The Learning and Skills Council claimed that Kids in Communication, which employs four staff, did not act with "reasonable care and skill" in delivering its contract to provide services to disadvantaged young people in the West Midlands. It began a 16-month battle to reclaim the money.
The case was due to go to court this week, but last Thursday the directors of the group, which has assets of £4,600, agreed to settle by paying the LSC, which receives £10.4bn a year from government, £50,000 of their own money. The directors said they had a strong case, but the organisation would go bust if the judge ruled against them.
Rob Smith, chief officer at Kids in Communication, said the quango's high legal fees were at odds with the LSC's claim that it was pursuing litigation to protect public funds. "It's a disgrace," he said. "How can any small voluntary organisation find the money to go to court against them?"
The NCVO, which claimed the LSC had abused the Compact on seven occasions and urged it to drop the case, described the LSC as "draconian and bullying".
Saskia Daggett, Compact manager at the NCVO, said: "The Compact was introduced to stop this kind of expensive litigation. The kids lose but the lawyers win."
Rob Wye, director of strategy and communications at the LSC, said this was about the principle of acting against organisations that "take our money and don't deliver".
The LSC, the NCVO, Acevo, the Office of the Third Sector and the Compact Commission are due to meet soon to discuss the case.