Investment Policies Are Not Optional

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As colleges, universities, and other nonprofit organizations have come under increased scrutiny by lawmakers, government regulators, and the news media, one area that is attracting special attention is how they invest their money.

Part of the reason for the growing attention to nonprofit investment policies comes from the well-publicized financial scandals that have occurred in the business world as well as at nonprofit institutions. In addition, portfolio losses and questionable investment choices by nonprofit endowments have added to the concern.

The need for sound investment policies is amplified by the prospect that competition for charitable donations will continue to intensify, and government funds for colleges and other nonprofit groups will become increasingly difficult to obtain. Such financial pressures mean that nonprofit groups will need to rely on their endowments to finance an ever-greater share of their activities. Recent studies suggest that it may be just as important to the overall growth of the endowment for an institution to have a well-considered, long-term policy on raising and spending money in an endowment as it will be to achieve strong investment returns. As a result, not only will an organization’s investment returns be subject to increased scrutiny, but so too will the oversight of fund-raising and investment decisions by nonprofit boards.

Even before the well-publicized corporate scandals created the atmosphere of public skepticism and heightened government scrutiny of governance at organizations of all kinds, investment managers at nonprofit institutions were not immune from liability. In fact, most states have adopted some variation of the Uniform Management of Institutional Funds Act as well as some form of the Uniform Prudent Investor Act. Those prototype statutes were drafted by the National Conference of Commissioners on Uniform State Laws, an organization that advises states on how they can adopt laws that will be consistent.

The Uniform Management of Institutional Funds Act requires that nonprofit trustees and others overseeing nonprofit investments exercise ordinary business care and prudence in overseeing the investments of the organization, given all of the facts and circumstances prevailing at the time and considering both the long- and short-term needs of the institution.

The Uniform Prudent Investor Act, similarly, requires that nonprofit board members and others carefully assess investment goals, risk versus return, and proper diversification of assets. Specifically, the Uniform Prudent Investor Act requires that trustees use modern portfolio theory and invest as a prudent investor would invest by “considering the purposes, terms, distribution requirements, and other circumstances of the trust” using “reasonable care, skill, and caution.”

In recent years, states and donors have become increasingly aggressive about ensuring that nonprofit organizations follow those standards and disclose information about their use of donations.

For example, in Idaho, Attorney General Lawrence G. Wasden last year demanded that the University of Idaho Foundation pay the state $18-million for “wrongful acts” in managing two trust accounts used to develop a satellite campus in Boise. Plans for the new campus involved a series of complicated real-estate transactions that allegedly resulted in heavy losses to accounts designated for scholarships and other university programs. Attorney General Wasden said that not only the university but also members of the board and its investment committee involved with the project were liable for those “wrongful acts.”

Due to numerous alleged conflicts of interest involving the foundation and its board, Mr. Wasden said that the foundation and its board had violated the Idaho Uniform Prudent Investor Act, which requires charitable foundations to avoid such conflicts and use “reasonable care” in investing the money that they control. The foundation has defended its actions, saying that it did not intentionally commit any wrongdoing and, in fact, has sued developers and lawyers involved in the project.

The University of Idaho situation serves as an important reminder that those charged with managing the funds of a nonprofit organization have a fiduciary duty. Although in many cases nonprofit executives and directors are overseeing funds long held by the institution and donated by people who died long ago, their fiduciary obligations must not be taken lightly.

In another example, an Iowa court in June reminded the Iowa State University Foundation that the State Supreme Court had ruled in February that it must open its records to the public. The foundation had argued that it was the private fund-raising arm of Iowa State University and therefore should not have to comply with open-records laws. In its opinion, the Iowa Supreme Court made clear that since the foundation is performing a public function, it is a public organization that must operate transparently.

It is not just courts and state officials who are taking action. In the U.S. Senate, the Finance Committee, which oversees the Internal Revenue Service and its monitoring of tax-exempt groups, is considering broad legislation that would change the way many nonprofit organizations operate.

Among the ideas that the Senate Finance Committee is said to be considering are:

• Requiring disclosure of investments. Charitable organizations would be required to make available to the public details about how their money and other assets are invested. Such rules already apply to private foundations. Senate aides say they hope that if members of the public are armed with more information about a charity’s investments, they will raise questions about investment policies that trouble them — and that just the prospect of greater public scrutiny will lead organizations to take greater care over their investments.
• Expanding coverage of prudent investing rules. Nonprofit groups would have to follow a single federal standard for prudent investing to avoid the problems caused by the conflicting approaches among the states and to ensure that all charitable funds nationwide are covered by appropriate rules.
• Giving the public more legal rights to challenge nonprofit groups. Anybody would be allowed to ask the Internal Revenue Service to investigate the investment and spending policies of a nonprofit group, or examine other concerns about abuse of tax-exempt status. This approach would be comparable to state laws that allow stockholders to sue a corporation’s board of directors for a breach of fiduciary duty.

Regardless of what actions lawmakers and courts take, leaders of nonprofit organizations must recognize that donors and beneficiaries of charitable trusts are becoming increasingly sophisticated about their legal rights and are demanding increased access to information. For example, students at Boston College who are concerned about discrimination and environmental and social-justice issues have been pressing the institution to provide more details about how the college’s $1.35-billion endowment is invested.

The students say they are frustrated that the institution doesn’t disclose much information about its policies. Boston College’s investments have achieved strong returns over recent years, but students say they want to know whether the investment policies used to achieve those returns are in line with the Jesuit institution’s values and mission.

Similarly, the Southern Baptist Convention’s Annuity Board came under fire in 2004 from some Southern Baptists over concerns that its annuities were invested in companies such as Carnival Cruise Lines, whose cruise ships feature gambling casinos and alcohol sales.

To deal with pressure from the public and the government, nonprofit officials must focus on the long term, not just on short-term investment returns. Nonprofit institutions — especially their top officials and board members — must recognize the special nature of the money they raise from private sources and restrictions that the law places on the use of such money.

Organizations must maintain regular communications with donors and promote increased transparency in financial activities. That may involve, at a minimum, the production and distribution of an annual report detailing the institution’s investment policies and performance.

Although each institution is different, a good investment-management policy will contain certain key elements, including:

• A statement of purpose that provides background information about the funds being managed and the purpose for which those funds are to be used.
• A statement of responsibilities that identifies the relevant parties within the institution and their respective roles in the management of the institution’s investments.
• Objectives and goals for investments. These should include both quantitative and qualitative measures, including return expectations, how much risk is appropriate, and the time span over which investment returns are to be measured.
• Guidelines that provide the framework within which investments are to be made. These include criteria such as portfolio allocation standards, socially responsible investment guidelines, restricted investments, and the types of investment approaches that can be used.
• Performance review and evaluation standards that establish a time frame, methodology, and metrics for measuring and evaluating the performance of investments and the people and organizations who manage them.
• A reporting schedule and requirements for communication from investment managers to the institution’s governing body.

Nonprofit institutions have long been accused of paying lip service to the notion of investment policies and procedures. That is because in all too many cases the people responsible for carrying out those policies are only superficially familiar with its contents. Today’s environment requires that nonprofit officials do a better job of making sure they understand their own policies — and that they have done everything they can not just to abide by the law, but also to honor a donor’s intentions for their gifts.

L. Robert Guenthner specializes in higher-education law at Gardner Carton & Douglas, in Chicago, as does Kathleen Nilles, who works in the Washington office of the law firm. Sheldon E. Steinbach is vice president and general counsel at the American Council on Education, in Washington.

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Section: Endowments
Volume 17, Issue 20, Page B4