Special Care for Special Dollars: Endowments and Restricted Funds

July 18, 2019

When donors place restrictions on the ability of 501(c)(3) organizations to use funds, directors must exercise care to meet their duties and responsibilities under state law.

With the exception of Pennsylvania, all states have adopted a version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). Accordingly, directors serving on boards of directors need to be familiar with the applicable state law for their tax-exempt organizations. In particular, directors have certain duties with regard to the management and investment of institutional funds, expenditures from endowment funds, and modification of donors’ restrictions on gifts received. Because compliance with UPMIFA is determined in light of the facts and circumstances existing at the time a decision is made or action is taken, directors need to be aware and proactive to meet their duties.

Overview of the Uniform Prudent Management of Institutional Funds Act

The standard-of-conduct rules for management and investment set forth in UPMIFA apply generally to “institutional funds.” Essentially, institutional funds under UPMIFA are the investment assets the institution holds. Additional rules under UPMIFA apply to endowment funds, which are institutional funds that, under the terms of the gift instruments, are not wholly expendable by the institution on a current basis. The key to the establishment of an endowment fund is the existence of a gift instrument that creates the restriction on how much is expendable. An endowment fund does not include assets that the institution, rather than a donor, has designated as an endowment fund for its own use, which is commonly referred to as board-restricted (or quasi-) endowment. Both institutional funds and endowment funds may be further restricted as to purpose or use by the terms of a gift instrument with a donor.

Standard of Conduct for Management and Investment Under UPMIFA

UPMIFA sets forth the standard of conduct that must be met in managing and investing institutional funds. Under this standard and subject to the intent of a donor as expressed in a gift instrument, an institution managing and investing an institutional fund must consider the charitable purposes of the institution and the purposes of the institutional fund. In addition to complying with the duty of loyalty owed to the institution, each person responsible for managing and investing an institutional fund is required to exercise ordinary business care and prudence when doing so.

Unless a gift instrument provides otherwise, the institution should consider the following factors, if relevant, in managing or investing an institutional fund:

  • General economic conditions
  • Possible effect of inflation or deflation
  • Any expected tax consequences
  • The role each investment or action plays within the overall investment portfolio of the fund
  • Expected return from income and appreciation of investments
  • Other resources of the institution
  • Needs of the institution and fund to make distributions and preserve capital
  • An asset’s special relationship or special value, if any, to the charitable purposes of the institution

Management and investment decisions about an individual asset should not be made in isolation but rather in the context of the institutional fund’s portfolio of investments as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the fund and to the institution. In general, there are no limitations on the types of property in which the institution may invest, but the institution must diversify the investments of an institutional fund unless the institution reasonably determines that, because of special circumstances, the purposes of the fund are better served without diversification.

In the case of contributions of property to the institution and within a reasonable time after receiving such property, the institution must make and carry out decisions concerning the retention or disposition of the property or to rebalance a portfolio, to bring the institutional fund into compliance with the purposes, terms and distribution requirements of the institution as necessary to meet other circumstances of the institution and these provisions of UPMIFA.

The comments under UPMIFA indicate that the standard-of-conduct rule “directs directors or others responsible for managing and investing the funds of an institution to act as a prudent investor would, using a portfolio approach in making investments and considering the risk and return objectives of the fund.” The comments specify that the section follows modern portfolio theory for investment decision-making and permits a broad range of investments.

The institution may incur costs in connection with the investment and management of an institutional fund as long as such costs are appropriate and reasonable in relation to the assets, the purposes of the institution and the skills available to the institution. The institution must make a reasonable effort to verify facts relevant to the management and investment of the fund.

If members of the institution’s board or investment committee have special skills or expertise, or were selected in reliance upon the person’s representation that the person has special skills or expertise, those persons have a duty to use those skills or that expertise in managing and investing institutional funds.

Expenditure of Endowment Funds.

UPMIFA sets forth the rules for appropriating for expenditure or accumulating endowment fund assets. Unless the gift instrument clearly provides otherwise, the institution may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines is prudent for the uses, benefits, purposes and duration for which the endowment fund is established.

In determining whether to expend or accumulate, the institution’s governing board must exercise ordinary business care and prudence under the facts and circumstances prevailing at the time of the action or decision. In addition, the institution’s governing board must consider, if relevant, the following factors:

  • Duration and preservation of the endowment fund
  • Purposes of the institution and endowment fund
  • General economic conditions
  • Possible effect of inflation or deflation
  • Expected return from income and appreciation of investments
  • Other resources of the institution
  • The institution’s investment policy

It is also important to understand the rules of construction that apply under UPMIFA’s expenditure rules. To limit the institution’s authority to appropriate funds for expenditure, the provisions of the gift instrument for the endowment fund must specifically state the limitation. UPMIFA interprets certain terms as creating an endowment fund and not otherwise limiting the ability of the institution to appropriate or accumulate. Terms in the gift instrument that designate the gift as an endowment or a direction to use only “income,” “interest,” “dividends,” “rents,” “issues” or “profits,” or “to preserve the principal intact” or similar instruction, will create an endowment fund of perpetual duration unless other language in the gift instrument limits the duration or purpose of the fund. Such terms and directions do not prevent the institution from expending as much of the income and principal of the fund as its board deems prudent under the factors listed above.

Release and Modification of Restrictions on Management, Investment or Purpose

UPMIFA also includes rules regarding when a restriction on the management, investment or purpose of a fund can be released or modified. Restrictions on a fund can be modified with the donor’s consent as long as the fund is still used for a charitable purpose of the institution. Other rules address occasions where the donor’s written consent cannot be obtained due to the donor’s death, disability or unavailability, or because the donor cannot be identified.

Under these rules generally, the court, upon application of the institution and with notification to the attorney general, may modify a restriction on management or investment of the fund if the restriction has become obsolete, inappropriate or impossible to achieve, or if it will further the purposes of the fund because of circumstances not anticipated by the donor. The court, upon application of the institution and with notification to the attorney general, may also modify the actual purpose of a fund or restriction on its use if the use has become unlawful, impracticable or impossible to achieve. Many states also provide rules for releasing restrictions on small funds without court approval, which usually involves seeking the approval of the attorney general of that state. Each state follows variations on these rules and procedures, so a close review of state law is necessary to determine the most cost-effective approach to obtain a release and modification of a restriction.