The tension between preserving charitable assets for the future and spending them currently to address critical needs has perhaps never been greater. Both operating charities that make annual appropriations from their endowments to meet current expenses and foundations that make grants to fund other charities are debating the level of spending from endowment that is possible in today's challenging economic environment.
This bulletin examines the laws that govern spending from charitable endowment funds and considers the options that an organization may pursue to access endowment assets when they are most needed. These options include prudently increasing endowment spending, seeking a release of endowment spending restrictions, making loans from endowment funds to other charities, and pledging endowment assets as security for loans to increase liquidity for spending.
What Is "Endowment" and What Is Not
In any discussion of endowment spending it is important first to define what is a "true" endowment from a legal standpoint, and what is not. Funds that a charitable organization's board has set aside with the intent not to use them for current spending are not an endowment, even if the board has labeled them as such. Such funds are sometimes called "quasi endowment" funds, but as a legal matter a board restriction by itself does not create an endowment, and a board can release such a restriction at any time that it chooses. Similarly, a donor's recommendation that a gift be used for an endowment, or a donor's attempt to designate a gift as an endowment after the donor has made the gift, does not create an endowment.
A "true" endowment is created only when:
- A donor makes a gift with a written gift document at the time the gift is made that designates the gift as an "endowment," or otherwise imposes a spending restriction on the gift; or
- A donor makes a gift in response to a charity's written solicitation for gifts to fund its "endowment."
A fund that is not a "true" endowment may be spent currently in any manner consistent with the charity's purposes and any use restrictions that a donor may have placed on the fund.
Permissible Spending From Endowment Funds
Spending from "true" endowment funds held by charitable corporations, or charitable trusts for which a charitable corporation is the trustee, is generally governed by the Uniform Prudent Management of Institutional Funds Act (UPMIFA). UPMIFA is a model statute developed by the Uniform Law Commission that has been adopted as law in 49 states and the District of Columbia. While the versions of UPMIFA adopted by each state are largely consistent with one another, there are important variations, as discussed below.
A donor may impose specific spending restrictions on an endowment, such as "spend no more than 5 percent of average asset value annually." If a donor has imposed such a specific spending restriction, the charity is generally legally obligated to comply with it. A donor's specific spending restriction will override the spending provisions of UPMIFA.
More commonly, though, a donor will simply label a gift as being for an "endowment" or impose a generalized restriction, such as "spend only the income." In these cases, the spending rules of UPMIFA will apply.
UPMIFA applies a prudence standard in determining how much a charity may appropriate from an endowment fund annually for spending. It does not apply concepts such as "principal," "income," or "historic dollar value" to determine how much may be spent. Instead, UPMIFA requires an organization to manage its endowment fund in a way that preserves its purchasing power in perpetuity (or for however long the spending restriction may last).
A charity's board must act prudently in determining how much to spend from its endowment. Specifically, UPMIFA requires boards, in making endowment spending decisions, to:
- Act in good faith;
- With the care that an ordinarily prudent person in a like position would exercise under similar circumstances; and
- Consider the following seven factors (to the extent that each is relevant) to determine the prudence of an appropriation from an endowment fund:
- The duration and preservation of the endowment fund;
- The purposes of the charity and the endowment fund;
- General economic conditions;
- The possible effect of inflation or deflation;
- The expected total return from income and the appreciation of investments;
- Other resources of the institution; and
- The charity's investment policy.
Some states, including California, Oregon and New York, have included in their versions of UPMIFA an additional rule under which an annual spending rate above 7 percent of the endowment fund's value (averaged over a period of years that varies by state) is presumed to be imprudent. Depending on the circumstances, it may be possible to rebut this presumption and spend more than 7 percent, but the board must develop a strong record as to why such a decision is not imprudent. Notably, states that apply this rule do not apply a presumption that a spending rate of less than 7 percent is prudent. The board must still separately establish the prudence of a decision to appropriate for spending at an annual rate of less than 7 percent.
So how much may a charitable organization prudently spend from its endowment in a period of recession when the value of endowment assets has sharply declined? The short (and often unsatisfying) answer will always be "it depends." UPMIFA's core principle is that an organization must preserve the purchasing power of its endowment. At the same time, however, it does not prohibit a charity from spending from an "underwater" endowment, i.e., one in which the current value of the assets is less than the value of the initial and subsequent donor gifts, so long as the organization acts in good faith and satisfies the multi-factor prudence standard above.
In the last recession, many organizations evaluated those factors and concluded that it was prudent to continue to make distributions at historic spending levels, even from underwater endowment funds. Depending on the facts, it may be possible to justify a higher spending rate as prudent based on extraordinary needs in the community that the charity serves, or if a higher level of spending is necessary to preserve the very existence of the charity, so long as there is a plan to allow the endowment fund to recover in the future to preserve spending power.
One thing that is clear: boards should document carefully in minutes their deliberations on endowment spending and the basis for their decisions in order to demonstrate satisfaction of the UPMIFA prudence standard and of their general obligations as fiduciaries.
"Borrowing" From an Endowment Fund to Pay Operating Expenses
In times of economic distress, charities sometimes ask whether they may "borrow" from their endowment funds to pay critical operational expenses. Such "loans" within a single legal entity would presumably be accomplished through inter-fund bookkeeping entries.
There is little legal guidance on this question. The drafters of UPMIFA never considered it, and it is not addressed in either the model statute or in the official commentary. This is likely because an inter-fund transfer is not a "loan" from a legal perspective. A loan is a contract in which one party agrees to repay the other. When the borrowing involves only one legal entity, i.e., the charitable organization that both holds the endowment and wishes to expend the funds, there can be no contract. As a result, the loan likely cannot be analyzed as an "investment" in the way that a loan to a separate charity may be, as discussed below. More likely, it would simply be treated as an appropriation for spending from an endowment that must be evaluated under UPMIFA's prudence standard, described above. A charity that wishes to spend from its endowment at a level that would not satisfy the prudence standard should seek a release of endowment restrictions, as discussed below.
A charitable organization that is considering "borrowing" from its endowment should know of the legal risks and seek state-specific legal guidance. A board that appropriates an amount for spending from an endowment that is later determined to be imprudent risks the wrath of donors and the potential for a state attorney general action to recover the endowment funds, and, in egregious situations, to remove board members.
Obtaining Releases From Endowment Spending Restrictions
A charitable organization that wishes to spend from an endowment fund at a level that cannot be justified as prudent under the UPMIFA standard above should seek a release of endowment spending restrictions in order to have greater access to the endowment funds. There is a variety of potential options for obtaining such a release, and what is feasible will depend on the particular factual situation. In the current unprecedented economic situation, it seems likely that donors, attorneys general and courts will be more flexible in agreeing to release spending restrictions than they might be in a more stable environment. The purpose of an endowment is, after all, to support a charitable organization, and if the charity is forced to close its doors the endowment cannot fulfill its purpose.
The first step is to examine the gift document that establishes the endowment. An endowment spending restriction must generally be expressed in writing, and the written gift document may itself set out a procedure that the charity may follow in order to release the restriction.
Beyond the gift document, UPMIFA sets out procedural avenues for obtaining a release of restrictions. First, UPMIFA permits a charity to release or modify a restriction regarding the "management, investment, or purpose" of a fund if the donor consents in writing. If the donor is living, or is an institution that remains in existence, it may be possible to obtain the donor's written consent, and this may permit the charity to release the restriction. If the donors to the fund constitute a relatively large group, on the other hand, each of whom made a relatively small donation to the fund, there may be significant practical challenges to obtaining written donor consents.
UPMIFA further permits a court to modify a "particular charitable purpose" or a restriction on the "use" of a fund that becomes "unlawful, impracticable, impossible to achieve, or wasteful." The court may "modify the purpose of the fund or the restriction on the use of the fund" in a manner consistent with the donor's intent. This option requires the charity to bring a court action to seek the release and to provide notice to the state attorney general. In some states, such as Washington, it may be possible instead to follow a non-judicial procedure involving a written agreement to which the attorney general must be a party.
Finally, UPMIFA permits a charitable organization to release a restriction on the "management, investment, or purpose" of an old and small fund that the charity determines is "unlawful, impracticable, impossible to achieve, or wasteful." For a charity to avail itself of this procedure the fund must be over 20 years old and have a value below a specific dollar threshold, which varies from state to state. The charity must also notify the state attorney general.
Loans From Endowment Funds to Other Charitable Organizations
Charitable organizations with endowment assets may seek to assist other charities in challenging economic times by lending them funds from their endowments. Such a loan should be analyzed as an investment by the lender, as opposed to an appropriation for spending, which is governed by the "prudent investor" rule. The prudent investor rule applies to most charitable organizations, whether they are formed as corporations or trusts, and applies to both endowment and non-endowment investment assets. (UPMIFA applies the rule to charities formed as corporations, while the Uniform Prudent Investor Act, which has been adopted in all 50 states and the District of Columbia, applies the rule to charitable trusts.) To satisfy the rule, in investing charitable assets, a charity's board must:
- Act "in good faith;
- With the care an ordinarily prudent person in a like position would exercise under similar circumstances"; and
- Consider the following factors:
- General economic conditions;
- The possible effect of inflation or deflation;
- The expected tax consequences, if any, of investment decisions or strategies;
- The role that each investment or course of action plays within the overall investment portfolio of the fund;
- The expected total return from income and the appreciation of investments;
- Other resources of the charity;
- The needs of the charity, or a particular fund within the charity, to make distributions and to preserve capital; and
- An asset's special relationship or special value, if any, to the charity's purposes.
In addition, the board must:
- Diversify investments, absent special circumstances; and
- Make decisions about each asset in the context of the overall investment portfolio, as part of an overall investment strategy that is appropriate for the specific fund and the charity.
Under the prudent investor rule, a charity may make a loan from an endowment fund to another charity as an investment, so long as the investment of the overall endowment portfolio satisfies the prudent investor rule and the obligation to diversify investment assets is met.
The percentage of an endowment portfolio that is used to make such loans will be important in evaluating prudence. It may be possible to justify loaning a small percentage of an endowment to other charities at reasonable terms, but not a large one.
It may also be possible to justify a loan that has an interest rate and payment or security terms that are more favorable to the charitable borrower than the borrower might be able to obtain from a commercial lender. The prudent investor rule permits the lender to take into account the loan's "special relationship or special value" to the lender's charitable purposes, and does not require the lender to seek to maximize the rate of return on each investment within its portfolio. This approach is consistent with a "mission-related investment" philosophy, in which an investment has both charitable and investment return purposes, and may be supported by an organization's investment policy that allocates a percentage of the portfolio to mission-related investments.
A loan from an endowment fund to another charity that bears no interest, on the other hand, cannot be evaluated as an investment, and would likely be treated as an appropriation for spending from an endowment fund, which would have to satisfy UPMIFA's prudence standard. It may be possible to make such a loan from non-endowment assets, in which case the loan may be treated under UPMIFA as a "program-related asset" held primarily to further charitable purposes, rather than as an investment. Such assets are not subject to the prudent investor rule. That analysis will not apply to loans from an endowment fund, however.
Pledges of Endowment Funds as Security for Loans
Charitable organizations sometimes ask whether they may permissibly pledge their endowment assets as security for a loan, in order to provide liquidity for grants or other spending in times of crisis. The Uniform Law Commission's official commentary to UPMIFA states that the model act permits such a pledge, but subject to the prudent investor rule described above. So while such pledges may be permitted in some circumstances, boards must still demonstrate that in approving any such pledge they have satisfied the prudence standard. Some states may require notice to the attorney general and/or a court order to take such action.
Some funders who provide gifts or grants for endowment funds may specifically restrict the charity's ability to pledge the assets. In addition, some lenders may decline to accept endowment assets as collateral, or may require a legal opinion as to the lender's ability to enforce its security interest against the collateral.
If a charity pledges endowment assets, defaults on the loan, and the lender takes the collateral, the result is a very unhappy situation indeed. There may be serious damage to the charity's relationship with funders and its reputation with the public, and questions may be raised as to whether the board satisfied its fiduciary obligations in approving the pledge. The charity may be treated as effectively having spent the endowment assets on whatever it used the loan proceeds for, which may constitute an imprudent appropriation from the endowment under UPMIFA.
Any charity considering a pledge of endowment assets as collateral should proceed cautiously and seek state-specific guidance from legal counsel.
With the extraordinary economic situation created by COVID-19, charitable organizations are exploring all options available to satisfy funding needs. In many cases it may be possible for charities to access some portion of their endowment fund assets currently, but charities and their boards should approach these issues thoughtfully, with awareness of the legal standards, the oversight role of the state attorneys general, and the board's fiduciary obligations.
The facts, laws, and regulations regarding COVID-19 are developing rapidly. Since the date of publication, there may be new or additional information not referenced in this advisory. Please consult with your legal counsel for guidance.
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