The Michigan Legislature is poised to adopt the Uniform Prudent Management of Institutional Funds Act (the New Act), a law that will regulate the administration of charitable endowments.
The New Act:
- modifies the rules used in determining withdrawals from endowments to meet current expenses;
- lists factors to be considered when investing in and making withdrawals from endowments; and
- provides procedures for modifying donor imposed restrictions.
Enactment of this legislation is also likely to require many organizations to change the way in which endowments are reported in their financial statements.
Educational institutions, hospitals, hospital foundations, churches and other charities often receive contributions that are subject to donorimposed limitations on their use. “Endowment funds” are assets that have been donated subject to requirements that the amounts given be retained in perpetuity (or for some shorter period) and that earnings be expended either for the general purposes of the organization or for some more specific purpose.
In the past, traditional legal rules allowed charitable institutions to expend only interest, dividends and rental income from their endowments, requiring that all capital gains be preserved as principal. During the 1950s and 1960s, those rules caused many organizations to invest their endowments primarily in bonds, resulting in significant decreases in the purchasing power of the funds. In 1972, the National Conference of Commissioners on Uniform State Laws approved model legislation designed to give charitable organizations greater flexibility with their investments. A version of the Uniform Management of Institutional Funds Act (the Old Act) was adopted in Michigan in 1976.
The Old Act allows charities to expend “prudent” amounts of net appreciation in excess of the “historic dollar value” of their endowments, that is, amounts greater than the market value of the funds at the time they were given. This rule has created several concerns. The “historic dollar value” of many older endowments has been a small percentage of their current market value, allowing almost unlimited expenditures. In the case of recently established funds and those that are “under water” due to investment losses, however, the rules in the Old Act have provided little flexibility.
Investment and Distributions under the New Act
The New Act, which was passed by the Michigan Senate in April and was reported out of committee in the Michigan House in June, will replace the Old Act. It is designed to provide greater guidance for board members and others responsible for managing charitable endowments.
The New Act requires that each person responsible for the investment of endowments to act (1) in good faith, (2) in a manner consistent with the intent of the donor, the mission of the organization and the purposes of the fund; and (3) “with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” The New Act directs that those investing funds consider factors such as current economic conditions, the possible effects of inflation, deflation and taxation and the anticipated total return on investments from interest, dividends and appreciation. It also provides that risk be evaluated in relation to the portfolio as a whole, mandates diversification of investments (in most circumstances) and requires that organizations determine if donated assets should be retained or sold. The New Act allows the delegation of investment responsibilities to committees, officers, employees or outside advisors, but requires prudence in the selection of agents, in establishing the scope of delegated authority and in reviewing performance.
A key feature of the New Act is that it eliminates the concept of “historic dollar cost.” Instead, organizations “may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines is prudent.” In making decisions with respect to expenditures, those responsible must exercise the care of an “ordinarily prudent person” and must consider the purposes of the organization and economic factors similar to those applicable in making investments. The model for the New Act has optional language stating that annual expenditures from an endowment of more that 7% of the market value of its assets are presumed to be “unreasonable.” That provision is not, however, included in the Michigan legislation.
The New Act raises concerns about its effect on the liability of directors and officers responsible for managing endowments. While the Old Act also included a “prudent person” standard of care, the provisions in the New Act enumerating the factors that must be taken into account in making investments and expenditures do not decrease and could even increase exposure to personal liability. Further, while Section 209 of the Michigan Nonprofit Corporation Act, MCL 450.2209, allows corporations to include language in their articles eliminating the liability of volunteer directors for ordinary negligence in the performance of their duties, those provisions may not be effective with respect to violation of the standards of care in the New Act.
Modification of Donor Restrictions on Endowments
Under the “cy pres doctrine,” the courts have traditionally had the power to change donor restrictions on charitable gifts when those limitations have become unlawful, impractical or impossible to carry out. Both the Old Act and the New Act provide specifically for modification of the terms of restricted donations by court order. The rules under the New Act are more liberal than the traditional standard, allowing limitations to be modified if they have become impractical or wasteful, if they impair the management or investment of the fund or if, due to circumstances not anticipated by the donor, a change furthers the purposes of the gift. Both statutes also permit the release of restrictions with the consent of the donor, as long as the property continues to be used for the charitable purposes of the organization. In addition, the New Act will allow organizations to release donor restrictions on a fund without a court order if the fund has a balance of less than $25,000 and been in existence for more than 20 years and if the organization has given 60 days’ notice of the proposed change to the Michigan Attorney General.
Under the accounting practices used under the Old Act, many organizations have reported the “historic dollar value” of their endowment funds as permanently restricted funds on their financial statements, but have reported the value of the endowments in excess of their historic dollar value as unrestricted or temporarily restricted property. In August, 2008, the Financial Accounting Standards Board (FASB) released a staff position (No. FAS 117-1) recommending that organizations subject to the Uniform Prudent Management of Institutional Funds Act report all of their endowments, other than the portions that have actually been appropriated for expenditure, as permanently restricted assets. This is likely to cause many organization to reclassify assets in their financial statements after the New Act is adopted. The FASB staff position also recommends that all organizations make much more detailed footnote disclosures with respect to the use and management of their endowment funds than in the past.