Law brings temptation to fund management

Published in the July 24, 2009 edition of Columbus Business First

Ohio recently became the 39th state to adopt a new standard for managing endowments, known as the Uniform Prudent Management of Institutional Funds Act, commonly referred to as UPMIFA.  At this time only three states have not introduced or enacted this model legislation, making this de facto the new standard for nonprofit investment.

More information can be found at the Web site http://www.upmifa.org.

The act is a model, so enacted legislation can vary and requires careful study.  It raises the bar of “standard of care” expected of nonprofit officials in three areas.  At the same time, it gives nonprofits two new powers that, if not controlled, can tempt cash-strapped nonprofits to make short-term decisions that can lead to long-term harm. 

●  First, in light of the substantial investment losses in 2008, nonprofits are reconsidering how they invest.  Some are avoiding equity or foreign investments and concentrating in a single class, such as cash or bonds.  But the standard requires diversification.  To do otherwise the nonprofit must identify special circumstances and articulate specific purposes for the investment fund that together justify and warrant concentration rather than diversification. 

●  Second, when a donor gives a large amount of stock, a piece of real estate, or other non-cash asset, some nonprofits are tempted to time the market by delaying selling the asset in hopes of a higher sales price.  To counter this temptation, many nonprofits have policies that require prompt sale of all gifts and immediate investment of the cash proceeds according to the asset allocation policy of the institution.  The act codifies this practice by requiring “within a reasonable time” that the institution “make and carry out decisions” regarding whether to hold or sell the gifted property. 

●  Third, whenever large gifts are received, the statute requires the institution to “rebalance” the newly enlarged portfolio to comply in a reasonable time with its asset allocation and other investment policies.  This requirement is especially notable in times when hard-hit nonprofits are wondering whether to get back in the market.  In positive equity markets, nonprofits have the opposite tendency and to ride their profits into excessive exposure to equities or other high-flying asset classes.  The law is clear:  The nonprofit must adhere to its asset allocation policy. 

Many nonprofits with small or newly established endowments have run into large investment losses that have reduced the market value of their endowed funds below the original value of the gift, called the corpus or historical market value.  Under the old statute, this situation (often called being underwater) requires suspension of any withdrawals from the affected endowed fund, causing a sharp reduction in revenue and possibly operating deficits. 

●  The fourth major change embodied in the act is to allow withdrawals from endowment funds that are underwater.  This new authority creates a significant dilemma for boards facing difficult budgets and looming operating deficits.  The statute only requires that withdrawal decisions be “prudent and in good faith.” 

Any hesitation about board members’ liability is further allayed by statutory provision of an “irrefutable presumption of prudence” as long as the withdrawal is less than 5 percent of the three-year quarterly moving average market value of the fund. 

The model statute offered a twig of counterpressure by suggesting a “rebuttable presumption of imprudence if the withdrawal from underwater funds were greater than 7 percent.  Ohio, and several other states did not enact this countermeasure. 

This new power is hazardous.  It can make sense only when budget pressures would otherwise irreparably harm the mission of the organization.  And even then, it is prudent only when the nonprofit has a solid plan and commitment to make the corpus whole from operating funds after the severe circumstances abate.  The persistent pressure on most nonprofits to use excess operating resources to expand or improve services in good times makes one skeptical the corpus will ever be made whole so that the long-term value of the endowment would have been permanently eroded. 

●  Fifth, the act has given nonprofits new authority to release gifts from donor restrictions.  Until now, to change restrictions on gifts, nonprofits had to get the written permission from the donor or else begin a lengthy and costly legal process called cy pres.  The act allows a nonprofit to unilaterally release or modify restrictions on small gifts made years earlier.  Ohio enacted an easier standard than the model legislation:  gifts of less than $250,000 made more than 10 years ago can be unilaterally modified.  The nonprofit must only notify the state attorney general of its intent and attest that the intended use would still be consistent with the original charitable purpose of the gift. 

Used with restraint, this new authority can allow nonprofits to tap myriad gifts whose restrictions have become antiquated, superseded, or extremely difficult to meet, and allow the funds to be used for purposes that are similar but were not apparent at the time of the gift. 

On the other hand, without restraint this new power can foster distrust by current and future donors and undermine fundraising. 

Overall, the new standard represents the lessons learned over the past 35 years.  It tightens up where needed and it loosens up where flexibility can help nonprofits sustain their missions. 

But this new authority requires enhanced internal discipline.  Nonprofits would be wise to use these new powers cautiously and with restraint. 

Allen J. Proctor was formerly chief financial officer of Harvard University and is the author of Linking Mission to Money® Finance for Nonprofit Board Members. Subscribe to his free newsletter at www.proctorconsulting.org.

Copyright 2009. Reprinted with permission, Business First of Columbus Inc.