CONNECICUT SOCIETY OF CERTIFIED PUBLIC ACCOUNTANTS

Transcription

1 CONNECICUT SOCIETY OF CERTIFIED PUBLIC ACCOUNTANTS UPMIFA, GENERALLY ACCEPTED ACCOUNTING PRINCIPLES, UNDERWATER FUNDS, AND BOARD RESPONSIBILTY JUNE 25, 2009 John M. Horak, Esq. Reid and Riege, PC One Financial Plaza Hartford, Connecticut

2 PREAMBLE On one level the meltdown in the financial markets creates an obvious immediate problem fewer dollars to pour into the operating budget. On a deeper level the diminution of value creates fiduciary/legal issues relative to investment and spending policies generally, but even more specifically for a class of donor derived funds commonly referred to as permanent endowment or perpetual funds. These are funds subject to a requirement that corpus or principal be kept intact with only the interest or earnings being expendable. The general historic understanding of lawyers, courts, academicians, attorneys general and fiduciaries has been that that there is a legal obligation to preserve the corpus or principal of endowments in perpetuity. 2

3 PREAMBLE (Cont.) The traditional interpretation of this principle was that at a minimum, the value of an endowment funds at the time received from the donor the historic dollar value or HDV had to be preserved. Others have argued that there is also a requirement to reinvest into these funds so that the perpetual portion increases in value to preserve spending power as a function of inflation. Some states require this by statute. This thinking was all embodied in a 1973 statute called the Uniform management of Institutional Funds Act (UMIFA). A word about the Uniform Laws Commission. An update of UMIFA --- the Uniform Prudent Management of Institutional Funds Act ( UPMIFA ) has been in the works nationally for a few years, and it purports to changes the rules for perpetual funds by giving boards the power to spend them below their HDV. UPMIFA also updated applicable fiduciary investment standards and other guidelines but much of this had already been done in Connecticut. UPMIFA was passed in Connecticut in 2007 with an effective date of October 1,

4 PREAMBLE (Cont.) As a result of the market meltdown many perpetual funds are underwater worth less than HDV. Under UPMIFA it would seem that monies from these funds are still expendable. Many governing boards, feeling the financial pinch, want to do just that or are just doing it. However, this notion has been resisted by state attorneys general, and has created a host of unanswered legal questions that make the fiduciary judgment calls even more difficult than they might otherwise be in these times. There is also some tension between UPMIFA and applicable accounting standards (FAS 117-1) that has to be dealt with. This presentation is about these questions. 4

5 A WALK THROUGH THE MATERIAL 1. A necessary legal history lesson 2. Donor power to restrict funds legally 3. Donor creation of perpetual funds 4. Fiduciary responsibility for all funds 5. Fiduciary responsibility for perpetual funds 6. What the law has accommodated well 7. What the law has not accommodated very well 8. Common stock as the most troublesome asset class 9. Fixing the problem in 1973 UMIFA 10. Fixing the fix in 2007 UPMIFA 11. The collapse of the financial markets 12. The unexpected resistance to UPMIFA 13. FAS What s a board to do? 5

6 THE LEGAL HISTORY LESSON THE LAW OF CHARITIES Charity law is derived from the English law of property Roots in medieval England Land Real Estate All rights flowed from the King Rule against Perpetuities Rule against Dead Hand (Mortmain) control of property Did a charity have the right to own property The statute of charitable uses (1601) clarified the law and established the rules that are still the law today The term common law. 6

7 THE LAW OF CHARITIES (Cont.) The law gives to donors the power to impose perpetual legal restrictions on charitable assets (the amazing significance of this) A pen and a napkin is all I need 1850 gift of $ 10,000 as an endowment with income to be used to maintain the horse trough outside the Yale Faculty Club The law accommodates changes in circumstances a court applying the cy pres doctrine will find an alternative use for the horse trough fund, but the fund will stay intact Role of Attorney General represents the public The exclusive power of the courts (will come back to this) 7

8 THE LAW OF CHARITIES (Cont.) To put this in perspective different types of restrictions Totally unrestricted money the most loved by institutions I hereby give $10,000 to Yale University Restricted only as to use I hereby give $10,000 to Yale University for the biology department The type of restrictions we are concerned about perpetual or endowment restrictions: Principal or corpus to be kept intact and income thereon to be used to support the horse trough outside the Yale Faculty Club. Principal or corpus to be kept intact and income thereon to be used to support Yale University. NOT TO BE CONFUSED WITH QUASI ENDOWMENT OR BOARD DESIGNATED ENDOWMENT 8

9 THE LAW OF CHARITIES (Cont.) FIDUCIARY DUTY OF GOVERNING BOARDS AS TO FUNDS Law here is quite modern plenty of statutory/legal guidance. Investment Policy: Money is fungible and investments are unitized. The same fiduciary rules generally apply to the investment of funds regardless of donor restrictions on the funds (unless a donor specifies the investments which is very unusual). See Connecticut General States Sec. 45a-535b (Standard of Conduct in Managing and Investing Institutional Funds) Spending Policy: The fiduciary obligations are different depending on the nature of the restrictions. As to unrestricted monies any lawful purpose As to use restricted monies for that use only As to endowment restricted monies This is where things get interesting and what we are all about in this presentation 9

10 LET S PAUSE FOR A MOMENT TO SUMMARIZE WHAT WE HAVE JUST COVERED: The law of charities is very old It is based on property law the common law Donors have great legal powers to create restrictions These are use and endowment restrictions The Attorney General has a mandatory role The courts have exclusive powers The law accommodates well outdated use restrictions as things change over time 10

11 WHAT THE LAW OF CHARITIES HAS NOT (AND STILL DOES NOT) ACCOMMODATE WELL The law has not accommodated as well developments in the endowment investment world resulting from increasingly complex economies and commerce. The specific form of property that has proven most troublesome is common stock and the appreciation in value expected thereon. This may seem very odd to all of us because of our familiarity with different types of investment vehicles Why is this the case? Why is it still the case? 11

12 THE ISSUE OF COMMON STOCK AS AN ASSET CLASS Go back in time again Law of trusts vs. law of corporations Principal preservation as prime directive of trustees Land endured and rents could be collected Debt instruments principal fixed Modern securities laws only in 1933 and 1934 Boom and bust cycles in 19 th Century 12

13 COMMON STOCK ISSUES Not as secure as real estate/rents Not as secure as debt lowest claim on assets Dividends payable at discretion of board of directors In a bankruptcy common stock loses all value The appreciation conundrum: realized appreciation (capital gains) unrealized appreciation (potential capital gains) must appreciation be added back to corpus is it legal to expend appreciation? if legal how much can be expended? 13

14 COMMON STOCK ISSUES (Cont.) As recently as the 1960 s the lingering legal question was whether it was legal to invest in common stock Question was important because by that time (1960 s) the data showed that common stock could increase yield dramatically and provide inflation hedge The Ford Foundation s commission to Professors Cary and Bright The risk/reward principle A law of nature? 14

15 FIXING THE PROBLEM IN 1973 THE UNIFORM MANAGEMENT OF INSTITUTIONAL FUNDS ACT (UMIFA) UMIFA CLARIFIED/UPDATED THE LAW TO MAKE IT CLEAR THAT IT IS LEGAL: To invest in common stock (. A fiduciary may invest in any real or personal property deemed advisable whether or not it produces a current return, including stocks.. and other securities ) To delegate investment authority to professionals For nonprofits to spend as much realized and unrealized appreciation as was prudent as long as the amount spent did not reduce the principal of any gift below its historic dollar value. Advent of total return investment theory and of emphasis on investment and spending policies by governing boards. 15

16 1973 UMIFA Sec. 45a 528. Expenditure of net appreciation, standards. The governing board may appropriate for expenditure for the uses and purposes for which an endowment fund is established so much of the net appreciation, realized or unrealized, in the fair value of the assets of an endowment fund over the historic dollar value of the fund as is prudent under the standard established by Sec. 45a 532. This section does not limit the authority of the governing board to expend funds as permitted under other law, the terms of the applicable gift instrument, or the charter of the institution.

17 WHAT HAPPENED BETWEEN 1973 AND TODAY FIXING THE FIX: THE UNIFORM PRUDENT MANAGEMENT OF INSTUTUTIONAL FUNDS ACT 2007 An effort to update UMIFA in several respects to stay current with developments. Specifically, many sections of the statutes were updated to refine and enhance the fiduciary standards boards have to follow. following the standards set forth in the earlier adopted Uniform Prudent Investor Act to merge the rules applicable to trusts and nonprofit corporations. Interestingly -- Connecticut had already done this with modifications to UMIFA Most significant change is elimination of HDV floor. Reasons given: HDV is arbitrary HDV may become meaningless after many years have elapsed What to do with underwater funds/distortions in investment/ spending policies. 17

18 UPMIFA 2007 Sec. 45a-535c. Appropriation for expenditure or accumulation of endowment fund. (a) Subject to the intent of a donor expressed in a gift instrument, an institution may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines to be prudent for the uses, benefits, purposes and duration for which the endowment fund is established. Unless stated otherwise in a gift instrument, the assets in an endowment fund are donorrestricted assets until appropriated for expenditure by the institution. In making a determination to appropriate or accumulate, the institution shall act in good faith, with the care that an ordinarily prudent person in a like position would exercise under similar circumstances and shall consider, if relevant, the following factors: (1) The duration and preservation of the endowment fund; (2) The purposes of the institution and the endowment fund; (3) General economic conditions; (4) The possible effect of inflation or deflation; (5) The expected total return from income and the appreciation of investments; (6) Other resources of the institution; and (7) The investment policy of the institution. (b) To limit the authority to appropriate for expenditure or accumulate under subsection (a) of this section, a gift instrument shall specifically state the limitation. (c) Terms in a gift instrument designating a gift as an endowment or a direction or authorization in the gift instrument to use only "income", "interest", "dividends" or "rents, issues or profits", or "to preserve the principal intact", or similar words: (1) Create an endowment fund of permanent duration unless other language in the gift instrument limits the duration or purpose of the fund; and (2) Do not otherwise limit the authority to appropriate for expenditure or accumulate under subsection (a) of this section.

19 FIRST REACTION TO UPMIFA Early 2008 Before effective date informal group of lawyers and CPA s met to discuss changes Included FASB representative and Attorney General Representative The big issues of concern at that time was how to deal with appreciation and inflation did boards have an obligation to add back to corpus (permanently restricted assets) to keep pace with inflation HDV was not on our minds Then the bottom fell out of the market and focus shifted to funds below their HDV (underwater funds), where it is today.

20 WHERE ARE WE TODAY? What is going on the legislature passes a statute saying HDV is gone. But state Attorneys General say it is not necessarily gone (some history here of the various s and correspondence). Legal basis of Attorneys General conclusion the old English Common Law principles (carried over the Atlantic) the Statute of Charitable Uses (and modern court cases) which state that the power to release or modify donor s restriction (a perpetuity ) is vested solely in the judiciary (the courts) Under the separation of powers doctrine of our constitution the argument is that the legislative branch does not (by legislation such as UPMIFA) have the power to trump a donor s perpetual restriction. If the Attorneys Generals are correct a spending policy that takes funds from perpetual endowments that are below HDV requires court approval (or a donor s release). 20

21 WHERE ARE WE TODAY? (Continued) What would a case before the court consist of, and what would a judge do? How long would it take? Is there personal liability to board members who approve spending below HDV? Would directors be protected from liability by the Volunteer Protection Statute and covered by D & O liability Insurance? What is the effect on loan, bond, and other covenants? AG opinion is still informal. Not a formal written opinion which has persuasive authority in Connecticut. What is a legal opinion anyway? Where is the Uniform Laws Commission on all of this? 21

22 WHAT DO AUDITORS DO: FAS 117-1? The evolution of FAS Permanency still exists: FAS still preserves a place for a permanent number (HDV?) on the balance sheet shall classify a portion of a donor restricted endowment fund of perpetual duration as permanently restricted net assets. The amount so-classified shall be the amount of the fund (a) that must be retained permanently in accordance with explicit donor restrictions, or (b) that in the absence of such stipulations, the organization s governing board determines must be retained (preserved) permanently consistent with the relevant law. 22

23 The belt is tightened even more because of new language in the statute: A not-for-profit organization shall classify the portion of the fund that is not classified as permanently restricted net assets as temporarily restricted net assets (time restricted) until appropriated for expenditure Additional disclosure required: (a) A description of the governing board s interpretation of the law (s) that underlies the organization s net asset classification of donorrestricted endowment funds. (b) A description of the organization s policy(ies) for the appropriation of endowment assets for expenditure (its endowment spending policy(ies)). (c) A description of the organization s investment policy(ies). The description shall include the organization s return objectives and risk parameters; how those objectives relate to the organization s endowment spending policy(ies); and the strategies employed for achieving those objectives.

24 (d) The composition of the organization s endowment by net asset class at the end of the period, in total and by type of endowment fund, showing donor-restricted endowment funds separately from board- designated endowment funds. (e) A reconciliation of the beginning and ending balance of the organization s endowment, in total and by net asset class, including, at a minimum, the following line items (as applicable): investment return, separated into investment income (for example, interest, dividends, rents) and net appreciation or depreciation of investments; contributions; amounts appropriated for expenditure; re-classifications; and other changes. (f) In accordance with the requirements of Statements 117 and 124,an organization also shall provide information about the net assets of its endowment funds, including: The nature and types of permanent restrictions or temporary (Paragraphs 14 and 15 of Statement 117). restrictions The aggregate amount of the deficiencies for all donor-restricted endowment funds for which the fair value of the assets at the reporting date is less than the level required by donor stipulations or law (Paragraph 15(d) of Statement 124).

25 CONCLUSIONS The bottom line is that there is no bottom line. Pragmatism and the absolute need to be prudent. Pressure on board members Our solution Reid and Riege Spring 2009 Newsletter Why didn t the Uniform Law Commission foresee this Pray for a surge in the Dow!!! 25