Nonprofit Mergers – Part I: Basic Legal Considerations

Nonprofit corporations may decide to merge for many reasons, including to better advance a common purpose or to expand the range of services offered to common beneficiaries. Generally, in a simple 2-party merger between A (the surviving corporation) and B (the merging corporation also referred to in the law as the disappearing corporation), A automatically assumes all of the assets and liabilities of B upon the merger by operation of law. Thus, the debts of B become the debts of A, and A is automatically substituted for B in any lawsuit or legal proceeding. This may be problematic if B’s liabilities cannot be identified or if B’s liabilities are greater than expected, particularly if they exceed the value of the assets A acquired in the merger.

Initially, the parties must determine which will be the surviving corporation and which will be the merging corporation, which may not be obvious. From a legal perspective, the parties might consider the history of each entity and its recognition of tax-exempt status (e.g., a church may not have an IRS determination letter), existing government licenses, contracts, or registrations, and each entities’ employees and their employment benefits. For example, a smaller, less established nonprofit might be the more suitable surviving corporation if it possesses a critical license that the larger, more established nonprofit values. In such case, the merging corporation’s board might take over the surviving corporation’s board and rename the surviving corporation with the merging corporation’s name. As a result, the public would likely believe the merging corporation was actually the surviving corporation.

Once it is determined which entity will be the surviving corporation, the surviving corporation must plan how it will absorb both the assets and liabilities of the merging organization and take over any transferable rights and obligations. Accordingly, proper due diligence is key. While there is no prescribed set of materials that should be considered by the board of each entity (though see our previous post on Nonprofit Mergers – Due Diligence Items for a sample), the goal of due diligence for each entity is to assure that its board has engaged in sufficient inquiry and acquired enough information to make an informed decision that merging is in the best interest of the corporation and that the integration will ultimately be successful.

From a corporate governance perspective, if either corporation has a voting membership structure, consideration should be placed on obtaining membership approval for the merger and the possible barriers. The mechanics of a membership vote can be onerous and may require additional time to obtain such approval. If an entity cannot get obtain a quorum of the members necessary for a vote, or if a faction of members disagrees with the merger, this may add significant cost and delay.

If the merging corporation has real property, the surviving corporation should consider issues such as the cost and requirements of transferring ownership, whether the terms of any loans require bank consent, whether there are any liens on the property, whether the merger will trigger transfer tax liability, and whether an environmental review should be conducted. The surviving entity will also want to review whether the merging corporation is a party to actual, pending, or threatened litigation, settlement agreements or court orders, and whether the merging corporation has any nontransferable permits or licenses. Further, the surviving corporation should consider the potentially complex employment issues that may result, particularly if not all employees of the merging corporation will be employed by the surviving corporation, there are union or organizing activities involved, compensation and benefit structures are markedly different and not easily harmonized, there are misclassified independent contractors who should have been treated as employees, or there are employees strongly opposed to the merger.

For the merging corporation, issues may arise if it has assets (e.g., restricted funds, endowment funds) that are bound by charitable trust to a purpose that does not completely line up with the surviving corporation’s mission. In such case, the surviving corporation may have to amend its governing documents to broaden its purposes in order to receive such assets (however, then it must be careful not to use any funds it previously raised under its more limited purpose for the new broader purpose) or the merging corporation may have to grant such fund out to another organization prior to the merger. Of course, the merging corporation must also consider the sustainability of the surviving corporation, which may involve careful review of the surviving corporation’s financial statements, information returns, compliance history, and other characteristics that would indicate the surviving corporation’s ability to integrate the operations and activities.

The merging corporation should also review its contracts and determine which may be freely assigned and which require consent from, or notice to, the other party to the contract. The board of the merging corporation should also think through the requests it will bring to the merger negotiations regarding its legacy, such as whether certain named programs will carry on, or ensuring that a specific geographical area continues to be served by the surviving corporation post-merger.

 Legal considerations of an asset transfer in lieu of a merger (dissolution and transfer)

In some cases, an organization may want to consider dissolving and transferring its assets to another entity. In this scenario, when B (the dissolving corporation) distributes its remaining assets to A (the recipient corporation) and then dissolves, A generally does not automatically assume B’s liabilities. A may be able to limit the risk it takes on when acquiring B’s assets, as, unlike a merger, B’s liabilities do not necessarily transfer to A by operation of law.

The terms of such a transaction are governed by an asset transfer agreement. The recipient corporation may be able to reduce its liability exposure though a contractual provision stating that it is assuming only certain explicitly identified assets and liabilities and structuring the transaction so it does not appear to be a merger either in substance or form. Special consideration should be given to whether indemnification provisions and representations and warranties will provide much protection, as the recipient corporation may be left without remedy if the dissolving corporation breaches the agreement and has dissolved.

If the recipient corporation has a complicated membership structure, and assuming the bylaws do not state otherwise, one advantage to a dissolution and transfer of assets is that the recipient corporation would not have to seek membership approval of this transaction. Typically, the due diligence necessary on the part of the board of the recipient corporation may be significantly less arduous if it is merely approving a receipt of assets.

For the board of the dissolving corporation, an asset transfer in lieu of a merger may be far less desirable if certain liabilities are carved out of the transaction, which could expose the individual board members of the dissolving corporation into litigation in the future. 

It is important to note that although the recipient corporation does not automatically assume the dissolving corporation’s liabilities, there is always some risk associated with a full transfer of assets that a court could conclude the transfer constituted a de facto merger. Accordingly, the recipient corporation would want to carefully review such risk. Factors that may contribute to the risk include whether the boards of the dissolving corporation and the recipient corporation (post-transfer) are substantially similar or integrated. It may difficult to argue that the recipient corporation is different than the dissolving corporation if it is now governed by the same people. Along the same lines, does the recipient corporation carry on all of the same programs as the dissolving corporation with the same employees and pursuant to the same names, policies, practices, and procedures?

Overall, if the transfer of assets and dissolution results in exactly what would occur in a merger, for example (1) assumption of certain obligations of the dissolving corporation that allow for the recipient corporation to continue operating the dissolving corporation’s programs/businesses and (2) continuity of the management, personnel, locations and operations of the dissolving corporation, a court could conclude that the corporate restructuring was in substance a merger and that the recipient corporation should be treated as a surviving corporation in a merger.