Merger due diligence

July 2009

Alana Lowe-Petraske and Rosamund McCarthy look at managing risk in an unsettled financial landscape

The recession has prompted lively debate in the sector as to the increased likelihood of mergers and collaborations. The government is keen to facilitate collaborative working and recently announced a £16.5m modernisation fund to assist merger transactions.

The general wisdom appears to be that the recession will force shot gun mergers. However, NCVO points out that the evidence is largely anecdotal. For example, there is no evidence that general philanthropy is declining and there is some suggestion that the voluntary sector may continue to grow, as the public sector outsources more of its services.

It is probably the mid-sized charities that are most vulnerable. Large charities are more resilient due to reserves and diverse funding streams, whilst small charities can often rely on local goodwill. In terms of sub-sectors, NCVO identifies mid-sized charities engaged in the employment and training sector, with typically less than six months’ reserves as being particularly at risk (UK Civil Society Almanac 2009). This type of charity may merge in order to achieve the necessary scale to pitch for public sector contracts. There will be considerable competition for outsourced contracts, both from the private sector as well as the public sector, which is hiving off social enterprises to win contracts.

Whilst the effect of the recession on mergers may have been exaggerated and it is most likely to impact on particular sub sectors, it is also the case that, in a merger scenerio, it may be necessary to move very quickly. Given the complexities of mergers, this article seeks to focus on one crucial aspect of the merger process: due diligence, and to identify any recession specific facts.

What is due diligence?

There are many different ways charities can merge. This article concerns the most common, where one charity transfers all of its assets and liabilities to another. However, our comments may also be relevant for partial transfers, as well as restructures whereby two charities transfer to a new third entity. In the context of such mergers, the phrase due diligence refers to the investigations by each party to build a reliable picture of the other party’s activities, assets
and liabilities.

Due diligence is usually undertaken through a series of questions about the transferring charity’s operations in a questionnaire. These enquiries broadly cover commercial, financial and legal areas of enquiry, and the Charity Commission has published a checklist which charities may find useful
as guidance [1].

The answers to the questionnaire, and any request for further information, will give the receiving charity’s board a full picture of the risks and benefits involved in going ahead with the merger, and may point to an alternative structure, or risk-mitigating steps that need to be considered.

Key outcomes for any due diligence process include:

‘destruction testing’ the planned merger structure and timetable process, including throwing up any legal or practical hurdles;
Identifying risk;
Increasing the level of trust and comfort between the parties;
Getting to know the other party’s organisational culture;
Determining whether any existing arrangements such as contracts and funding will hamper the new entity;

When?

Due diligence should be undertaken promptly, as soon as the parties have agreed in principle to merge. The results of the due diligence may identify problematic areas that must be addressed before the merger can go ahead, such as a pensions ‘cessation event’. They may also identify further time-intensive steps necessary, such as regulatory consents, novations or other third party consents.

Pre-merger confidentiality

It may be appropriate for the parties to enter into a confidentiality agreement immediately prior to starting the due diligence process. This step is absolutely essential in commercial mergers, particularly where the parties do not wish to share any information that could cause damage if the merger does not go ahead.

Who?

Who manages the due diligence process can vary. The process can be document intensive, so charities will need to devote appropriate time and resources. Professional advice will be required for particularly complex and risky areas such as pensions and compatibility of objects. Charities may wish to save costs by analysing as much of the due diligence information as they are able, while others will welcome the chance to share the burden with legal advisers.

Financial health

The due diligence questionnaire will ask for copies of the accounts, usually over the last three financial years. The accounts will necessarily be slightly out of date, which must be considered in light of the shifting financial landscape. A stark example would a charity with all of its cash assets held in Kaupthing, Singer and Friedlander Bank in Iceland. An optimistic outlook, not reflected in its accounts, would have such a charity re-couping around 50 per cent of its deposited cash within the next few years.

Trustee duties

Trustees will be tasked with considering the ‘big picture’, and in uncertain financial times external factors become even more important. When analysing the answers to the due diligence questionnaire, the receiving charity should add the following recession-specific points:

which areas of their partner’s operations are particularly recession- susceptible;
whether changes in circumstances mid-way through a due diligence process raise any further areas to be investigated;
how up-to-date available information is; and
how information can be ‘refreshed’ periodically.

There is clearly a balance to be struck between keeping information ‘refreshed’ and the amount of time and cost involved in further due diligence investigations.

Areas of special risk

Pensions

The due diligence questionnaire should request details of the pensions arrangements of the transferring charity. It should also request any less formal ‘moral obligation’ arrangements.

One particular risk, and sometimes a showstopper, is when the transferring charity is a member of a defined benefit multi-employer pensions scheme. A scheme of this nature guarantees the benefits that an employee will receive on retirement. Where there is a transfer of the undertaking, unless appropriate procedures are followed, there may be a cessation event and a withdrawal debt may become due. The size of such a debt can be eye-wateringly enormous.

Insurance

The due diligence questionnaire should request details of all existing insurances as well as past, current and anticipated claims. It will also be important to consider how – if at all – liabilities which may arise in future may be covered by the transferring charity’s insurances. In most merger scenarios past liabilities are taken on by the receiving charity. If those liabilities were insured risks, they may be covered even in the hands of the merged charity.

If the insurance cover is written on a ‘claims arising’ basis then the trustees should remain covered for any claims that are made after they have stopped paying the premiums and the insurer may cover the merged charity in place of the transferring charity if it is wound up. If the insurance cover is written on a ‘claims made’ basis, however, then it will lapse as soon as the premiums are not paid. The trustees of the merged charity need to consider purchasing ‘run-off’ insurance to cover liabilities of the transferring charity, which relate to the period prior to the merger.

Property

The title of freehold and leasehold property and details of any properties let by the transferring charity to tenants will need to be carefully considered.

To avoid a nasty surprise, the parties should ensure that the cost of making good dilapidations when yielding up the property is included in the overall assessment of the transferring charity’s assets and liabilities.

Property owned by the transferring charity may have decreased in value recently, and the parties will need to consider carefully any disposal plans.

Areas often overlooked

Office of the Scottish Charities Regulator (OCSR)

Local advice should be sought if either of the charities operates in Scotland or Northern Ireland. In particular, if either of the charities operates in Scotland, consent must be sought from the Office of the Scottish Charities Regulator (OCSR). Section 16 of the Charities and Trustee Investment (Scotland) Act 2005 requires this consent in various circumstances, including where a charity is amalgamating with another body and when proposing to wind up.

Data protection

Charities proposing to merge need to consider what sorts of regulated personal data they each hold. Although prosecution for a data protection offence is rare, the reputational fallout that a breach may bring is a serious concern. This will particularly be the case if the transferring charity holds ‘sensitive personal data’, such as information about an individual’s:

racial or ethnic origin;
political opinions;
religious beliefs or other beliefs of a similar nature;
trade union membership;
physical or mental health or condition;
sexual life;
status as having commissioned or allegedly commissioned any offence;
status as having been subject to any court proceedings.

In principle such data cannot be transferred from the transferring charity to the receiving charity without the consent of the individual data subject. However, the Information Commissioner’s Office has indicated that such consent will not be required where the data is to be used for the same purpose post-transfer, although notification will be required as soon as possible when a transfer date is known.

Objects and restricted funding

The parties are likely to have considered the compatibility of the charities’ vision and purposes as part of their initial merger discussions. However, the exact wording – and legal meaning – of the charities’ objects is something that must not be overlooked. Objects that appear similar may in fact be sufficiently different to restrict the funds after transfer, effectively defeating the purpose of merging the two charities in the first place! This point will be evident to legal advisers as soon as they have sight of the parties’ constitutional documents. It may be necessary to seek Charity Commission consent to vary the objects of one or more of the charities prior to transfer.

Restricted funds and permanent endowment

The transferee charity should consider whether any restricted funds or permanent endowment restrictions apply to some or all of the assets to be transferred. Restricted funds are funds held by a charity on special trusts which are narrower than the charities’ objects as a whole. Restricted funds cannot be spent freely by the merged charity. Permanent endowment refers to a restriction on some or all of the assets of a charity which prevents the capital from being spent.

The charities’ respective accounts should identify restricted funds and permanent endowment funds, but in practice do not always do so. Even where no permanent endowment is recognised by the current trustees, the point should be checked by the legal advisers.

Mergers register

Winding up a party to a merger can be risky, because a legacy given subsequently to the organisation which has been wound up may fail if the organisation no longer exists. The register of mergers, created as a result of the Charities Act 2006, was intended to ensure that even if an organisation has been wound up; such legacies will pass to the newly merged organisation. Unfortunately, a loophole in the Act is causing problems. In most cases a charity which might receive a legacy should not be wound up after the merger. It may be possible to streamline accounting for such a ‘shell charity’ by making it a subsidiary and asking the Charity Commission to provide a direction to allow joint accounting.

Warranties and indemnities

No amount of documentation exchange will mitigate risk in a merger if the information cannot be relied on. The parties may consider going down the commercial route and trying to limit their risk by seeking warranties and indemnities in respect of the transferring assets. The practice of seeking warranties and indemnities is a matter of contention in the sector. Many argue that this practice, imported from the commercial world, is inappropriate to the gift of a charitable undertaking. Even if the charity trustees of the transferring charity are willing to give personal indemnities, only the wealthiest trustees would be able to cover a serious liability, so in practice such indemnities only mitigate risk to a limited extent. However, our view is that seeking warranties and indemnities ‘concentrates minds’ and encourages disclosure of information. Usually personal warranties are limited to trustees’ personal knowledge and without the need to make special enquiry.

Outlook for the future

Whilst the effects of the downturn are too complicated to allow for helpful generalisation, there is little doubt that, as the recession starts to bite, some charities will have no choice but to merge. Rapid due diligence, which quickly identifies the key issues, will be vital to a smooth merger and to protecting the interests of beneficiaries.

[1] www.charity-commission.gov.uk/Library/enhancingcharities/pdfs/chkmerger.pdf