DATELINE: March 12, 2009, Chicago
On Tuesday, Senator Charles Grassley, ranking member of the Senate Finance Committee, spoke at some sort of conference or event sponsored by a Washington, D.C. law firm. His remarks are up on his Web site and they largely cover ground that Senator Grassley has sown before. There, however, is...
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one notable exception. Part way through his speech, Senator Grassley said:
However, since the 1969 Act passed, we have seen an explosion in other types of grant-making vehicles like supporting organizations, donor-advised funds, endowment funds, and more recently, venture philanthropy funds. Since some of these walk and talk like private foundations, it's fair to ask why the private foundation rules shouldn't apply to them. For example, some are struggling because of poor investment decisions. Harvard's investment in illiquid private equity and hedge funds means they have to take out a loan or issue bonds to increase liquidity. Those who invested with Madoff appear to have boards that may have looked the other way in return for the promise of high earnings.
Both of these examples raise the question of why the jeopardy investment excise tax should only apply to private foundations. On the other hand, some of the rules create perverse incentives for private foundations to give out more money. For example, a large foundation that decides it wants to continually fund a small charity may actually "tip" that charity into private foundation status. Or, if it increases its payout, it may be subject to an increased excise tax on its investment income a few years down the road. And for those foundations that view the 5 percent threshold as a floor rather than a ceiling, there is no reward. They get treated the same as those who treat the 5 percent as a ceiling and don't pay out any more. It would seem that these are unintended consequences of the 1969 rules. Discussing changes to these rules is timely since many charities are struggling with liquidity during this economic crisis.
We applaud Senator Grassley. He is doing what a senator is supposed to do: addressing policy through legislation. We think Senator Grassley’s question as to whether the jeopardy investment provisions should apply to public charities is a good one, but we think the question needs to better focused. The reference to jeopardy investments turns the focus to prudence and whether asset allocation procedures and the resulting allocations are appropriate. That’s the right focus, but it is too tax-centric in terms of the solution. Whether particular investments and investment strategies are appropriate is a longstanding concern of state law. The Uniform Prudent Investor Act (UPIA) (roughly speaking, applicable to trusts), the Uniform Management of Institutional Funds Act (UMIFA) (roughly speaking, applicable to corporate charities in practice, but with slightly broader application), the Uniform Prudent Management of Institutional Funds Act (UPMIFA), (roughly speaking, applicable to corporate charities in practice, but with slightly broader application), the Restatement (Third) Trusts (sections 90-92), and state nonprofit corporate law, each contain law addressing investments and prudence. If things are as both Senator Grassley and we suspect, those laws, like the tax law prohbition in Section 4944 on private foundation jeopardy investments, have failed to achieve their intended results.
The legal system does not seem capable of dealing with or preventing faulty investment decisions by nonprofit boards and managements. One approach would be to prescribe a list of permissible types of investments and asset allocations. That is in keeping with the fanciful notion that extreme specificity in regulations can solve all problems. Of course, this suggestion will be met with immediate and vocal objection, from many, including us. It flies in the face of modern portfolio theory. Moreover, it ignores the fact that the reasons that individual institutions invest and their individual risk tolerances differ widely. At the other end of the spectrum, we have the existing approach, which is a case by case examination of decisions by individual institutions. As noted, that doesn’t seem to work, either. As a practical matter, the only way the regulators end up reviewing decisions is after a problem has arisen. That is due in large part to limited resources.
Now let’s think about extending Section 4944 to public charities. Before doing that, Section 4944 is sorely in need of overhaul. First,the maximum penalty on the entire board for an “investment” is $20,000. As a practical matter, each member of a 20-person board is therefore subject to a $1,000 penalty. That is not much of a deterrent, particularly given the fact that millions or even tens of millions dollars may have been lost due to one investment.
Second, before a director can be held accountable, the IRS must demonstrate that the investor had the requisite knowledge. Treasury Regulation section 53.4944-1(a)(2)(i). Under the existing regulations, it is virtually impossible to establish that level of knowledge. The director must have specific knowledge that there is a tax law provision governing the investment and that the investment would violate that provision. Unless boards are made up of highly specialized tax lawyers and accountants, very few directors will ever have that type of knowledge. This prong of the test should be eliminated. The question should focus on whether the investment is too risky given the mission.
Third, reading further in the regulation shows an additional problem. “Knowing” does not mean “having reason to know” which strikes us as basically eliminating an obligation to undertake due inquiry. Given the fact that state law requires an informed process, the failure to engage in that process should not serve as a defense to Section 4944 penalties.
Fourth, the rules permit a board to rely on advice of counsel to shield the members from the penalty. This reflects the clear risk with letting lawyers write regulations. When we were in law school, we never took a course in investment analysis or portfolio theory. We don’t think the law school has changed in the ensuing years. Plain and simple, lawyers are not trained in investments or portfolio theory no matter how shrewd they think they might be when it comes to investing. If a board is permitted to rely on an opinion to shield itself from liability, it should be an opinion from an investment professional with no conflicts of interest.
Fifth, the substance of the regulations needs to be rewritten. Even for 1972, Treasury Regulation section 53.4944-1(a)(2) is poorly written in terms of flushing out what prudence, risk, and diversification mean. In the ensuing 37 years, we have seen major advances in investment portfolio theory and risk assessment. Entire new classes of investment assets and hedging devices have been developed. Depending how a particular asset is used, it can expose a portfolio to major risk or significantly reduce risk. These developments should be reflected in regulations.
Now let’s turn to our friends at the IRS. There has been little visible or meaningful activity under Section 4944 since the regulations were issued. This area obviously is not high on the IRS’s list of concerns, and for good reason. Just as lawyers in private practice don’t have the necessary expertise, the lawyers at the IRS lack the expertise, too. Were the IRS to take this issue on as a consequence of new legislation, Congress would need to provide it with the funds necessary to hire the cadre of financial professionals that would be necessary to permit meaningful enforcement. A new schedule would need to be added to the Form 990 and Form 990-PF that would examine each institution’s asset allocations and portfolio risk using conventional models. Passing another law is not enough.
We will be interested to see how Senator Grassley proceeds. We aren’t convinced that applying the jeopardy investment rules to public charities is practical under the existing legal or administrative regime. But we would favor a rule that imposes strict limitations on conflicts of interest in this area. In our view, there is no reason for a large college or university to be seeking professional investment advice from a firm controlled by board members or to be investing in assets managed or marketed by board members.
At the end of the day, active and engaged boards are the only surefire way to assure rational and informed decisionmaking. If we could pass a law, it might read like this:
Section 1. Board members cannot suggest that the institution invest in funds or assets that they learned about in the country club locker room.
Section 2. Boards should not sit in dark rooms watching PowerPoint presentations by consultants while eating morning buns and sipping coffee.
Section 3. Board members should not be permitted to brag about how their institution placed money with a hot money manager.
Section 4. Membership on an institution’s investment committee doesn’t give the member the right to experiment with or test a new investment theory that the member wants to apply to his personal investments.
Section 5. Just because an institution has high-paid in-house investment managers does not mean those investment managers should be setting the risk parameters.
Section 6. Maximizing return cannot be an end in itself. Return should be maximized in light of pre-defined risk tolerances.
The recent problems are not new. For the best article written about an investment blowup, we recommend a 2002 Wall Street Journal article describing a hedge fund investment by the Art Insitute of Chicago. Ianthe Jeanne Dugan, Thomas M. Burton, and Carrick Mollenkamp, Chicago Art Institute Hedge Fund Loss Paints Cautionary Tale for Investors (Feb. 1, 2002). It gets upfront and personal in terms of how one investment committee was perceived, as the following quote indicates:
The night before their first presentation, in July 2000, Messrs. Seghers and Dickey dined at the elegant University Club in Chicago with William Kennedy. Mr. Seghers rehearsed his script. Then, he says, he and Mr. Dickey went to an all-night Kinko's to redo their
marketing material. Mr. Kennedy had told them the museum trustees "are all old people, so make the font size bigger and the background lighter," Mr. Seghers recalls. David Kennedy confirms that his father suggested making the material more readable.
Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.
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