Endowment Funds – Investments, Distributions, and Enforceability
Governing Law
Trust and Corporate Law
Courts have traditionally wrestled with the issue of whether corporate law or trust law principles should regulate the operations of charities.
City of Paterson v. Paterson General Hospital, 97 N.J Super. 514, 235 A.2d 487 (Ch. Div. 1967) (“To what extent a charitable corporation is to be governed by laws applicable to charitable trusts is a vexed question to which the authorities give irreconcilable answers.”).
Stern v. Lucy Webb Hayes National Training School for Deaconesses, 381 F. Supp. 1003 (D.D.C. 1974) (“The charitable corporation is a relatively new legal entity which does not fit neatly into the established common law categories of corporation and trust.... [H]owever, the modern trend is to apply corporate rather than trust principles in determining the liability of the directors of charitable corporations, because their functions are virtually indistinguishable from those of their ‘pure’ corporate counterparts.”).
In Colorado, it is clear that directors and officers of nonprofit corporations are not to be considered trustees. C.R.S. Section 7-128-401(5) (“A director, regardless of title, shall not be deemed to be a trustee with respect to the nonprofit corporation or with respect to property held or administered by the nonprofit corporation including, without limitation, property that is subject to restrictions imposed by the donor or transferor of such property.”).
What has been less clear is whether a nonprofit corporation itself can be deemed to hold in trust property that has been contributed to it subject to restrictions imposed by the donor. To a large extent, that issue was resolved by the enactment of the Uniform Management of Institutional Funds Act in 1973, an Act that was amended in its entirety in the 2008 legislative session.
Many of the new law’s provisions, however, have been borrowed directly from trust law, including the prudent investor standards of the Uniform Prudent Investor Act and the equitable deviation and cy pres principles of the Uniform Trust Act, and the new law’s default spending policy rule originates from, but extends, the principles of the Uniform Principal and Income Act.
UPMIFA
House Bill 08-1173 was signed by Governor Ritter on April 21, 2008. Known as the “Uniform Prudent Management of Institutional Funds Act,” it is codified at C.R.S. Section 15-1-1101 et seq.
UPMIFA became effective in Colorado on September 1, 2008.
On its effective date, UPMIFA applies to all existing endowment funds, but only with respect to decisions made or actions taken after that date. C.R.S. Section 15-1-1108.
The full text of the official comments to the Uniform Law Commission’s 2006 official text of UPMIFA are included, as “nonstatutory matter," in the Colorado Revised Statutes.
History and Adoption
UPMIFA was the result of four years of effort, beginning in 2002, by the National Conference of Commissioners on Uniform State Laws, now known as the Uniform Law Commission.
It supersedes the Uniform Management of Institutional Funds Act, which had been enacted in Colorado in 1973.
It has been adopted in every state but Pennsylvania.
Definitions Used in UPMIFA
Endowment Fund
C.R.S. Section 15-1-1102(2) defines an “endowment fund” as an “institutional fund or part thereof that, under the terms of a gift instrument, is not wholly expendable by the institution on a current basis.”
Note that this definition has nothing to do with the purposes for which a fund may be spent, only its duration.
The definition also does not describe how much of the fund may be spent, or what portion of the fund may be spent in any particular year, only that the fund not be wholly exhausted “on a current basis.”
Examples:
a capital campaign fund that is intended to accumulate moneys to pay for a construction project that is expected to span more than a year
a fund that will distribute 20 percent of its principal each year until it is fully exhausted at the end of the fifth year
a perpetual fund
a fund that is designed to distribute “income only”
Board-Designated Endowments. The term “endowment fund" does not include so-called “board-designated endowments” or “quasi-endowments,” that is, assets that an institution itself designates as an endowment fund for its own use. C.R.S. Section 15-1-1102(2). It only includes funds that are subject to spending restrictions that arise under a “gift instrument.”
Institutional Fund
An “institutional fund” is one that an “institution” holds for “chartable purposes.” C.R.S. Section 15-1-1102(5).
Certain funds are excluded from this definition –
“program related assets,” that is, assets that the institution holds primarily to carry out a charitable purpose and not primarily for investment
funds held by a trustee that is not an “institution” for the benefit of an institution
funds in which any beneficiary who is not an institution has an interest, other than a interest that could arise upon a violation or failure of the purposes of the fund (for example, charitable remainder and charitable lead trusts)
Denver Foundation v. Wells Fargo Bank, N.A., 163 P.3d 1116 (Colo. 2007), rev’g 140 P.3d 78 (Colo. App. 2005), involved two trusts created in 1976 by Charles Sterne and his wife, Dorothy Elder Sterne, that named the United Bank of Denver as trustee for the benefit of the Denver Foundation, a large community foundation. At the time of their formation, therefore, the Sterne trusts would not have been considered “institutional funds,” since they were held by a noncharitable trustee for the benefit of a charitable institution. However, following the Sternes’ deaths, the Denver Foundation asked Wells Fargo Bank, the successor in interest to United Bank of Denver, to transfer all the assets of the trusts to it. The Colorado Supreme Court concluded that the Sternes’ ultimate intent was “to establish a perpetual gift and a permanent endowment for the uses and purposes of the Foundation,” rather than to maintain “the usual tripartite trust relationship,” and affirmed the decision of the Denver Probate Court (which had been reversed by the Colorado Court of Appeals) directing Wells Fargo to transfer the trust assets to the Denver Foundation., thus converting the trust assets into an endowment fund governed by UMIFA/UPMIFA.
Institution
C.R.S. Section 15-1-1102 defines an “institution” as any –
“person, other than an individual, organized and operated exclusively for charitable purposes”
“government or governmental subdivision, agency, or instrumentality, to the extent that it holds funds exclusively for a charitable purpose”
“a trust that had both charitable and noncharitable interest, after all charitable interests have terminated”
Charitable Purpose.
A “charitable purpose” means “the relief of poverty, the advancement of education or religion, the promotion of health, or any other charitable or eleemosynary purpose.”
Gift Instrument
The concept of a “gift instrument” is crucial to determining whether an endowment fund exists and how it is to be maintained and operated.
A “gift instrument” means any “record or records, including an institutional solicitation, under which property is granted to, transferred to, or held by an institution as part of an institutional fund.”
The reference to an “institutional solicitation” suggests that a gift instrument is certainly broader than a two-party endowment fund agreement, broader even than a will, trust, or instrument of conveyance, and that the term can include letters mailed out in a fundraising appeal, information contained on an organization’s web site, and even email.
The fact that a gift instrument must be embodied in a “record,” however, suggests that communications that are merely verbal, made face-to-face or via telephone, cannot create an endowment fund.
Record
A “record” is any “information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form.”
Management of Endowment Funds
Consideration of Charitable Purposes
In the course of managing an endowment fund, there is a fundamental requirement that a charity must consider both the charitable purposes of the charity itself and the purposes of the fund. C.R.S. Section 15-1-1103(a).
In all cases, the charity’s considerations of these factors are subject to the intentions of the donors expressed in a gift instrument. However, according to the official comments, the “emphasis on giving effect to donor intent does not mean that the donor can or should control the management of the institution.”
Because endowment funds typically have only one “beneficiary,” it may seem that the interests of the charity and the interests of the fund coincide, but that is not always the case. Charities have both present and future needs for funds, and the spending policy of an endowment fund may favor one or the other. Donors may establish endowments to finance particular activities, and those activities may or may not represent priorities of the charity.
Standards of Loyalty and Care
C.R.S. Section 15-1-1103(b) alludes to compliance with the duty of loyalty “imposed by law other than this Part 11.” This is, as the official comments state, merely a reminder, not a provision that sets forth an affirmative duty.
With respect to the directors and officers of nonprofit corporations, there are two components to the duty of loyalty.
The first relates to transactions that involve conflicts of interest, and C.R.S. Section 7-128-501 provides that no such transaction may be enjoined or give rise to damages so long as certain procedures are followed.
The second is embedded in the more general standards of conduct set forth in C.R.S. Section 7-128-401(1)(c) that require directors of nonprofit corporations to act in a manner they reasonably believe to be “in the best interests” of the corporation.
With respect to charities organized as charitable trusts, a stricter duty of loyalty may apply. While, in the case of charities, corporate and trust law may be converging, Brody, Who Guards the Guardians? Monitoring and Enforcement of Charitable Governance; What’s Trust Law Got to do With It?, 80 Chi.-Kent L. Rev. 641 (2005), trustees historically have operated under a duty to act in the sole interests of the trust. Restatement (Second) of Trusts Section170(1) (“trustee is under a duty to the beneficiary to administer the trust solely in the interest of the beneficiary”).
C.R.S. Section 15-1-1103(b) does impose a duty of care on each person responsible for managing and investing an endowment fund and requires that each such person act “in good faith and with the care that an ordinarily prudent person in a like position would exercise under similar circumstances.”
The standard of care is identical in this regard with that imposed on the directors and officers of a nonprofit corporation. C.R.S. Section 7-128-401(1)(c).
The standard presumably applies whether the fund is held in trust by a charity or not.
The comments to the ABA’s Revised Model Nonprofit Corporation Act note that the phrases “like position” and “similar circumstances” are intended to reflect the sometimes unique character of nonprofit corporations and their boards, the fact that the corporations may operate with limited financial (and often donated) resources, that their board members may be volunteers, and their mission generally relates to promoting public good, as opposed to maximizing a return on investment. Presumably, these phrases will be similarly interpreted when applied to persons managing or investing endowment funds.
Note, however, that the standard of care applies to all persons managing or investing an endowment fund, not just corporate officers and directors. This would include volunteers, as well as professional money managers to whom authority may have been delegated.
The comments to Section 3 of UPMIFA note that UPMIFA is not intended to affect the application of statutes that provide immunity to volunteers serving nonprofit organizations.
According to the official comments of UPMIFA, the duty of care is mandatory and cannot be overridden or minimized by terms in a gift instrument.
Reasonable Expenses
C.R.S. Section 15-1-1103(c)(1) states that a charity “may incur only costs that are appropriate and reasonable in relation to the assets, the purposes of the institution, and the skills available to the institution.”
This duty to minimize costs in the management and investing of an endowment fund is similar to Section 7 of the Uniform Prudent Investor Act, C.R.S. Section 15-1.1-107.
Because C.R.S. Section 15-1-1103(c)(q) is not prefaced with language like “subject to the intent of the donor” or any reference to a gift instrument, this duty is mandatory.
Verification of Facts
C.R.S. Section 15-1-1103(c)(2) requires the charity to “make a reasonable effort to verify facts relevant to the management and investment of the institutional fund.”
Again, this language is similar to that of the Uniform Prudent Investor Act, C.R.S. Section 15-1.1-102(d).
Because C.R.S. Section 15-1-1103(c)(2) is not prefaced with language like “subject to the intent of the donor” or any reference to a gift instrument, this duty is mandatory.
Pooling of Funds
C.R.S. Section 15-1-1103(d) permits a charity to pool or commingle endowment funds.
Pooling likely allows greater economies of scale and possibly promotes diversification.
A charity will be obligated, however, to maintain adequate accounting records to identify each pooled fund’s share of investment gains and losses, and, according to the official comments of UPMIFA, the rules relating to spending policies and deviating from the restrictions applicable to endowment funds, apply on a fund-by-fund basis, whether or not endowment funds have been commingled.
Note that the ability to pool funds is not qualified with reference to any gift instrument.
Delegation of Authority
C.R.S. Section 15-1-1105 allows a charity to delegate investment and other management authority with respect to an endowment fund. In fact, under some circumstances, delegation may be necessary in order for a charity to carry out its own management and investment duties prudently, for example, to enhance the diversification of investments or to gain the advantages of special expertise that a charity lacks internally.
The official comments to UPMIFA note that only decisions concerning the investment and management of an endowment fund may be delegated, and that decisions concerning expenditures may not.
The gift instrument may, however, limit the extent to which delegation is permissible.
In any event, delegation is permitted only to the extent it is prudent under the circumstances.
Under C.R.S. Section 15-1-1105(a)(1) - (3), the charity must exercise a defined standard of care (good faith, ordinarily prudent person, like position, similar circumstances) in connection with selecting an agent to whom authority will be delegated, establishing the scope and terms of the delegation, and periodically reviewing the agent’s actions.
C.R.S. Section 15-1-1105(b) states that an agent to whom investment or management authority has been delegated owes a duty to the charity to exercise “reasonable care to comply with the scope and terms of the delegation” That is probably a more relaxed standard than applies to the charity making a decision to delegate in the first place.
To the extent that the charity has exercised the appropriate standard of care in making and supervising a delegation, it is not liable for the acts or decisions of the agent to whom the delegation has been made. C.R.S. Section 15-1-1105(c).
An agent to whom authority has been delegated is deemed to have submitted to jurisdiction in the courts of Colorado “in all proceedings arising from or related to the delegation or the performance of the delegated function.” C.R.S. Section 15-1-1105(d). It will be interesting to see how this provision can be reconciled with the near universal practice within the securities industry of incorporating mandatory arbitration clauses in all brokerage, investment advisory, and similar agreements.
Investment of Endowment Funds – General Considerations
The Emergence of Modern Portfolio Theory
Trustees have been obligated to preserve trust property and to make it productive. Historically, when evaluating whether trustee investments meet that duty, courts have scrutinized specific investments, to determine whether those investments, standing alone, are sufficiently prudent and even whether they fall within “legal lists” of permissible trust investments. See generally Halbach, Trust Investment Law in the Third Restatement, 27 Real Prop. Prob. & Tr. J., No. 3, 407, at 409-411 (1992).
As opposed to traditional investment practices, which attempt to identify specific investments that can be expected to outperform their peers, modern portfolio theory applies statistical principles to measure a portfolio’s short-term volatility and long-term returns. By quantifying the ratio of risk to return for particular markets, modern portfolio theory seeks to minimize the risk associated with a targeted rate of return though an efficient blend of investments from different markets.
In trust law, this means that a “trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust.” C.R.S. Section 15-1.1-102(b). In other words, as stated in the official comments to the Uniform Prudent Investor Act, “[a]n investment that might be imprudent standing alone can become prudent if undertaken in sensible relation to other trust assets.”
In large measure, prudent trust investing requires diversification. See C.R.S. Section 15-1.1-103 (“A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying”). Diversification usually means acquiring, not just multiple different assets within a particular industry or market, but rather assets among multiple different markets.
Application to Endowment Funds
UPMIFA incorporates several of these modern trust law principles largely unchanged.
C.R.S. Section 15-1-1103(e)(3) states that “an institution may invest in any kind of property or type of investment consistent with this section,” while C.R.S. Section 15-1-1103(e)(2) provides that “management and investment decisions about an individual assets must be made not in isolation but rather in the context of the institutional fund’s portfolio of investments as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the institutional fund and to the institution.”
Similarly, C.R.S. Section 15-1-1103(e)(4) requires an institution to diversify investments unless the institution reasonably determines that, because of special circumstances, the purposes of the institutional fund are better served without diversification.
The official comments to UPMIFA note that a decision not to diversify must be based on the needs of the charity, “not solely for the benefit of a donor.”
Retention of Donated Assets
“Within a reasonable time after receiving property,” C.R.S. Section 15-1-1103(e)(5) states, “an institution shall make and carry out decisions concerning the retention or disposition of the property or to rebalance a portfolio, in order to bring the institutional fund into compliance with the purposes, terms, and distribution requirements of the institution as necessary to meet other circumstances of the institution and the requirements of this Part 11.”
That section does not require a charity to dispose of donated assets, nor does it expressly permit the charity to retain them; it is neutral with respect to the result, but does require that the charity conduct an appropriate review of the wisdom of retaining or disposing of assets and that it reach a decision on the matter.
On occasion, donors may contribute property subject to a stipulation that the recipient charity retain it. It may be prudent to accept such a donation under those terms, and the charity may weigh the possible consequences of doing so, including the possibility of receiving further donations from the same donor, but the charity must still consider the effect of the donation on its portfolio as a whole.
Special Considerations
UPMIFA sets forth a list of factors or considerations that a charity must take into account in connection with managing and investing its endowment funds. C.R.S. Section 15-1-1103(e)(1).
These are –
general economic conditions;
the possible effect of inflation or deflation;
the expected tax consequences, if any, of investment decisions or strategies;
the role that each investment or course of action plays within the overall investment portfolio of the institutional fund;
the expected total return from income and the appreciation of investments;
other resources of the institution;
the needs of the institution and the institutional fund to make distributions and to preserve capital; and
an asset’s special relationship or special value, if any, to the charitable purposes of the institution.
The terms of the gift instrument may modify or limit any of these considerations or add new ones.
Spending Policies
Introduction – UPMIFA’s Revolutionary Decoupling of Spending from Investments
Traditionally, the amounts that might be distributed from endowment funds has been directly coupled with, in fact defined by, the fund’s investments. The common conception of an endowment fund is one that is required to “distribute income only” or to “preserve principal.” The result was that spending from endowment funds was not controlled by the needs of the charity or of the community, but rather by the decisions made regarding the investment of their assets.
Under UPMIFA, investment decisions and spending policies are now completely decoupled. Investment decisions are required to be made with a view towards maximizing yield and minimizing risk, without considering whether that yield is generated by traditional trust accountng income or capital appreciation. Spending policies now have nothing to do with the increase or decrease in the portfolio’s value and are governed instead by the charitable purposes of the fund.
Lessons Learned from Private Trust Administration
Preference for Distributions of “Income” or “Earnings.” Professor Joel C. Dobris, a law professor at the University of California, Davis School of Law, has noted that, as our economy emerged from agrarian roots, we may still hold a collective, cultural preference in favor of “living off the harvest,” of spending only the “recurring yield from a set of assets meant to be passed down from generation to generation.” Dobris, Why Trustee Investors Often Prefer Dividends to Capital Gain and Debt Instruments to Equity – A Daunting Principal and Income Problem, 32 Real Prop. Prob. & Tr. J. 255 (1997). This cultural bias has, according to Professor Dobris, heavily influenced the practice of trust law, and so the creation of private (noncharitable) trusts intended to distribute income only and to preserve principal for the future generations represents a deep-seated and widely-accepted practice.
Distortion of Investment Decisions. One principal difficulty, however, with trusts structured to distribute income only is that such a distribution scheme often distorts the trustee’s investment decisions.
Trustees owe a duty of impartiality to all the beneficiaries, both the current income beneficiaries and the “remaindermen,” and the trustee’s dilemma is that their interests invariably conflict.
In a private, noncharitable trust, for example, drafted to pay income only “to my children” and then to distribute the principal to “those of my grandchildren as may be living at the death of the last survivor of my children,” the children, if asked, would probably insist that the trust estate be invested in high-yield bonds, while the grandchildren would likely prefer non-dividend paying stocks with a high potential for appreciation.
Historically, trustees have sought to meet this duty of impartiality by investing in a portfolio that generated a sufficient level of traditional income for the current income beneficiaries, while striving to preserve (and hopefully grow) principal for the remaindermen. In practice, such a portfolio might have consisted of, say, 60 percent bonds and 40 percent equities (or whatever other ratio seemed suitable at the time), so that there would be an acceptable level of bond interest income and dividends for current distributions and some growth in the equity portion of the portfolio.
There is now a widespread consensus among the investment and fiduciary communities that asset allocation formulas that are driven by distribution requirements in this fashion are rarely likely to achieve optimal investment results.
Stocks have historically outperformed bonds, a fact that might have traditionally tempted a trustee to invest more heavily in stocks, and yet the current income yield on equities has fallen to historical lows, with the result that a portfolio heavily weighted to equities would generate a dividend yield that the current income beneficiary would likely find disappointing.
Conversely, a portfolio consisting of a heavy concentration in bonds would delight the current income beneficiary, but would allow for no growth of principal to accrue for the benefit of the remaindermen (and result, in fact, steady erosion of principal as the effects of inflation are factored in).
Total Return Investing. The prevailing theory is now that trust assets should be invested in a manner that is designed to achieve the greatest total return – whether from traditional income or from capital appreciation, or both, that is consistent with a reasonable level of risk.
A dollar is a dollar, under this principle, and it should not matter whether that dollar is earned in the form of interest or dividends or capital appreciation.
The Uniform Prudent Investor Act implements these principles, as it stresses the importance of diversification and asset allocation to maximize total returns while minimizing risks. As a result, trustees are now not only free, but may also be required, to invest to achieve the greatest total return, without focusing on the need to generate sufficient current income to satisfy the income beneficiaries or sufficient growth of principal to satisfy the remaindermen.
Applicability to Endowments
Charities have historically encountered similar, if not identical concerns.
An endowment established to distribute “income only” to fund current operations, and to preserve principal in perpetuity, is in one respect functionally no different than a private trust created to pay “income to my children, principal to my grandchildren.” Each case involves a tension between balancing present against future needs.
More important, an endowment that permits an expenditure of “income only” can similarly lead a charity’s management to seek inappropriate investment results. Just as the private trustee may have felt compelled to invest a substantial portion of the trust portfolio in assets that generate traditional trust accounting income (like dividends and interest income) to satisfy the needs of an income beneficiary, a struggling charity managing an income-only endowment might equally engage in asset allocation strategies that are over-productive of income, as opposed to ones that generate the greatest total return for the endowment as a whole.
As stated in a study commissioned by the Ford Foundation and quoted in the prefatory comment to UMIFA –
Too often the desperate need of some institutions for funds to meet current operating expenses has led their managers, contrary to their best long-term judgment, to forego investments with favorable growth prospects if they have a low current yield.
It would be far wiser to take capital gains as well as dividends and interest into account in investing for the highest overall return consistent with the safety and preservation of the funds invested. If the current return is insufficient for the institution’s needs, the difference between that return and what it would have been under a more restrictive policy can be made up by the use of a prudent portion of capital gains.
Investment Authority Under UMIFA. The approach that UMIFA adopted was to authorize charities to “invest and reinvest an institutional fund in any real or personal property deemed advisable by the governing board, whether or not it produces a current return” (essentially incorporating a total return investing approach). C.R.S. Section 15-1-1106(1)(a) (pre-September 1, 2008).
Expenditure Authority Under UMIFA. C.R.S. Section 15-1-1104 (pre-September 1, 2008) then authorized the institution to “appropriate for expenditure for the uses and purposes for which an endowment fund is established so much of the net appreciation, realized and unrealized, in the fair value of the assets of an endowment fund over the historic dollar value of the fund as is prudent.”
For these purposes, “historic dollar value” was defined as “the aggregate fair value in dollars of an endowment fund at the time it became an endowment fund, each subsequent donation to the fund at the time it is made, and each accumulation made pursuant to a direction in the applicable gift instrument at the time the accumulation is added to the fund.”
In simpler terms, the historic dollar value of a fund is generally the dollar value of each contribution or addition to the fund at the time it is made. That value remains constant and does not fluctuate with any subsequent investment gains or losses.
Problems With Historic Dollar Value. In the case of a endowment fund subject to UMIFA that had declined in value below its historic dollar value as a result of investment losses, the inescapable conclusion is that the charity could not spend any portion of the fund until its fair market value once again surpassed that historic dollar value. At the same time, while UMIFA dictated that spending decisions must be prudent, some charities accepted UMIFA as an invitation to spend down to historic dollar value in all events, thus never allowing their endowments to keep pace with inflation.
Uniform Principal and Income Act
The solution in the world of private trust administration to the problem of reconciling total return investing principles with a trustee’s obligation to treat both present and future beneficiaries fairly was amazingly clever. Effective July 1, 2002, the Colorado Uniform Principal and Income Act simply redefined “income.” C.R.S. Section 15-1-401 et seq.
C.R.S. Section 15-1-402(4) defines “income” as “money or property that a fiduciary receives as current return from a principal asset,” including “a portion of receipts from a sale, exchange, or liquidation of a principal assets” to the extent provided in the Act. Like the prior version of the Act, the UPIA defines certain types of receipts that are categorically income (like interest, rents, and dividends) and others that are categorically principal (like money received from the sale of stock).
What is truly innovative about the UPIA, however, is its Section 104, C.R.S. Section 15-4-404, which states that a trustee “may adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages trust assets as a prudent investor, the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income, and the trustee determines, after applying the rules in section 15-1-403(1) [which require administering the trust in accordance with the trust agreement and the remainder of the UPIA], that the trustee is unable to comply with section 15-1-403(2) [which requires a trustee to administer a trust impartially, based on what is fair and reasonable to all the beneficiaries].” As stated in a comment to the UPIA, “[t]he purpose of section 104 is to enable a trustee to select investments based on the standards of a prudent investor without having to realize a particular portion of the portfolio’s total return in the form of traditional trust accounting income such as interest and dividends.” See generally Cline, The Uniform Prudent Investor and Principal and Income Acts: Changing the Trust Landscape, 42 Real Prop. Prob. & Tr. J., No. 4, 611 (2008).
What C.R.S. Section 15-4-404 does, in simple terms, is to allow a trustee to characterize as trust accounting income some portion of what would otherwise have been treated as principal, and visa-versa, to the extent necessary to treat the income and remainder beneficiaries impartially.
In other words, in a period of high interest rates, a trustee might consider it prudent to invest a substantial portion of the trust estate in high yielding bonds. However, paying out all the resulting interest income to the income beneficiary could be considered unfair to the remaindermen, and so C.R.S. Section 15-4-404 would authorize the trustee to allocate some of that interest income to principal.
Conversely, in another economic climate, stocks might be deemed the most attractive investment for their potential for capital appreciation, but, if their dividend rate is below what the trustee might consider an appropriate return on capital, the trustee would be allowed to allocate some portion of realized or unrealized capital gains to income and distribute a corresponding amount.
UPMIFA – Income Is No Longer Relevant
It is telling and significant that the word “income” appears in UPMIFA only three times, and one of those is in the context of a rule that states that the term “income” doesn’t really mean income. Quite simply, the distinction between principal and income is no longer relevant to spending policies under UPMIFA.
In its place, UPMIFA adopts a default rule that offers charities extraordinary freedom and flexibility in making decisions regarding expenditures from the endowments they hold, but that freedom and flexibility is coupled with a heightened degree of responsibility.
Under C.R.S. Section 15-1-1104(a) –
Subject to the intent of a donor expressed in the gift instrument, an institution may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines is prudent for the uses, benefits, purposes, and duration for which the endowment fund is established.
In other words, an endowment spending policy must be prudent, but it is no longer even remotely linked to the concepts of “income” and “principal,” nor does it limit expenditures, as UMIFA essentially did, to notions of appreciation in value.
A charity’s decision to spend or accumulate portions of its endowment fund is subject to a standard of care that is identical to that applies to the management of the fund generally. Under C.R.S. Section 15-1-1104(a), the charity must act in good faith and with the care that an ordinarily prudent person in a like position would exercise under similar circumstances.
In addition, UPMIFA sets forth a variety of factors that should be taken into account, if relevant, in determining what level of spending from an endowment is prudent, as follows –
The purposes of the institution and the endowment fund;
General economic conditions;
The possible effect of inflation or deflation;
The expected total return from income and the appreciation of investments;
Other resources of the institution; and
The investment policy of the institution.
The flexible spending rule is, however, a default rule; it may be overridden by the terms of a gift instrument.
Nonetheless, C.R.S. Section 15-1-1104(b) provides that, in order to limit a charity’s spending authority under the default rule or to impose a different spending policy, the gift instrument “must specifically state the limitation.”
The traditional language that defined endowments will not be sufficient to do so. C.R.S. Section 15-1-1104(c) states that –
Terms in a gift instrument designating a gift as an endowment, or a direction or authorization in the gift instrument to use only “income”, “interest”, “dividends”, or “rents, issues, or profits”, or “to preserve the principal intact”, or words of similar import:
[i] create an endowment fund of permanent duration unless other language in the gift instrument limits the duration or purpose of the endowment fund; and
[ii] do not otherwise limit the authority to appropriate for expenditure or accumulate under subsection (a) of this section.
In an effort to clarify the accounting treatment of endowments, C.R.S. Section 15-1-1104(a) states that “[u]nless stated otherwise in the gift instrument, the assets in an endowment fund are donor-restricted assets until appropriated for expenditure by the institution.”
The accounting profession has responded to the increasingly widespread adoption of UPMIFA with proposed FSP FAS No. 117-a, Endowments of Not-for-Profit Organizations: Net Asset Classification of Funds Subject to an Enacted Version of the Uniform Prudent Management of Institutional Funds Act, and Enhanced Disclosures (February 22, 2008) (available at http://www.fasb.org).
Commentary on the FASB draft has been less than complimentary. See Siegel, FASB Puts Infinity Up On Trial: Accounting for Endowments, 60 Exempt Organizations Tax Review, No. 1, 23 (April 2008) (“FSP 117-a reflects a clear intention upon the staff’s part to maintain the incorrect treatment that GAAP has applied to endowment accounting for more than a decade.”).
Structuring Endowment Spending Policies
In one of the most insightful articles written on this topic, Wolf, Defeating the Duty to Disappoint Equally - The Total Return Trust, 32 Real Prop. Prob. & Tr. J. 45 (1997), the author identifies objectives that should be addressed in the design of a private (noncharitable) trust intended to benefit sequential beneficiaries. Virtually all of those objectives are equally applicable to an endowment fund that is intended to fund current operations as well as preserve corpus for the indefinite future.
Briefly summarized, several of those factors are as follows:
The endowment should allow its management to invest for the highest possible total return consistent with an acceptable level of risk
The endowment should allow for a fair allocation of principal and income returns between the present and future needs of the charity
The interests of the present and future operational needs should be as consistent and congruent as possible with respect to investment decisions
The endowment should be governed by a clear rule defining what may be distributed on a current basis from year to year
Any distribution rule should have a self-adjusting mechanism to some extent in the case of unusual market volatility
Current distributions should be relatively smooth, without unduly favoring either current of future operational needs
There should be some sort of provision that permits the distribution rate to be modified in the case of prolonged or permanent changes in economic or financial circumstances
Mr. Wolf’s solution is a unitrust, which would avoid all of the problems associated with the possible applicability of the UMIFA and the UPIA discussed above, as well as accomplish most, if not all of the objectives that Mr. Wolf outlines.
A unitrust mechanism can facilitate an identity of interest, rather than a conflict of interest, between the current and future needs of a charitable endowment. Since the distribution formula is already fixed, the trustee is freed to concentrate on achieving the highest possible levels of growth in the fund from any combination of income and appreciation.
Clearly, a remainder beneficiary (or its charitable endowment surrogate — the future needs of the charity) would prefer that the trust or fund grow as rapidly as possible over as sustained a period of time as possible.
What is perhaps less intuitive is that such growth is also in the best interests of the current beneficiary, since, due to compounding, growth of corpus will generate an increasingly larger base against which the annual unitrust percentage can be applied.
Thus, a unitrust mechanism can be particularly appealing to an endowment that is expected to balance providing a consistent stream of distributions from year to year with increasing the principal for the future.
Significantly, a fund subject to a unitrust payout can never be entirely depleted, whatever its investment performance and however high its payout rate may be.
The unitrust amount is always a fraction of the existing fair market value, and so, even if the fair market value consistently declines, further distributions will contribute to that decline, but will never exhaust the fund in its entirety.
As an extreme example, if a fund never has any earnings, but is required to distribute half its value each year, then it will distribute 50 percent in the first year, 25 percent of its original value the second year, one-eighth of its original value the third year, and so on, but never quite reaching zero.
Much of the success of a unitrust formula depends on the payout rate selected.
First, the payout rate should allow for the absolute preservation and, more preferably, growth of the principal of an endowment, on an inflation-adjusted basis.
If inflation has, over a long-term historical basis, averaged around three or four percent, then the chosen payout rate should allow for at least that amount of the fund’s annual returns, together with some additional percentage to allow for continued growth, to be retained as principal.
Thus, if one assumes an average annual rate of return on investments of nine percent and four percent inflation and desires a one percent per year real growth in a fund, then the payout rate should not exceed four percent.
Modification of Endowment Restrictions
Need to Accommodate Changed Circumstances
Endowments are commonly perpetual, yet few endowment agreements and other gift instruments are drafted to include mechanisms that will accommodate the inevitable changed circumstances that will arise in perpetuity.
UPMIFA accordingly provides a variety of means by which a charity can seek to modify the terms of an endowment fund.
According to the official comment to UPMIFA, these rules apply on a fund-by-fund basis, rather than permitting a charity to engage in a sweeping modification of all its endowments.
With Donor Consent
C.R.S. Section 15-1-1106(a) allows a charity to release or modify, in whole or in part, “a restriction contained in a gift instrument on the management, investment, or purpose of an intuitional fund,” if the donor consents “in a record.”
No such modification may permit the endowment to be used “other than for a charitable purpose of the institution.”
With Court Approval
Equitable Deviation – Modifying Management or Investment Restrictions. C.R.S. Section 15-1-1106(b) allows a charity to seek court approval to “modify a restriction contained in a gift instrument regarding the management or investment of an institutional fund.”
The restriction must have become “impracticable or wasteful,” or it must impair the management or investment of the fund, or, “because of circumstances not anticipated by the donor,” modification of the restriction must “further the purposes of the institutional fund.”
The Attorney General must be notified of any such court proceeding and be given an opportunity to participate. While the law does not require that the donor be notified or be given any opportunity to be heard, it may be good practice to do so if the donor can be located and is alive.
Any such modification must “be made in accordance with the donor’s probable intention.”
This provision is designed to be employed when a charity intends to continue to devote an endowment fund to the charitable uses or purposes for which it was created, but certain restrictions on its operation have become unworkable. As the official comments suggest, “[d]eviaton does not alter the purpose but rather modifies the means in order to carry out that purpose.”
Cy Pres – Modifying Purposes or Uses. C.R.S. Section 15-1-1106(c) allows a charity to apply to a court to “modify the purpose of the institutional fund or the restriction on the use of the institutional fund.”
The charitable purposes of the fund or the restrictions on its use must have become “unlawful, impracticable, impossible to achieve, or wasteful.”
According to the official comments, the term “modify” includes a release of a restriction and also permits the funds to be transferred to another institution.
Again, the Attorney General must be notified of any such court proceeding and be given an opportunity to participate, and, while the law does not require that the donor be notified or be given any opportunity to be heard, it may be good practice to do so if the donor can be located and is alive.
Any such modification must be made “in a manner consistent with the charitable purposes expressed in the gift instrument.”
Older, Smaller Funds
Finally, a charity may, on its own initiative, without notice to the donor and without seeking court approval, modify any restriction in a gift instrument on the management, investment, or purpose of an old, small endowment fund that has become “unlawful, impracticable, impossible to achieve, or wasteful.”
The fund must have a total value of less than $100,000 (adjusted by increases in the consumer price index), and ore than 20 years must have elapsed since the fund was first established (not from the date of each gift to the fund)
The charity must notify the Attorney General 60 days in advance of the modification, and the charity must continue to use the fund in a manner consistent with the charitable purposes expressed in the gift instrument.
Donor Standing to Enforce Endowments
Legal Background.
Historically, only the Attorney General has had standing to enforce charitable trusts. MacKenzie v. Trustees of Presbytery of Jersey City, 61 A. 1027 (N.J. 1905).
Cf. C.R.S. Section 25-31-101(5) (“The general assembly hereby recognizes and reaffirms that the attorney general has all powers conferred by statute, and by common law in accordance with section 2-4-211, C.R.S., regarding all trusts established for charitable, educational, religious, or benevolent purposes.”).
Carl J. Herzog Foundation v. University of Bridgeport.
Carl J. Herzog Foundation v. University of Bridgeport, 243 Conn. 1, 699 A.2d 995 (1997). The Plaintiff Foundation granted $250,000 to the Defendant University as a matching grant “to provide needs-based merit scholarship aid to disadvantaged students for medical related education,” and the University accepted the grants and their restrictions in writing, agreeing to use the funds for its nursing program. Several years later, the University discontinued its nursing school and transferred the donated funds to its general operating funds.
The sole issue was whether a provision of Connecticut’s Uniform Management of Institutional Funds Act gave the Plaintiff Foundation standing to enforce the conditions it placed on its gift. That statute states that the governing board of an institution may release a restriction imposed by a donor in his or her gift instrument, with the consent of the donor.
The court held that the statute did not confer standing on a donor to enforce restrictions placed on a gift to an endowment fund and that only the Attorney General had standing to do so.
It probably didn’t help matters that, a year after the university diverted the endowment funds, an affiliate of the Rev. Sun Myung Moon’s Unification Church took control over the university. Arenson, Making Those Good Causes Do What the Donor Intended, THE NEW YORK TIMES (August 24, 1997).
Smithers v. St. Luke’s-Roosevelt Hospital Center.
Smithers v. St. Luke’s-Roosevelt Hospital Center, 281 A.D.2d 127, 723 N.Y.S.2d 426 (2001). Mr. R. Brinkley Smithers contributed $10 million to a hospital for the establishment, maintenance, and operation of a free-standing alcohol treatment and rehabilitation center. The gift was made in several installments, some of which followed extensive communications between the Hospital and Mr. Smithers.
In the 1990’s, the hospital indicated that it needed additional funds to renovate the treatment center and proposed a silver anniversary gala celebrating Mr. and Mrs. Smithers. The gala was planned for April, but Mr. Smithers died in January. In the intervening March, the hospital told Mrs. Smithers that it had cancelled the gala because the hospital planned to sell the building. In the words of one commentator, Mrs. Smithers “became suspicious, asked to review the hospital’s financial records for the treatment center and found that the hospital had used $5 million from the restricted endowment ... for the hospital’s general charitable purposes.” Smith, Power to the Donors, Trusts & Estates (October 2007) 66, at 68. The widow brought suit as personal representative of his estate to enforce the terms of the gift.
The New York court held that the estate had standing to seek an injunction over the transfer of the proceeds and that its standing was shared with the state Attorney General.
L.B. Research and Education Foundation v. UCLA Foundation.
L.B. Research and Education Foundation v. UCLA Foundation, 29 Cal. Rptr. 3d 710 (Cal. App. 2005). The plaintiff foundation made a $1 million donation that was intended to establish an endowed chair in cardiothoracic surgery at the UCLA School of Medicine.
In a dispute between the donor and the medical school, the court enforced a provision in the gift agreement that required the endowment to be transferred to another institution in the University of California system.
Tennessee Division of the United Daughters of the Confederacy v. Vanderbilt University.
Tennessee Division of the United Daughters of the Confederacy v. Vanderbilt University, 174 S.W.3d 98 (Tenn. App. 2005). In 1913, the Tennessee Division of the United Daughters of the Confederacy contracted to contribute $50,000 to what was then known as the George Peabody College for Teachers, in Nashville, Tennessee, for the construction of an on-campus dormitory, on the condition that the college name the building “Confederate Memorial Hall.” The George Peabody College subsequently merged into Vanderbilt University, which concluded that the name of the dormitory “created a marketing problem for the university.” Smith, Power to the Donors, Trusts & Estates (October 2007) 66, at 68.
The university proposed to remove a large stone pediment that contained the dormitory’s name and replace it with a small plaque located inside the hall that recited its history.
The Tennessee Court of Appeals held that the university’s proposed renaming of the hall violated the terms of its 1913 agreement and denied the university’s motion for partial summary judgment.
Robertson v. Princeton University.
In 1961, Marie Robertson donated $35 million in shares of the Great Atlantic and Pacific Tea Company (which subsequently became the A&P supermarket company) to Princeton University. To facilitate that donation, Mrs. Roberson formed a new supporting organization, four of the trustees of which were appointed by Princeton and three of whom were representatives of the Robertson family, to expand and support the graduate program at the Woodrow Wilson School of Public and International Affairs.
By 2002, the Robertson Foundation’s assets had grown to $550 million and vastly exceeded the amount needed to support its intended purposes. Mrs. Robertson’s son, who was one of the trustees of the Foundation, sued Princeton, alleging among other things that the University had diverted Foundation assets to other uses and had mismanaged their investment.
The lawsuit was the most expensive in Princeton’s history, and, according to the university’s general counsel, the plaintiff’s suit had been financed by a Robertson family private foundation whose assets declined (presumably as a result of the payment of the plaintiff’s legal fees) by $20 million between 2002 and 2006. http://www.princeton.edu/robertson/documents/docs/Endowments_and_Donor_Restrictions.pdf
Other Controversies.
In 1973, Avery Fisher donated $10.5 million to New York’s Lincoln Center for the renovation of its symphony hall, and Mr. Fisher was promised that the facility would be named after him in perpetuity. Lincoln Center has since considered substantial renovations to the hall that were expected to cost $300 million and had announced that it might be named after a new donor. Mr. Fisher’s children have announced that they are prepared to file suit to prevent that from happening. Wiesbord, Reservations About Donor Standing: Should the Law Allow Charitable Donors to Reserve the Right to Enforce a Gift Restriction?, 42 Real Prop. Prob. & Tr. J., No. 2, 246 (2007).
Georgia O’Keeffe donated some of her paintings, as well as photographs by her husband, Alfred Stieglitz, to Fisk University in 1949, accompanied by a letter setting forth her understanding that the university would not sell any of the collection. The university, however, which has historically had a predominantly black student body, sought to sell the most significant painting in the collection in an effort to raise operating funds. The matter has been in litigation, and the university and the Georgia O’Keeffe Museum of Santa Fe, agreed that the university would sell the painting to the museum for $7.5 million, considerable below its appraised value. According to National Public Radio, Tennessee’s Attorney General sued to block the sale, calling the sale price “too deep a discount” to approve. Cornish, Bid to Sell O’Keeffe Work Thwarted, NPR Weekend Edition (Sunday, April 8, 2007). The Tennessee Chancery Court issued an order authorizing the University to sell an undivided one-half interest in the collection for $30 million, but it must reserve $20 million of the proceeds to establishing an endowment fund solely for covering the costs of displaying and maintaining the art.
