsible for breaches of environmental laws (pollution, destruction of protected environments etc).

In some states, industrial manslaughter offences have also been passed, which could make directors liable to prosecution for manslaughter arising in an unsafe workplace.

Personal guarantee and indemnities

Often financial institutions or landlords will require directors of companies to provide personal guarantees and indemnities with respect to the company's performance under a lease or contract.

These guarantees and indemnities are always broadly drafted in favour of the guaranteed/indemnified party. For example, regardless of the number of directors that sign the guarantee and indemnity, liability will usually be joint and several, meaning that the guaranteed party can effectively choose which director they want to claim against.

The potential liability under these guarantees and indemnities can be significant. For example, under a typical lease guarantee, not only does the director promise to make the lease payments on default, but also to indemnity the landlord from any loss it might suffer as a result of the company's breach of the lease (i.e. damage caused to the leased premises by the tenant or its invitee is usually a breach of the lease).

What also needs to be remembered is that the guarantee might be called upon a number of years after it was given. For example, a guarantee given for a lease is given at the commencement of the term. If the term is subsequently renewed, the guarantee will usually continue for the renewed term. By the time the guarantee is called upon, the director may no longer be involved in the management of the company. Nevertheless, the director is still liable under the guarantee.

We always strongly recommend to our non-profit clients that they resist any such guarantees and indemnities. They are not, in our view, appropriate in the context of a non-profit entity and voluntary directors. However, directors often provide the guarantee without full knowledge of the consequences.

Breach of Duty

Liquidators can also pursue directors of a company where the directors have breached their duties, and that breach results in loss for the company (section 598 of the Corporations Act).

Generally, the scope of relevant duties of a director can be summarised to include:

• duty to act in good faith in the best interest of the company;
• duty to act with care and diligence;
• duty to avoid conflict of interest; and
• duty to avoid misuse of information obtained in the capacity as directors

Related Party Transactions

The Corporations Act provides a number of Related Party rules. These rules only apply to public companies. Any company that is limited by guarantee is a public company.

The provisions are designed to protect the interests of a public company's members as a whole, by requiring member approval before a company gives a financial benefit to a Related Party.

A Related Party is defined in section 228 of the Act, and includes (but is not limited to) the following persons:

• The directors of a public company;
• The directors of an entity that controls a public company;
• Any spouses or de-facto's of the directors; and
• Parents or children of a director.

‘Financial benefit' is not specifically defined in the Act. However, the term must be given a broad definition. The Act provides a number of examples of giving a financial benefit, including:

• Giving a Related Party finance or property;
• Buying an asset from a Related Party, or selling an asset to a Related Party;
• Leasing an asset from a Related Party;
• Supplying services to a Related Party, or receiving services from a Related Party;
• Issuing security, or granting an option, to a Related Party; and
• Taking up an obligation from a Related Party, or releasing a Related Party from an obligation.

As can be seen, the application of ‘giving a financial benefit' is wide, and will involve a large range of circumstances.

If a Public Company is giving a financial benefit to a Related Party, it needs to obtain member approval before giving the financial benefit, and must give the financial benefit to the Related Party within 15 months of obtaining the approval.

In obtaining the member's approval, there is a complex process of arranging for a member's meeting, and providing the members with an explanatory statement and any other material documents to assist a member in deciding how to vote.

There are a number of "common sense" exceptions to the rule, including:

• Where the terms of the financial benefit are reasonable in the circumstances and the parties are dealing at arms length;
• Providing reasonable remuneration to an officer or employee;
• Providing reasonable reimbursement of expenses;
• Indemnifying an officer of the company in respect of a liability they incur because of their position (provided the liability does not fall within section 199A of the Act, which relates to breaches of the Act);
• Small payments to Directors of their spouses (being less then $2000 in total);
• Benefits to or by closely-held subsidiaries; or
• The benefit is given to a related party in their capacity as a member of the company, and giving the benefit does not discriminate unfairly against other members of the company.

If an exception does not apply, and member approval is not obtained, the person or persons involved in the contravention commit a civil penalty infringement, which can result in a significant debt being payable to ASIC.

Entity C - The Incorporated Association

Incorporated Associations are "unincorporated associations" that have decided to incorporate under the relevant State or Territory legislation.

Through the relevant Act, the association becomes a legal entity, can sue or be sued in it's own name, and can contract or hold property in it's own name.

Generally, the Act will convey limited liability on the members and directors of the association.

However, the limitation of this liability for Committee Members will generally not extend to "insolvent trading". It is also possible for Committee Members to be liable for loss or damage sustained by the Association as a result of the Committee Member breachings its fiduciary duties to the Association. This liability could be expressly provided for in the State or Territory Act, or through a common law action against the Committee Member.

Committee Members should not assume, therefore, that they have limited liability in all circumstances.

BUT WHAT ABOUT INSURANCE?

Insurance is a primary and effective method of transferring risk from the company to the insurer.

All entities should have adequate insurance in place, regardless of the structure chosen for that particular entity. It is always worthwhile to take advice on the most appropriate insurance for your circumstances from your insurer.

However, you need to be aware that insurance policies, as a stand alone asset protection strategy, are not foolproof.

In particular, insurance policies are drafted with a view to excluding many liabilities. It is not uncommon for a non-profit organisation to discover that the activities it has been conducting for many years is excluded from the policy - hence no insurance. It is crucial that you regularly examine your insurance policy, and consider it against your organisation's actual activities. If there is any doubt regarding whether an activity is covered, you should clarify this with your insurer (in writing).

Additionally, with the collapse of some insurers (for example, HIH) insured parties have found themselves without indemnity from a solvent fund.

For these reasons, it is always wise to consider insurance as part of a broader risk management and asset protection strategy.

ASSET PROTECTION MEASURES MUST BE TAKEN EARLY

It is pointless to consider your asset protection strategies when a claim has been made or may be made. By this time, it is too late, and your personal assets will be at risk.

In this regard, you need to be aware of the following claw back provisions in the Bankruptcy Act 1966.

Section 120 of the Bankruptcy Act 1966

Section 120 of the Bankruptcy Act 1966 provides that the Trustee in Bankruptcy can overturn a transfer of property at less than market value, where the transferor subsequently becomes bankrupt and the transaction occurred in the five years preceding the bankruptcy. Some exemptions may also apply.

This is a broad power for the Trustee in Bankruptcy.

If the transferee, that is the person who received the property, can prove that, at the time of the transfer, the transferor was solvent, and the transfer took place more than two years before the commencement of the bankruptcy, Section 120 will not apply. This period increases to 4 years where the transferee is a related entity to the transferor (i.e. a relative of the transferor or a related trust).

The onus of proof for this is on the transferee. If the transferor has not kept adequate books, accounts or records (as would be usual and proper in relation to the business), or the transferor has failed to preserve such books, accounts or records, there is a presumption that the transferor was insolvent at the time of the transfer (which must therefore be rebutted by the transferee with supporting evidence).

Proving that the transferor was solvent at the time will be a costly and difficult task.

Section 121 of the Bankruptcy Act 1966

Section 121 of the Bankruptcy Act 1966 provides further avenues for a Trustee in Bankruptcy. That section provides that a transfer of property by a person who later becomes a Bankrupt is void if:

• a) the property would probably have become part of the Bankrupt's estate or would probably have been available to creditors if it had not been transferred; and
• b) that the Bankrupt's main purpose in making the Transfer was:
• to prevent the transferred property from becoming divisible among the creditors; or
• to hinder or delay the process of making the property available for division among the creditors.

Again, there is a presumption of insolvency if the Bankrupt has not kept adequate books, accounts or records, or has failed to preserve those books, accounts or records (which must be rebutted).

The transfer will not be void if:

• the consideration given by the transferee was at least as valuable as the market value of the property;
• that the transferee did not know, and could not reasonably have inferred, that the transferor's main purpose in making the transfer was to defeat the creditors; and
• that the transferor could not reasonably have inferred that, at the time of the transfer, the transferor was, or was about to become, insolvent.

This section includes specific provisions to address the transfer of property to a spouse, de-facto spouse or fiancé of the Bankrupt. In particular, the section states that consideration for the transfer will be valueless if the consideration is:

• the fact that the transferee is related to the transferor;
• if the transferee is the spouse or de-facto spouse of the transferor - the transferee has made a Deed in favour of the transferor;
• the transferee promises to marry or become a de-facto spouse of the transferor;
• the transferee's love or affection for the transferor; or
• where the transferee is the spouse of the transferor, the transferee grants the transferor a right to live at the transferred property (unless the grant is specifically made under the Family Law Act 1975).

Importantly, this Section does not include any time limits on when the Transfer is made as opposed to when the Transferor becomes Bankrupt.

However, the Trustee does carry the onus of proof under this section, and if a longer period of time has lapsed between the transfer and the Bankruptcy, it will be more difficult for the Trustee to meet this burden.

It will generally be difficult for the Trustee to succeed if the Transferor can show that the decision to Transfer the property was based on:

• tax planning considerations;
• estate planning considerations; or
• there was no particular or imminent financial risk to the Transferor at the time of making the Transfer.

Cummins

The High Court decision of Cummins [2006] HCA 6 is a interesting example of the scope of this particular section.

Mr Cummins was a barrister in New South Wales. He was first admitted as a Solicitor in 1957, and became a Queen's Counsel in 1980.

Notwithstanding his preeminence at the bar, he determined that the lodgment of Income Tax Returns was somewhat unnecessary. For that reason, from 1955 through to February 2000, Mr Cummins decided not to lodge any Income Tax Returns, despite the large amount of income he would have been earning as a Queen's Counsel.

On 26 August 1987, Mr Cummins decided to transfer his full legal and beneficial interest in his home in Sydney to his wife. Later that same year, he also transferred his shares in a company to his Family Trust. He intended to transfer other shares to his Family Trust, however unfortunately those instructions to his Solicitors were never implemented.

On 14 February 2000, Mr Cummins finally decided that it was time to lodge an Income Tax Return. He covered the years 30 June 1992 to 30 June 1999 in this Tax Return.

The ATO, somewhat expectedly, were excited about the prospect of recovering such a large amount of Tax, and instituted proceedings against Mr Cummins for the recovery of $955,672.92. Not surprisingly, Mr Cummins went into Bankruptcy. The ATO was the only creditor, and clearly the assets remaining in his personal estate were insufficient to meet his tax liability.

The ATO funded the Trustee in Bankruptcy to institute proceedings against Mr Cummins and his wife. Section 121 was relied upon. The High Court noted that, for the Trustee to be successful in its application against Mr and Mrs Cummins, they needed to demonstrate that the circumstances gave risk to a reasonable and definite inference that in making the August transactions, Mr Cummins had the "main purpose" of preventing the transferred property from becoming divisible among the creditors or hindering or delaying the process of making the property available for division among the creditors.

The Court noted that Mr Cummins practice at the Bar would have been a busy practice, particularly as a Queen's Counsel. In this regard, they noted that when he took silk in 1980, he obtained a favourable recommendation by the President of the New South Wales Bar Association to the NSW Attorney General (not an insignificant indication of his abilities). He also was able to maintain two separate chambers, one being generous (and expensive) accommodation in Phillip Street.

The Court noted that it was unlikely that a Senior Counsel with a meager practice would be able to afford what he was able to afford. The Court concluded that Mr Cummins main purpose in effecting the transfers was to prevent those assets being divisible among his creditors, namely the ATO. In particular, Mr Cummins had made the decision based upon the need to protect his assets from pursuit by the Taxation Commissioner in the light of his decision over the preceding thirty five years not to lodge any Tax Returns.

Of course, this case did require the funding of the Australian Taxation Office and the wider Commonwealth Government. For creditors that are less well funded, it may be difficult for them to maintain an action against a Bankrupt under Section 120 or 121. Nevertheless, these provisions are potent weapons for Trustees in Bankruptcy to recover assets that have been transferred in dubious circumstances.

A SIMPLE FORM OF ASSET PROTECTION - THE FAMILY HOME IN THE NAME OF THE LOW RISK SPOUSE

One of the simplest strategies of asset protection is the vest the family home in the name of the low risk spouse.

This will require determination as to which spouse carries the lowest degree of risk. Where both spouses have equal amounts of risk as a result of their occupation, consideration will need to be given to more complex forms of asset protection.

It needs to be understood that this particular method is not foolproof. There is still a presumption that, even though the property is owned by one spouse, the purchase of that property is contributed to by both parties and can be considered to be joint property. The High Court, in the Cummins case, concluded that the Trustees in Bankruptcy where also successful in showing that Cummins had a beneficial ownership in the family home, even though it was only owned by his wife.

To protect against this risk, you should ensure that all payments for the house is funded by the "low-risk spouse" (using his/her salary).

In our view, it is pointless to implement this strategy after the family home is purchased. Firstly, this strategy will incur a substantial Stamp Duty cost for the Transferee. A Queensland home that has a market value of $700,000.00 would, if transferred to the low risk spouse after purchase, incur a further Stamp Duty payment of $17,500.00. It is unlikely that any person would want to incur such a significant debt.

Additionally, transferring the property post purchase will always have the "whiff" that the transferor is merely attempting to defeat creditors. It would be difficult for the Transferor to demonstrate that he or she was not offending Section 120 or 121 of the Bankruptcy Act.

However, if you implement this strategy at the time of purchase, the Stamp Duty payable will not be an additional cost.

If you do have this strategy implemented as an asset protection strategy, you should also reconsider your estate planning and Wills. For example, your spouse's Will should not gift all his/her property to you upon his/her death. This will defeat the strategy. Rather, your spouse's Will should create a Testamentary Discretionary Trust on death, of which you are the Trustee and a beneficiary.

Other forms of asset protection

Of course, there are many other options to protect your assets, many of which range in complexity and set-up costs. It is beyond the scope of this paper to consider these additional measures. If you are inclined towards additional asset protection measures, you should take specific legal advice.