DATELINE: January 5, 2009, Chicago
One of our faithful readers asked us to expand on our recent discussion of family foundations that have lost money in the Madoff scandal. In our earlier post, we suggested that state charity regulators needed to take some action in response to what appears to us to be poor investment management practices on the part of some of those running these foundations. The specific question was whether...
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foundations with under $10 million in assets could have economically undertaken due diligence on Madoff before investing with him. Our reader's apparent view was that it was not economical, raising the possibility that the directors and managers of those foundations didn't have an obligation to undertake due diligence.
Our answer is quite simple: Smaller family foundations had many many ways to protect themselves from the likes of Madoff. These steps were simple and inexpensive. There is no excuse for failing to have taken them: Specifically—and let this serve as a guide for other small family foundations:
Reconsider the Decision to Create a Foundation. If the administrative costs (including investment advisory fees and due diligence costs) are too high relative to the size of a foundation's assets, donors should consider alternative vehicles for carrying out their philanthropic intentions. Having your own foundation is cool and elite, but it is not necessary to do good. Individuals can obtain most of the benefits that come with foundations by establishing funds with community foundations or setting up donor-advised funds with organizations like Charles Schwab, Fidelity, and Vanguard. Much of the administrative hassle that comes with a family foundation can be eliminated through these alternatives, leaving more money for charity.
Lawyers who advise the wealthy should do their clients a favor instead of just saying "Yes" when asked to create a foundation. Unless the client has more than $5 million or $10 million to fund the foundation with, the lawyer should suggest alternatives and explain the ongoing costs. The lawyer also should explain the responsibilities that come with creating a foundation. Clients should know that their are costs that come with the tax benefits and opporunity to employ their children (as we have seen several Web sites advocating the creation of family foundations extol). As we pointed out last week, the time has come for lawyers to begin saying "No" and assume the position of the wise man.
Understand What You Invest In. We were talking to an attorney who sees plenty of offering circulars for hedge and private equity funds. The investors aren’t looking for investment advice from this lawyer, just an assessment of the legal structure and the tax implications. This lawyer shakes her head every time she reads the clause about proprietary strategies that can’t be disclosed. No matter how trendy the investment, if the managers won’t explain it, a foundation has no business investing in it.
Hedge Funds Aren’t The Only Option. Long before hedge and private equity funds became popular, people and foundations were able to invest and make money. Unless the foundation has professional advisors and tens of millions of dollars to invest, it should stay away from these complex and byzantine investments. A small foundation can build a profitable portfolio consisting of a mix of blue chip and other stocks, high-grade corporate bonds, and treasury securities. It may not return 10% to 12% each year for seventeen years, but no investment strategy does.
There are Advisors Who Specialize in Family Foundations. Many years ago, the Ford Foundation recognized the problems encountered by smaller foundations in managing their investment assets. It therefore seeded the Commonfund, a nonprofit that specializes in advising charities on investing their endowments. It provides training, offers investment funds, and provides advisory services to foundations and other charities. It currently has over 1,800 institutional clients. More than half of those have assets under $25 million. We took a quick look at the Commonfund’s summary of its investment funds and we have to say, the returns are more than acceptable. Those who like competition also should take a look at TIFF, The Investment Fund for Foundations, which also offers advisory services and investment vehicles. It is a cooperative-style organization that serves the foundation community. Rather than hearing stories about Madoff and his returns in country club locker rooms and other places where fungus-like rumors spread, the directors of the foundations that chose Madoff could have just as easily sought advice from the Commonfund or TIFF.
These folks also could have looked to institutional investment advisors like Northern Trust, J.P. Morgan, Merrill Lynch, and other household names. Sure there are fees, but those fees are in effect covering someone's due diligence and controls. Nothing is free.
Use a Custodian. It is standard procedure to use a custodian independent of an investment advisor when an individual or foundation uses an investment advisor. It is easy to use a Fidelity, Schwab, or other established firm brokerage account and give the advisor trading authority, but not the ability to remove assets or funds from the account. The individual or foundation receives monthly statements and can check activity and balances 24/7. Allowing an investment manager to also have custody of the securities and be responsible for all the reporting violates the basic tenets of internal control—separate incompatible functions. Custody, reporting, and management should not be vested in the same person. Legitimate investment managers will refuse to take custody of assets.
Diversify. Our faithful reader suggested that the foundations had diversified because Madoff claimed to invest in a wide variety of equities. We respectfully disagree. Madoff was not just buying a basket of stocks. Madoff ostensibly employed a split-strike strategy, which is an options/trading strategy. That is not diversification. Moreover, diversification is not limited to just diversification over different investment classes, but also includes diversification of investment strategies and investment advisors. In our view, a foundation should diversify across asset classes—bonds, U.S. equities, foreign equities, mid-cap and small-cap equities, real estate, commodities. Smaller foundations are not going to be able to do this in a pure sense, but there are ways to acquire interests that serve as proxies for investments in real estate and commodities. Buying a basket of stocks in the S&P 500 is not one of them. In any event, investors should not rely on one investment manger's strategy or one investment manger.
Ask About Insurance. We don’t rely on SIPC to protect our accounts. We have asked about supplemental fidelity insurance maintained by our brokerage firm. If we can ask that question, those running a foundation with $10 million can ask that question. The question is particularly pertinent when the size of the assets is too small to warrant separate investment advisors or brokers.
Don’t Invest If You Don’t Understand—Clean Hands. We recall our days as tax shelter lawyers back in the 1980s. We understood the questionable opinions that some of our clients received from tax shelter promoters, but some clients weren’t interested in technicalities. Was it because those technicalities were too boring? Probably, but we don’t think that is the only reason some people weren’t interested in the details. In some cases they wanted the high promised return and hoped the IRS wouldn’t raise the issues. It has been widely reported that many Madoff investors also wondered how he achieved his returns. Was he front-running or relying on insider information? Some likely didn’t want to know the details just as long as the statements showed the impossible returns.
Whenever anyone makes an investment, they need to understand the details and the risks. If they hide from the facts and get burned, they have no one to blame but themselves, particularly if they didn’t want to know what made something too good to be true.
In terms of the foundations that lost money, each foundation and its directors should have the presumption of due care until it is established otherwise. However, and this was the point of our earlier post, in light of the reports to date, we believe state attorneys general and charity regulators should be examining whether due care was exercised. If the directors of these foundations failed to take the most elementrary and inexpensive precautionary steps, the state regulators need to take some action if state laws and those who enforce them are to have any credibility. It is not necessary for the regulators to sue the directors for monetary damages -- given that acting in good faith protects fiduciaries from monetary liabilty-- but as we pointed out, the regulators can look to other remedies to make their point. In egregious cases, the regulators might demand the resignation of directors. In most cases, it would be sufficient to require the organization and its directors to enter into a consent decree requiring the foundation’s investments to be administered according to a prescribed set of limits and controls.
So dear reader, now you know.
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