DATELINE: December 30, 2008, Chicago
We now have a spreadsheet listing charities that have lost money in Bernie Madoff’s Ponzi scheme. We anticpate that the reported losses by charities will eventually exceed $2 billion--we have identified $1.7 billion of losses to date. The word “reported” needs to be emphasized. Take Hadassah, for example. It has been widely reported that it lost...
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$90 million to Madoff. The amount is arguably much lower. Its initial investment was $7 million. Jacob Berkman, Haddassah Addresses Madoff Investments, JTA (Dec. 24, 2008). That is apparently attributable to a gift from one person who required that the funds be invested with Madoff. Hadassah then reportedly invested $33 million of its own money with Madoff, bringing the total out-of-pocket investment to $40. So $50 of the $90 million loss is apparently attributable to paper profits. The better way to measure loss would be to take out-of-pocket cash and add a factor for opportunity cost. The bottom line: the losses are large and still devasting, but the reports probably overstate them.
Now, let’s turn to our friends, the charity regulators. As we have written in the past, we don’t see how Yeshiva University cannot sue Ezra Merkin, one of its trustees, for allegedly steering a portion of Yeshiva’s endowment to Madoff through Merkin's own investment fund. To date, Yeshiva University's losses raise the most interesting questions involving charity fiduciaries that have come out of the Madoff debacle. But there were a number of family foundations that also invested with Madoff. Those foundations, which also raise important and interesting questions, now place state charity regulators in a difficult position.
We refer to them as family foundations, but they are nevertheless charities, subject to the same state law as any other charity. The families who created them received large charitable contribution deductions. Those who managed the investment of these foundations are subject to the same fiduciary duties as the directors of any other charity. Therein lies the problem for regulators. The directors who authorized the investment of all a foundation’s assets with Madoff didn’t diversify--a fundamental tenet of investment management by charitable fiduciaries. There also are serious questions as to whether some of these directors did adequate due diligence. It is everyone's rightful choice to rely on an old-boys’ network to invest their personal funds, but fiduciaries of charities are held to a higher standard.
Although a court ultimately must decide the question, we strongly suspect that some directors who authorized investing with Madoff breached their fiduciary duty of care. The question that everyone immediately jumps to is whether monetary liability should attach. Commonly, an uncompensated director can only be held monetarily liable if the director was grossly negligent and failed to act in good faith, engaged in criminal acts, or engaged in acts of self-dealing. That is a high standard and it generally precludes a finding of monetary liability.
As it turns out, the analysis is more subtle than the one that most people focus on. The first question is whether there has been a breach of duty. As noted, we strongly suspect that in some cases there was a breach of duty--although the answer ultimately rests with a judge sitting in equity (only in a few states are juries available) after a full airing of the facts. An attorney general finding a breach of duties (gross negligence) can sue (or seek a settlement) for a wide range of remedies, including monetary liability if the action was not in good faith. In our minds, monetary liability is a viable remedy in cases where directors deliberately failed to diversify. It also may be viable if the directors deliberately failed to do adequate due diligence. However, the other remedies that an attorney general could seek require a lesser finding of gross negligence or reckless behavior. In such cases, an attorney general could seek to replace the board of a family foundation or force it to transfer its assets to a community foundation or demand a consent decree requiring any remaining funds be professionally managed by specified managers.
Those options are what place state attorneys general in a difficult position. If they want to argue that family foundation money represents charitable assets, then they need a strong response to Madoff; otherwise they are treating family foundations and their assets as incorporated pocketbooks that are somehow less charitable than the assets held by brand-name charities. If action is not taken against the foundation directors who authorized the investment with Madoff without any due diligence or diversification, then what circumstances warrant taking action?
We are practical and state attorneys general are political creatures. We are willing to bet that no action is ever taken against any of the directors of these foundations. Many of these individuals lost personal fortunes and therefore appear to be victims. The AGs who decide not to pursue legal action also will point to the unquestionable generosity of these families and their foundations evidenced through years of charitable giving. In short, AGs will be reluctant to kick a dog when it is down. This logic is reflected in a California Appeals court decision dating to 1954—George Pepperdine Foundation v. Pepperdine, 126 Cal. App. 2d 154, 271 P.2d 600, in which the court wrote:
Assuming that the alleged losses were due to the alleged egregious blunders of the board under the leadership of President Pepperdine, and to have been the result of his negligence and of the lack of zealous interest on the part of the others, why should he be now required to restore to his corporation what he once gave from his bounty and which was lost solely by reason of his ignorant or careless reckoning?... If Mr. Pepperdine had never organized the Foundation, but had set himself up to bestow his fortune on deserving charities and had at the same time continued to “invest and reinvest” his own moneys and properties and finally by miscalculations have lost it all, would any one be so crazy and cruel to assert a claim against him for carelessness in not holding intact the fortune which he intended to bestow on others? Who is “Foundation” otherwise than the shadow of George Pepperdine, if not his alter ego? If he as an individual could not be sued for negligently investing his own moneys intended for charitable uses, why should his own “Foundation” under the management of strangers prosecute an action to recover from the original donor and his friend what, through negligence, they lost for the Foundation?
The answer actually is quite simple. When Pepperdine held the money himself, he still had the choice of spending it on luxury rather than charity. An unspoken intended use does not convert personal assets to charitable assets subject to state regulation. But when Pepperdine gave his assets to a foundation organized and recognized as a charity, those assets were no longer his. Certain restrictions attached to those assets. Moreover, Pepperdine himself presumably received certain tax benefits as a result of the gift. In short, the assets entered the charitable sector and were no longer “his” as the court suggests. The court’s logic likely will carry the day when state attorneys general decide whether to seek monetary recompense from family foundation directors who authorized the Madoff investments, but that logic undercuts the regulatory regime. It is wrong and it is not the law, not even now in California.
Our concern is not so much about the directors of these victimized foundations. It is with the directors of other family foundations who may be just as negligent in their investment decisions, but who have been lucky not to run across another Madoff yet. For state charity regulators, this is a teachable moment. The way a regulator teaches is by taking action against people who screw up. A regulator sets an example.
That brings us back to an earlier point. In seeking a remedy, an attorney general is not limited to seeking only monetary damages. In our view, charity regulators should pursue non-monetary remedies if they don’t have the ability or political will to pursue monetary damages when appropriate under the law. State charity regulators should look to consent decrees, removal of boards, and forced transfers of remaining charitable assets to more institutional charities as viable remedies. Unless investment practices improve, other charities will fall victim to another Madoff. It is time for a New Era in charitable fiduciary investment practices.
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