Investment of Funds by California Charities: Law Changes in ’09
State adopts UPMIFA; effective Jan. 1, 2009
Legislation enacted in 2008 as SB 1329, effective Jan. 1, 2009, and entitled the Uniform Prudent Management of Institutional Funds Act (UPMIFA), changes California rules governing the investment of funds by a nonprofit public benefit corporation (hereinafter, a charity). Such charities include nonprofit hospitals, colleges, museums and social service agencies, as well as some governmental entities.1
It is critical that the governing boards and, in particular, finance and investment committees of charities, be aware of their responsibilities in regard to the issues addressed in UPMIFA, especially in light of current economic conditions. Responsible parties should educate themselves regarding this statute and, if needed, seek assistance from their lawyers and/or outside financial advisors. This advisory provides some background on UPMIFA, an overview of its implications, and steps charities should take to ensure compliance with new requirements.
The governing board of a nonprofit public benefit corporation is responsible for establishing and adhering to guidelines for the management and proper utilization of the charity's investment assets, including any endowments. Such guidelines must include (i) parameters for asset allocation; (ii) procedures for the selection and monitoring of investment managers/advisors; and (iii) the establishment of spending policies, including specific provisions governing the disbursement of funds from endowments that are consistent with donor limitations. A charity's board typically fulfills these responsibilities by delegation to or with the assistance of a finance committee, an investment committee, and/or an investment sub-committee of a finance committee.
As implied by its name, UPMIFA is a statutory scheme developed by experts in the field that has been adopted in 26 states and is slated for consideration in many others. UPMIFA will apply not only to newly created investment funds, but also to existing funds held for investment as of Jan. 1, 2009.2
The two components of UPMIFA are: first, a set of “prudent” management and investment standards that are applicable to all investment decisions by a charity and, second, spending limitations that apply to a charity's endowment funds.
The term “endowment” as used in UPMIFA, refers to funds a donor has given to the charity that are subject to donor-specified restrictions on spending, including both gifts subject to permanent restrictions and those for which such restrictions are in force for only a specified term. The term endowment encompasses only gifts that are subject to spending restrictions specified by donors; it does not apply to gifts that are subject only to donor-imposed use restrictions. As an example, a fund for which the donor has specified that the charity can spend only the income, but not the principal, is an endowment. A fund that the donor requires the charity to use only for a scholarship program, but with no restriction on how much the charity may spend currently, is not an endowment for purposes of UPMIFA.
Further, the only funds that are considered to constitute endowments for purposes of UPMIFA are those that are subject to donor-imposed restrictions on spending. Accordingly, the fact that a charity's board designates certain funds as an endowment and imposes spending restrictions similar to those that a donor might impose does not cause the fund to become subject to UPMIFA endowment spending limitations.
UPMIFA does not change the general requirement under current California law that a charity must follow the donor's directions as to both spending and use of investment funds to the extent that compliance with such directions is legal and reasonably practicable. Although, as discussed below, the new law provides for the release of such donor restrictions for endowments below a certain size; in circumstances not covered the UPMIFA release provision, a charity that holds an endowment subject to spending restrictions the board considers to be unlawful, onerous and/or impractical will likely have to resort to court action to obtain relief from such restrictions.
Investment and management
UPMIFA provides more standards in this area than are set forth in current law. A charity's board remains subject to general current fiduciary duties of good faith and prudence. UPMIFA further specifies that (i) the board of a charity is authorized to incur only reasonable and appropriate expenses for the management of endowments and other investment assets; and (ii) as part of its fiduciary responsibility for management of investment assets, the board is expected to make “a reasonable effort” to verify the relevant facts on which decisions concerning the investment and management of such assets will be based.
Not surprisingly, in light of the fact that most large charities use investment advisors, UPMIFA specifically articulates the previous general understanding that it is appropriate for a charity to delegate, subject to reasonable board oversight, the management and investment of their investment funds to appropriately qualified outside contractors that are selected in accordance with a process meeting UPMIFA standards. In practice, this means charities that can afford to do so will still have the authority to enter into contracts with outside advisors authorizing the contracted entity to manage and make certain investment decisions regarding the charity's investment assets. Typical sources that charities may use to obtain investment management services and advice include investment managers, non-discretionary investment advisors, bankers, investment brokers, financial planners and other types of appropriately qualified financial advisors.
Charities that choose to engage outside advisors for this purpose will need to seek bids from more than one advisor in order to assure that the board and/or the responsible board committees and officers are adequately informed regarding, and have utilized, an organized and appropriate decision process to evaluate the costs and benefits of the contracted services. Charities that enter into such delegated investment management relationships will also need to meet on a regular basis with their contracted advisors/managers both to monitor their performance and conduct appropriate reviews and investigations of the reports and advice provided by such contractors.
UPMIFA also requires a charity to diversify its investment funds (subject to limited exceptions). UPMIFA retains the approach of current law in endorsing the so-called “modern portfolio theory,” under which investment risk and return are evaluated over the entirety of the portfolio, rather than on an individual investment-by-investment basis, in order to assure that the projected risk and return for the portfolio as a whole are appropriate for the charity.
However, board members of California charities also need be aware that California nonprofit corporate law also mandates a conservative investment standard applicable to each investment held in a portfolio. Under this standard, as set forth in Cal. Corp. Code § 5240, charities are directed to manage their investments so as to “avoid speculation, looking instead to the permanent disposition of the funds, considering the probable income, as well as probable safety of funds” and “comply with any additional standards imposed by the articles, bylaws, or express terms of the agreement by which the assets were contributed to the corporation.”
Consistent with this standard, charities subject to California law need to maintain a conservative approach in order to “avoid speculation.” Thus, the level of risk assumed across all elements of an investment portfolio should still be geared toward the conservative end of the spectrum of investment opportunities.
Finally, in making decisions on the placement of their investment assets, UPMIFA standards direct charities to take the following seven factors into account:
- General economic conditions
- Possible effects of inflation
- Where applicable, the expected tax consequences, of particular investments
- The role of each investment in the context of the entire portfolio
- Total realized and projected current return and capital appreciation
- Availability of other resources (such as current income and other non-investment assets) of the charity to meet projected budgetary requirements
- The charity's projected need for distributions from investment assets to meet current and projected operational requirements
Under UPMIFA standards it will be important for investment committees and their advisors to look methodically at each of these factors in the assessment of significant investment decisions. Documentation of such considerations (whether in minutes, agreements or letters of instruction) will also be important, and the charity's investment policies should also specifically reference these factors.
Spending rules for endowments
The primary objective of an endowment spending policy is generally thought to be to allocate, in a reasonable and balanced manner, the total earnings from an endowment between current spending and reinvestment for future earnings and expenditures, with the goal of maintaining or enhancing the purchasing power of the endowment.
A secondary objective often noted is to provide a stable source of income. In its restrictions on spending, UPMIFA departs significantly from current law. Current law permits the expenditure only of current income and certain capital appreciation, both realized and unrealized, from an endowment. UPMIFA, in contrast, does not set specific expenditure limits. It instead authorizes the expenditure of so much of an endowment fund as the charity determines is prudent for its uses, benefits, purposes and duration of the endowment. UPMIFA also sets out a series of considerations similar to the seven factors previously noted that the charity must take into account in making this determination.
In the absence of any alternative standard or limitation established by a donor, UPMIFA provides that the annual expenditure of more than 7 percent of the fair market value of an endowment fund results in a rebuttable presumption of imprudence. “Rebuttable” means that the charity will need to convince any reviewer (such as the California attorney general) of the prudence of any annual expenditure from an endowment that exceeds this standard. Market value for purposes of the application of this standard is determined on the basis of the average of quarterly market values over a three-year period.
The expenditure of 7 percent of an asset's fair market value would generally be considered a high percentage for an annual appropriation. UPMIFA makes it clear that any expenditure from an endowment must still be prudent. Boards therefore should not consider the 7 percent figure as establishing a “safe harbor” for all expenditures of less than this amount. Depending on the facts and circumstances, expenditures of less than 7 percent could be considered imprudent.
UPMIFA also provides a procedure under which a charity may obtain release of restrictions on endowment funds that have been held more than 20 years and which have a value of less than $25,000 without seeking a court order, so long as the charity uses the funds so released in a manner consistent with the gift instrument. This provision is intended to allow charities holding such funds to avoid waste or impracticability, such as when the fund does not generate enough funds to cover its own operating expenses. Applying the release provision allows these funds to be distributed in their entirety or without regard to the otherwise applicable presumption of imprudence under the 7 percent spending rule.
Perspectives on the general impact of UPMIFA and related board responsibilities
In many ways UPMIFA may be seen as a codification of practices and considerations that many charities had already incorporated in their administration of the investment and management of available investment assets. Nevertheless, charities will need to review their investment and spending policies to make sure they are consistent with the following:
- The investment considerations specified in UPMIFA are referenced in the charity's investment policy.
- Investment advisors are selected through an RFP or other appropriate competitive evaluation process and such designations are reviewed and rebid on an appropriate periodic basis.
- Regular meetings with the charity's investment advisors are conducted to review and verify underlying facts regarding the activities and results achieved by the investment advisors and the performance of such advisors as measured against UPMIFA standards, competitive market performance criteria, the commitments made by the advisors, and any specific polices and procedures adopted by the charity. The meeting should also focus on monitoring the actual performance of the investment portfolios, including a review of any performance evaluations provided by the advisors, to determine whether the investment goals and objectives are being met, and to assure that appropriate action is taken if such goals and objectives are not being met consistently, with due regard for overall market conditions, over a reasonable period of time.
- The spending standards and related considerations specified in UPMIFA are referenced in any endowment spending policy.
- The market values of the invested endowment funds are determined on a quarterly basis and the spending policy amended to require such determinations.
- The spending policy is consistent with and, where necessary, adequately justified under the prudence standard. Generally this will limit any spending from endowment funds to less than 7 percent of their average market value over a three-year period; and in the event the policy provides for spending in excess of the amount so determined, the charity should be prepared to make a very compelling case to rebut the presumption of imprudence resulting from such presumptively excess spending.
1 The jurisdictional reach of UPMIFA is not addressed in the statute. The investment, management and endowment spending provisions of UPMIFA would appear to apply to any nonprofit charitable corporation (incorporated in California or otherwise) whose principal place of business is in California as well as California nonprofit charitable corporations with significant operations in California, but whose principal place of business is outside of California. It is not clear whether other nonprofit entities with California contacts are intended to be covered by investment and management provisions of UPMIFA. It is also not clear whether endowments received from California donors and held by out-of-state nonprofit corporations will be subject to UPMIFA; a determination on this question would appear to call for a detailed facts and circumstances analysis.
2 UPMIFA is an update that replaces the existing Uniform Management of Institutional Funds Act (UMIFA). UMIFA will remain in effect through the end of 2008.