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Charities in Financial Distress - Is a Merger the Answer?

on Friday, 19 February 2021.

The not for profit sector, along with most of the wider UK economy, continues to face financial challenges which have been exacerbated by the Coronavirus (COVID-19) pandemic and ongoing national lockdowns.

Identifying a Charity in Financial Distress

Charity trustees should be aware that in insolvent situations, or in cases of impending or inevitable insolvency, their primary duties switch from acting in the interests of the charity and its beneficiaries to acting in the interests of a charity's creditors. Trustees in such situations are often faced with difficult decisions as the interests of beneficiaries and creditors rarely align.

In order to assist trustees in understanding if a charity is insolvent or facing insolvency, trustees should be aware of the two ways in which insolvency can be identified: the cashflow test and the balance sheet test. A charity will be considered insolvent if it meets the conditions of any one of the two tests.

A charity will be considered to be insolvent:

  1. on a balance sheet basis, if the charity's total assets are outweighed by their total liabilities (including contingent or prospective liabilities) - in considering balance sheet insolvency, care must be taken not to include assets which are not available to the charity (such as assets held on trust or perhaps for designated purposes)
  2. on a cashflow basis, if the charity cannot pay its debts as they fall due - cashflow insolvency can arise even if the charity holds significant fixed assets, if there is not the requisite time or mechanisms to monetise those assets or if they are held for restricted purposes

Continuous monitoring of a charity's finances means that trustees are able to identify situations of doubtful solvency sooner rather than later. Reviewing up-to-date financial information regularly means trustees have more time and opportunity to explore ways in which to take preventative measures and rescue the charity, potentially avoiding the need for a formal insolvency procedure.

Are Mergers an Alternative to Formal Insolvency?

An organisation facing financial challenges will typically look to increase income or reduce costs as a way by which to improve cashflow. Mergers may represent a way in which a charity can potentially achieve both of those outcomes. A prudent board of trustees will want to ensure that, when considering options for a charity in distress, the possibility and viability of a merger is considered even if it is subsequently disregarded.

The possible advantages of a merger for a charity in distress include:

  • increased efficiencies and economies of scale in terms of administrative costs and running expenses
  • reduced costs by merging office space, sharing databases and IT resources and undertaking combined marketing campaigns
  • the ability to combine the skills and knowledge of a wider group of trustees
  • increased ability to fundraise by expanding geographical reach and avoiding donations being 'split' amongst what would otherwise be separate charities supporting the same or similar causes
  • the possibility of exploring new forms of fundraising and grants, particularly if the merged charity is not duplicating the work of other organisations
  • greater level of donations due to size and visibility of the merged charity
  • the perception of gravitas that a larger merged charity attracts, again leading to better opportunities

However, trustees of charities should be aware of the potential difficulties which may come with a proposed merger which, in particular for a charity facing insolvency, may greatly impact on a viability of exploring a merger in any significant way. Trustees will need to consider why they reasonably believe it is in the interests of the charity's creditors (or beneficiaries as the case may be) to:

  • continue to operate the charity in a potentially insolvent situation whilst seeking a merger partner and completing on any transaction
  • spend the charity's limited resources on professional advisors' fees and expenses in connection with a proposed merger, rather than preserve them to maintain the status quo for creditors
  • negotiate a merger from a relatively weak financial position

Trustees would also have to consider additional liabilities which may arise as a result of a merger (such as staff redundancies or termination costs in respect of supply and rental agreements), and the impact those liabilities will have on the charity in distress or alternatively the merged entity.

Coronavirus guidance employers

Standalone Moratorium

The Corporate Insolvency and Governance Act 2020 (CIGA 2020) introduced a new moratorium which can help charities, in certain situations, benefit from breathing space from creditor action whilst proposals to rescue or turnaround the incorporated charities are formulated and implemented.

The moratorium, which comes with strict conditions and must be monitored by an insolvency practitioner, should only be applied for in situations where the aim is to rescue the charity as a going concern and where the charity can meet its day to day running costs during the period of the moratorium.

Whilst CIGA 2020 is still relatively new and the standalone moratorium process generally untested, it would appear that the legislation envisages that the rescue under the standalone moratorium will be via a Company Voluntary Arrangement or part 26A Restructuring plan and not via a merger. However, if charity trustees are exploring a merger, which will result in all liabilities being paid in full and the legal identity of the charity remaining intact, it may be helpful for the trustees to consider with an insolvency specialist whether the new standalone moratorium could be applicable based on the specific circumstances which the charity finds itself in.

What Action Should Trustees Take?

Trustees of charities in financial distress should be mindful of their fiduciary duties, and the change in focus required in situations where they knew or ought to have known that insolvency was inevitable.

Trustees should also consider all options available to them which may assist the charity in avoiding a formal insolvency process, including the viability and feasibility of a merger. All decisions made by trustees should be documented, even if it is only to record that a merger was briefly considered and the idea dismissed.

Trustees should also regularly review and monitor up to date financial information for the charity. The sooner any position of distress is identified and professional advice sought, the wider the range of options which may be available to the charity and its trustees.

Our upcoming webinar, 'Charity Mergers - A Look Behind the Legal Process', will give practical tips to trustees, chief executives, and finance directors (as well as other stakeholders) on the merger process, and improve knowledge and understanding on the topic to assist charities in making strategic decisions in the interests of their beneficiaries. Book your free place today.

If you have any queries about any of the above, please do not hesitate to contact Ambuja Bose of our Restructuring and Insolvency team on 07469 850886. Alternatively, complete the form below.

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