National Heritage Foundation Debacle Offers Lessons About Donor-Advised Funds

The implosion of the National Heritage Foundation—at its peak, a more-than $200-million organization—provides a cautionary tale for donors, especially the growing number who create so-called donor-advised funds.

In January the National Heritage Foundation, in Virginia, filed for bankruptcy following a court decision that ordered it to pay millions of dollars to donors who said they had been misled by the organization.

In the latest twist in the saga, the organization has filed a plan of reorganization that involves using money from its donor-advised funds to pay its creditors and cover other expenses. Such a move would clearly cause distress for the donors, who intended their dollars to be used for charitable purposes.

Donor-advised funds provide an alternative to setting up a private foundation by giving people a way to put money into an account, take a tax deduction at the time of the transfer, and then make recommendations about which charities should receive money from the fund.

The National Heritage Foundation bankruptcy, and other potential situations in which charities run into financial trouble, discontinue donor-advised funds, or, even worse, appear to simply take advantage of a donor raise the question: Can money from donor-advised funds be used to pay the claims of creditors or for other uses not intended by the donors?

Because the vast majority of charities that offer donor-advised funds are prudent and conservative and make their donors their No. 1 priority, this is not a widespread problem.

Yet donors should be aware of the potential risks involved. With the growing popularity of donor-advised funds—some $22-billion in assets are held by the biggest groups—combined with the rise in groups offering such funds and the challenging economic environment, the need for strong oversight and caution also grows.

In another recent case involving donor-advised funds—one in which I represent the donor—my client accused an organization called Friends of Fiji, which is incorporated in Nevada and has its office in Danville, Calif., of ignoring his wishes and using his donations instead to pay the charity’s directors substantial salaries, sponsor celebrity golf tournaments at lavish resorts, and transfer funds to another entity controlled by the directors. The trustees in the case have denied wrongdoing.

The Nevada District Court determined that Friends of Fiji failed to use the donor’s contribution to satisfy his charitable goals, and, as a result, was “in violation of the implied covenant of good faith and fair dealing.” However, it also ruled that the donor had no recourse against the charity. The case is now on appeal before the Nevada Supreme Court.

In both this and the National Heritage Foundation case, the nonprofit organizations overseeing the donor-advised funds have argued that donors give up all of their rights at the time they transfer funds to a donor-advised account.

Donors and the courts, however, should reject the position that such organizations face no limits on how they may use the money in donor-advised funds.

When a charity declares bankruptcy, courts have generally attempted to identify those charitable assets that donors earmarked for a specific cause—and therefore exclude them from the bankruptcy estate and the claims of creditors.

For example, in a case involving Parkview Hospital, a nonprofit institution in Toledo, Ohio, that closed its doors shortly before filing for bankruptcy, the court found that donors had earmarked money to provide osteopathic care, and therefore the funds “were not assets of the bankruptcy estate which can be administered for the benefit of the creditors in the bankruptcy case.”

In Hobbs v. Board of Education of Northern Baptist Convention, the Grand Island College, in Nebraska, was unable to continue its operations due to its deteriorating financial condition and was forced to close, “with a large indebtedness staring it in the face.”

In protecting its endowment from creditors, the court emphasized that the donors intended for their contributions to be kept intact for educational purposes. Thus, the endowment was considered sufficiently restricted so that, in the face of the bankruptcy and closure of the college, the endowment was sheltered from creditors.

The courts have distinguished between cases in which a charity is given “absolute control” over contributions by its donors, where the money may be used for general purposes, including paying creditors, and contributions for restricted purposes, such as to establish an endowment.

Donor-advised funds should be considered sufficiently restricted to be excluded from the sponsoring organization’s bankruptcy estate and the claims of creditors.

Just as with restricted endowments, a charity holding donor-advised funds has ownership and control over the funds, but it should not be considered to have “absolute control.”

Indeed, it is clearly understood that donors who set up such funds can recommend how the money in them is distributed to charities. While the sponsoring organization has the final authority to approve or reject such recommendations, donors do not expect their money to be used for general purposes or to pay off creditors.

Many court cases involving commercial transactions have held that where a party to an agreement is provided some level of control over a transaction, that party must still exercise that control in good faith. The same principle should be applied to donor-advised funds. Although a sponsoring organization may have ownership and control over a donor-advised fund, it should not be permitted to exercise such control in a manner that is not faithful to the spirit and intention of the donor-advised-fund agreement.

Until the courts clarify that position, donors should be aware of the potential risk they take when entrusting their money to an organization that offers donor-advised funds.

And they should consider including a provision in the donor-advised fund agreement that specifies how their money should be handled in the event that the organization declares bankruptcy or becomes insolvent.the money in the account should be transferred to another organization i.

CAnd charities that oversee such funds also should be prepared to answer new questions from what could well become an increasingly skeptical pool of donors.