Charities: Prudent Investment Laws

Charitable nonprofits organizations must comply with state prudent investment laws that apply to their investment assets. In California, as is the case in 49 of the 50 states, the Uniform Prudent Management of Institutional Funds Act (UPMIFA) sets the rules. Note that there may be some (mostly minor) variation among state laws, but we’ll specifically review UPMIFA as it applies to California nonprofit organizations.

Some refer to UPMIFA as the law governing endowments, but, while that’s true, UPMIFA also governs other institutional funds. Generally, an institutional fund includes any fund held by a charitable nonprofit corporation or unincorporated association (“Charity”) exclusively for charitable purposes except for program-related assets. Accordingly, a Charity’s investment funds and assets (regardless of whether part of an endowment) are generally encompassed by the definition.

8 Factors

Except as otherwise provided by a gift instrument (e.g., the donor’s written instructions at the time of making the gift), in managing and investing an institutional fund, all of the following factors, if relevant, must be considered:

  1. General economic conditions.
  2. The possible effect of inflation or deflation.
  3. The expected tax consequences, if any, of investment decisions or strategies.
  4. The role that each investment or course of action plays within the overall investment portfolio of the fund.
  5. The expected total return from income and the appreciation of investments.
  6. Other resources of the institution.
  7. The needs of the institution and the fund to make distributions and to preserve capital.
  8. An asset’s special relationship or special value, if any, to the charitable purposes of the institution.

There is no guidance as to whether certain factors are more important than others, but with respect to director (board member) exposure to liability for breach of fiduciary duties with respect to management and investment of the fund, the business judgment rule should apply. Accordingly, if directors make their decisions in good faith in what they believe to be in the corporation’s best interest, after exercising reasonable care in their decision and/or oversight, noting all of the above considerations, they should be protected.

Portfolio Theory – Diversification

“Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to maximize expected return based on a given level of market risk. … Modern portfolio theory argues that an investment’s risk and return characteristics should not be viewed alone, but should be evaluated by how the investment affects the overall portfolio’s risk and return. MPT shows that an investor can construct a portfolio of multiple assets that will maximize returns for a given level of risk.”

Investopedia

Subject to any conflicting instructions in a gift instrument, in making its management and investment decisions, a Charity must consider each investment decision in the context of its overall investment portfolio. UPMIFA elaborates:

Management and investment decisions about an individual asset must be made not in isolation but rather in the context of the institutional fund’s portfolio of investments as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the fund and to the institution.

The level of risk tolerance may then vary depending on the purposes and goals of the fund and of the Charity. A capital campaign fund of a typical public charity will likely have a lower risk tolerance (and shorter investment horizon) than a board-created quasi-endowment fund of a typical private foundation.

Notwithstanding the need to consider the Charity’s investment portfolio in the context of a particular investment decision, UPMIFA provides a vague carveout for special circumstances:

An institution shall diversify the investments of an institutional fund unless the institution reasonably determines that, because of special circumstances, the purposes of the fund are better served without diversification.

This provision, together with the 8th investment factor described above regarding an investment’s special relationship or value to a Charity’s mission, would seem to support a portfolio of investments that are entirely mission-related even if such portfolio might not be considered prudent if viewed solely from a financial perspective.

There have been some vigorous public discussions about whether well-endowed private foundations and public charities should move their investments assets in this direction so that substantially all of their investments are made primarily in furtherance of their mission. While this is not currently required, such a strategy would match up with the 501(c)(3) Operational Test which requires that a 501(c)(3) organization be operated primarily in furtherance of one or more exempt purposes and only insubstantially in furtherance of other purposes.

Additional UPMIFA Provisions

  • Subject to donor intent expressed in a gift instrument, a Charity, in managing and investing an institutional fund, shall consider both the charitable purposes of the Charity and the purposes of the fund.
  • Each person responsible for managing and investing an institutional fund (not just the directors) shall manage and invest the fund in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances. Further, a person that has special skills or expertise, or is selected in reliance upon the person’s representation that the person has special skills or expertise, has a duty to use those skills or that expertise in managing and investing institutional funds. This represents a heightened standard of care over the ordinarily prudent person standard applicable to directors.
  • Within a reasonable time after receiving money or property that would be included as an institutional fund, a Charity must make and implement decisions concerning the retention or disposition of the money/property or to rebalance a portfolio, in order to bring the institutional fund and Charity into compliance with its policies and applicable law (including UPMIFA).
  • UPMIFA does not restrict the types of individual investments that can be made.
  • A gift instrument may include a Charity’s own solicitation materials that in significant part causes the donation to be made by a donor. In certain cases, such materials can create a restriction on the charitable contribution even absent a donor’s specific instruction regarding such restriction.

Additional Investment Laws

Other state nonprofit corporate laws may apply, including those regarding self-dealing transactions (e.g., investments in a company owned by one of the Charity’s directors) and investments (e.g., CA Corporations Code Sections 5240-5241).

Private foundations are also subject to additional laws regarding jeopardizing investments and excess business holdings.

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Charities: Prudent Investment Laws