January 15, 2009 | Read Time: 6 minutes
These are trying times for the boards of charities and foundations that have seen investments evaporate in the Bernard Madoff fraud. But for the board members themselves, things could get even worse. Attorneys general, lawyers representing the very charities the board members serve, and possibly even the Internal Revenue Service could go after them under an array of state and federal laws that impose a fiduciary duty on board members and require them to act prudently when making investment decisions.
Richard Blumenthal, Connecticut’s attorney general, has asked the court-appointed trustee responsible for liquidating Bernard L. Madoff Investment Securities to provide a list of nonprofit organizations in Connecticut that had investments with it.
He says he asked for the list for two reasons: He wants to help the charities recover as much as possible from the fraud, but he also wants to determine whether some directors of the charities should be held accountable for failing to appropriately evaluate the Madoff firm before placing assets with it.
“We don’t have in mind any particular individuals or entities, but it’s my statutory responsibility to help safeguard the assets of charities and nonprofit organizations,” Mr. Blumenthal said. “The standard is that the director or fiduciary at any nonprofit has to exercise due diligence and the care and caution of any ordinary prudent investor.”
Asking Questions
At least five foundations closed due to losses in the Madoff Ponzi scheme, and dozens of other foundations and charities suffered steep losses.
No one is accusing the board members of colluding with Mr. Madoff on the fraud. And even the harshest critics of board members acknowledge that a charity or foundation could have taken all the right steps and simply been burned by a con man.
But Jack Siegel, a Chicago lawyer who advises charities, notes that a number of investors have revealed that they steered clear of Mr. Madoff after looking closely at the firm and not understanding how it earned such strong and consistent returns.
“Board members who chose to invest with Madoff aren’t necessarily at fault,” Mr. Siegel says. “If they did their due diligence but came to a different conclusion about Madoff — you can’t fault them for that. It’s all about process. The question is, did they do what normally would be done in selecting investment managers?”
Trustees at Yeshiva University, based in New York, are already facing tough questions about whether they upheld their fiduciary duties. Yeshiva lost a $14.5-million investment it made in a hedge fund, Ascot Partners, controlled by one its trustees, J. Ezra Merkin, who subsequently placed all of the fund’s money with Mr. Madoff. (The university originally estimated its loss at $110-million, but most of that total represented “fictitious” gains.) Mr. Merkin headed the university’s investment committee, but allegedly failed to tell other board members that he had reinvested Yeshiva’s funds with Mr. Madoff. Mr. Madoff was also a trustee at the university. Both men resigned after the fraud was exposed.
New York University, which lost $24-million, and New York Law School, which lost $3-million, also invested in Mr. Merkin’s hedge funds and are suing him for recklessness, gross negligence, and breach of fiduciary duties.
Yeshiva also is considering suing Mr. Merkin, according to the New York Post. A Yeshiva spokesman told The Chronicle the university has not yet filed a lawsuit and declined to comment further. Andrew J. Levander, Mr. Merkin’s lawyer, said in a statement that Mr. Merkin and his family are “personally among the largest victims of the massive fraud confessed by Bernard Madoff.” Mr. Siegel, who has written about the Yeshiva case on his blog, Charitygovernance.org, notes that Mr. Merkin failed to heed the basic tenet of diversification by placing all of Yeshiva’s investment with Mr. Madoff. Mr. Siegel also maintains that if Mr. Merkin accepted fees from Yeshiva, he was essentially profiting from a “retail” price when Yeshiva presumably could have received the “wholesale” price by investing directly with Mr. Madoff.
Appropriate Sanctions
Many charity observers view Mr. Merkin’s actions as being on the egregious end of the spectrum, but less clear is what sanctions, if any, board members who placed all of a charity’s or foundation’s assets with Mr. Madoff should face.
Richard A. Marker, a senior fellow at New York University’s George Heyman Jr. Center for Philanthropy and Fundraising, and a consultant who works with foundations and charities, says states and the IRS will probably not waste their time prosecuting board members who simply made a mistake by investing in a fund that many others had deemed too good to be true. Instead, attorneys general may focus on charities or foundations that ignored their own investment policies, or conflict-of-interest policies, in an ill-conceived gamble on the Madoff firm.
“The law does not penalize stupidity — the law penalizes abuses,” Mr. Marker says. “The question is, were they stupid, or was somebody essentially saying, willfully, ‘We can do better than the law requires?’ ”
Investing Rules
The Madoff scandal may prompt Congress to make a second attempt to require all charities to abide by prudent-investor rules.
Those rules, outlined in Section 4944 of the Internal Revenue Code, currently apply only to private foundations. But in 2004, staff members on the Senate Finance Committee proposed expanding the rules to all public charities.
The Panel on the Nonprofit Sector, made up of 24 nonprofit and philanthropic leaders, argued at the time that the change was not needed. “Given that the [Internal Revenue] Service’s expertise is primarily in tax administration, rather than investment practices, and the demands on the service’s limited resources, it is unreasonable to expand its responsibility to include oversight of the investment practices of public charities,” the panel wrote.
In a statement, the senior Republican on the finance committee, Sen. Charles E. Grassley, said that he might try again in 2009 to apply the rule to charities. “Better transparency of investments might help to prevent this kind of mess in the future,” Senator Grassley said. “It may be time to re-examine that reform.”
The current federal rule prohibits any foundation from investing “in such a manner as to jeopardize the carrying out of any of its exempt purposes.” Both the foundation and its managers can face taxes equal to 10 percent of the amount invested if they violate the rule.
Theresa Pattara, tax counsel to Republicans on the finance committee, believes the IRS might have grounds to tax board members of foundations who placed all their assets with Mr. Madoff.
“I’d be curious to know if any of those foundations considered the impact of 4944 before they made those investments,” Ms. Pattara says. “It would be fair to ask for board minutes, the thought processes, and the decision making they went through before putting all their money at risk.”
Steven J. Pyrek, an IRS spokesman, says he does not know of anyone at the IRS who is examining the role of board members in the Madoff fraud.
Betsy Buchalter Adler, a San Francisco lawyer who represents charities, cautions that the practices under scrutiny in the Madoff case are neither illegal nor harmful in and of themselves. She points out that many foundations can get a better deal by investing with a board member — provided any proposed transactions are thoroughly investigated and approved by disinterested board members.
“Simply doing business with an insider is not in itself bad,” Ms. Adler says. “It is very often a good thing.”
