The what and the why of due diligence
Due diligence is part of a process undertaken by charities and other organisations when they are looking to work together and/or merge to try to ascertain from a legal and financial perspective the strength of their partner organisation.
The due diligence exercise in the context of a charity merger has two principal aims:
- to ascertain the nature and extent of the assets and liabilities of the merger partner, to establish whether the partner is viable and/or whether the proposed merger or transaction is likely to generate the anticipated benefits
- to ensure that any transaction you decide to enter into can be put into legal effect and does not itself create or trigger unforeseen liabilities
The scope of due diligence
The scope of the due diligence exercise will depend very much on the context within which you are working and the activities undertaken by the proposed merger partner. The risks inherent in an endowed grant giving charity that merely distributes income from its endowment compared to an organisation running a residential home for vulnerable people are clearly very different.
It is generally sensible to set a financial threshold beneath which any potential “problems” are immaterial and can be ignored. This might be set at say 5% of the turnover of a particular organisation. But note: numerous minor issues could together constitute a material issue. You will also want to consider how you phase the work so that you can manage the costs of the exercise.
Effective management and organisation is critical
- Who is carrying out the due diligence and co-ordinating the exercise?
- Do you need additional resource in the form of a project manager? In the context of charity merger it is often helpful to have an independent person driving the process.
- Will there be a legal and/or financial report for boards of trustees etc?
- What do your board of trustees need to understand and consider in order to approve a transaction?
- Have you scoped the project and agreed engagement letters where necessary to ensure professional costs are carefully managed?
What does legal due diligence in the context of a charity merger generally cover?
The list below is merely a starting point for your enquiries. You should not regard it as exhaustive or necessarily appropriate as it will need to be considered in the context of the arrangement and the respective organisations.
Depending on the nature and structure of the transaction, you may need to consider different issues.
- If a transaction is structured as a merger by way of group structure (in other words you transfer the whole organisation to become a subsidiary of another by changing its membership) you may want to consider lighter touch due diligence but look for provisions which create liabilities on a change of control.
- Where you are planning to assume the assets and liabilities of an organisation, you will need to consider the provisions in much more detail on a contract by contract basis.
- Where you are undertaking the incorporation of an existing charity or converting a new legal structure, the current trustees and management team will have a pretty good idea of assets and liabilities. But are there any restrictions on transferring them to the new corporate body? Leases for example will almost certainly require landlord’s consent to assign even if to a successor body.
Due diligence checklist for a charity merger
- Who is your partner? You should check publicly available sources of information and particularly Companies House and the Charity Commission.
- Obtain details of the constitution and ensure the partner has the relevant authority to enter into any transaction.
- Is the organisation subject to any other statutory obligations in relation to its business or subject to any other regulatory or licence regime (for example is it registered with the Care Quality Commission or making loans that might be subject to the Consumer Credit Act)?
- Are there any charges registered against the partner or over any of its assets? If so, what needs to be done to release them and when?
Employment law is increasingly complex and the Employment Tribunals generally look to protect the rights of employees. One of the most significant risks in any organisation or any transaction comes from employment issues. Therefore, you should check the following:
- will TUPE apply to the transaction?
- identify key employees
- obtain details of all employees and/or consultants working in the organisation including:
- terms of employment
- wage agreements and pay awards
- bonus schemes
- other benefits
- notice periods
- sickness records etc.
- obtain copies of employment contracts and handbooks; ensure handbooks are not contractually binding
- identify existing and potential employment claims
- analyse employee morale, turnover, training and competitiveness of employment terms
- details of labour relations, union recognition, strikes and sickness records
- Consider employee representation
In certain circumstances where a multi-employer defined benefit pension scheme (such as certain Pension Trust schemes) is involved, a transaction can trigger a requirement to make good any deficit on that scheme.
Where employees are members of certain government schemes such as the Local Authority Pension Scheme additional considerations will apply. If there are, it is likely that specialist advice will be required.
You should ensure you obtain details of all pension schemes and details of employees who participate in those schemes.
Intellectual property and data
- What data does the organisation hold and on what basis? Charities will need to consider carefully whether the data can be transferred and used based on existing consents or whether there is some other basis under applicable data protection law. Detailed advice will be required especially where donor data is used to email marketing materials to donors and supporters.
- Consider what, if any, intellectual property is subject to the transaction and/or used in the relevant business
- Is there any business intellectual property? How was it created?
- Details of all licences of intellectual property.
- Domain names/ trademarks etc.
- Integrating computer systems is a significant issue in merger discussions. This will likely require detailed technical advice.
- Does the partner have all the relevant licences to use the relevant systems and applications?
- Does it own the copyright to software that it uses?
- Are there any restrictions on the transfer of software licences or their uses?
- On their website who owns the copyright in the design and content?
- Details of technical problems.
Depending on the nature of the transaction the merger partner’s solicitors may produce “certificates of title” in respect of properties. Alternatively, your solicitors may need to investigate title to properties. This involves obtaining official copies of the title of the properties from the Land Registry together with any other relevant documents and making further appropriate contract enquiries.
- You should request a schedule of properties to be acquired and details of any properties previously occupied or in respect of which there may still be any liability.
- Obtain details of all leases, tenancies and licences held or granted by the partner organisation.
- Are the properties subject to mortgages or charges?
- Is the value of the properties an issue in relation to the collaboration or merger?
- Do you need any surveys?
- Are the buildings compliant with statutory regulations?
- Are there are any planning considerations?
- Depending on the nature of the premises you may wish to undertake enquiries in relation to environmental matters, in particular in relation to contaminated land.
Health and safety and safeguarding
- Is any health and safety due diligence required? The assessment of this will depend very much on the nature of the operations undertaken by your partner.
- These issues may cover matters such as the protection of vulnerable adults and children. The Charity Commission regards “safeguarding” as much wider than just being applicable to children and vulnerable adults, so make sure your enquiries cover all incidents.
Financial and tax
- Generally, your accountants will undertake a detailed financial and tax review. You should ensure this covers VAT.
- Is there an asset register?
- Are all assets owned or are any subject to finance leases or hire purchases? B. If leased or on hire purchase consents are likely to be required for the transfer of the asset.
- Is there any stock?
- You should obtain copies of all standard terms and conditions of sale and purchase used by the partner. You should try to understand how often these are used and in what context.
- Obtain copies of all material agreements in connection with the partner’s business.
- Some businesses have very few contracts. Others have many.
- If there are only a few contracts you will need to understand the details of their terms and conditions, for example, how long they have to run, whether they are transferable etc.
- If there are many contracts, you will need to try to identify those individual contracts or groups of contracts that are “material” in the context of the business.
- You may consider looking at the contracts by value, by the period they have to run, by the nature of the contract or the contract counterparty. Usually funding agreements are of considerable interest.
- This is an area where you will need to exercise some discretion to ensure that the due diligence does not become unmanageable.
Things to consider:
- agreements which cannot be terminated on one month’s notice without payment of compensation
- contracts with more than, say, six months to run
- contracts which prohibit the assignment or transfer to a third party
- any credit arrangements or commitments over a certain value
- details of hire purchase, rental or leasing agreements
- you should note these often contain clauses which prevent assignment. A transfer can trigger an obligation to “pay up” the contract
- details of any guarantees or indemnities given
Litigation and regulation
- details of any serious incident reports made to the Charity Commission
- communications with any regulators such as the Charity Commission, the ICO, CQC etc
- details of any existing or threatened litigation or regulatory proceedings
- details of any outstanding judgments
- Does the Partner’s insurance cover transfer or do you need new insurance or run off cover?