With the plethora of news articles about charitable endowment losses as a result of investments with Bernie Madoff, it is incumbent on fiduciaries to review some fundamental laws on endowment. These laws differ in each state. This article will briefly review the rules applicable to endowments in New York.
An endowment fund is created when a person or entity donates money to a charity with the condition that the corporation cannot spend the money freely (commonly known as “permanently restricted”). The original donation is called the historic dollar value, that is, the aggregate fair value in dollars of (i) an endowment fund at the time it became an endowment fund; (ii) each subsequent donation to the fund at the time it is made, and (iii) each accumulation made pursuant to a direction in the applicable gift instrument at the time the accumulation is added to the fund. In New York, the governing board of an endowment fund operates under standards and guidelines from The New York Not for Profit Corporation Law (“NPC”), the New York Attorney General (“Attorney General”) and because New York has adopted it, principles of the Uniform Management of Institutional Funds Act (“UMIFA”).
Rules Governing Endowment Funds
New York law requires a governing board of a non-profit corporation to use all assets received for the purposes specified by the donor, including payment of reasonable and proper expenses. The board must also account for the endowment fund separate from other accounts. Further, the treasurer of the non-profit corporation must provide members of the board with annual reports of the fund’s assets and income, unless the donor states otherwise.
The Prudence Standard
Directors and officers of a non-profit corporation must discharge the duties of their positions in good faith and with the degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances, according to the NPC and UMIFA. Before deciding whether to appropriate appreciation from endowment funds, the board must consider factors, such as the long and short term needs of the corporation in carrying out its purposes, its present and anticipated financial needs, expected return on total investments, price level trends and general economic conditions.
A governing board cannot expend the historic dollar value of its endowment fund. Instead, it must invest the fund’s assets and then use the resulting income for spending. Importantly, it may decide to spend the income generated even if the fund’s principal value drops below the historic dollar value (commonly known as an “underwater endowment”) unless the gift instrument says otherwise.
Although not required, the New York Attorney General suggests that a governing board should upwardly adjust the historic dollar value of the endowment fund for inflation to maintain its buying power. Another viable option is to create a spending rate policy. This policy, based on assumed rates of inflation, sets spending rates at levels that over time that are sufficiently below the fund’s expected long term investment return. This policy is likely to preserve a fund’s purchasing power as well as its historic dollar value. Regarding deflation, however, UMIFA takes a different view. According to UMIFA, a fund’s historic value is not revised downward if market losses reduce the principal below that value.
If prudent, a governing board may appropriate an amount of the net appreciation for expenditure in the fair value of the assets of an endowment fund over the historic dollar value of the fund. According to New York law, this includes realized appreciation with respect to all assets, and unrealized appreciation with respect to readily available marketable assets. Still, the law makes it clear that this limitation is not meant to forestall the governing board from expending funds in accordance with other law, terms of the gift instrument or the corporation’s certificate of incorporation. According to the NPC, “this section is not intended to restrict the authority of the governing board to expend funds as permitted under other law, the terms of the applicable gift instrument or the certificate of incorporation of the corporation.” So, if the terms of the donation allow for expenditure of endowment fund appreciation, the board may spend such appreciation where prudent.
Spending Rate and Historic Dollar Value Restoration
According to the NPC, a governing board cannot appropriate net appreciation through application of its spending rate policy if the value of an endowment fund is at or below historic dollar value. The New York Attorney General believes that to comply with the law and its responsibility, the corporation has an affirmative duty to restore to the fund any appropriation that occurs when the fund is already below the historic dollar value. If the decrease in the historic dollar value was due to an appropriation, the governing board must restore to the fund an amount equal to the difference between the historic dollar value and the post appropriation value of the fund regardless of whether the loss of historic dollar value was a result of a spending rate policy. According to the Attorney General, failure to restore a fund to historic dollar value may subject directors and officers to liability for breach of their duty of care. Nevertheless, a governing board can expend the net appreciation even if at the time of expenditure the endowment fund value drops below historic dollar value so long as the board prudently appropriated the appreciation. If the board requires funds in excess of the income and appreciation over historic value, the board may seek the donor’s consent or ask the court to, apply the cy pres doctrine.
Aggregation for Purposes of Appropriation
According to the New York Attorney General, the NPC does not authorize aggregation of endowment funds for purposes of appropriation for expenditure. A review of the NPC also does not appear to allow aggregation. The NPC discussion of appropriation of appreciation refers to a single endowment fund and discusses appropriation on a fund by fund basis. Practically, the prohibition on aggregation means that where there is a general decline in market values, the application of a total return spending policy could conflict with a board’s obligation to preserve the historic dollar value of each endowment fund. If so, the governing board should be subject to the appropriation and expenditure limitations discussed above.
NOTE: New York currently follows UMIFA and has not yet adopted the Uniform Prudent Management of Institutional Funds Act (“UPMIFA”). UPMIFA legislation has been introduced this year in New York, however. It is believed that UPMIFA would help to address the issue of “underwater endowments” because the Act would remove the focus on the historic dollar value of a fund and place it instead on seven prudent investment criteria. For more information on UPMIFA’s adoption in New York, please visit the New York State Assembly’s site.
Despite guidelines and standards enunciated by the NPC, UMIFA and the New York Attorney General, there are still questions regarding income expenditure when an endowment is below its historic dollar value and whether a board should restore the historic dollar value of an endowment. These are complex decisions that require a governing body to act prudently and consult with its counsel.