Prudent Investment Management by rak58497


									American Health Lawyers Association                                        Michael W. Peregrine, Esq.
2008 Tax Issues for Healthcare Organizations                             McDermott Will & Emery LLP
September 11-12, 2008
Washington, D.C.
                        “Prudent Investment Management”


        Health lawyers who advise their clients on corporate and governance matters will want to
brief the board and senior leadership on the implications of the new Uniform Prudent
Management of Institutional Funds Act (“UPMIFA”), which is being adopted by states across
the country. This is especially the case given the combined shock effect of the recessionary
securities markets, the implications of the Madoff and other investment scandals and, most
recently, the willingness of state charity officials to pursue enforcement actions against nonprofit
boards for alleged misuse of endowment funds.

        UPMIFA was adopted in 2006 by the National Conference of Commissioners on
Uniform State Laws (“NCCUSL”) and recommended for adoption by the legislatures of the
states. UPMIFA is intended to clarify previously existing standards for the investment and
expenditure of a broad array of charity endowment funds. In so doing, it strengthens traditional
concepts of prudent investing by charitable organizations, removes outdated investment
management concepts such as historic dollar value, provides specific guidelines for board
oversight of investments, and generally sets forth a more integrated system for effecting fund
management by charities. As such, UPMIFA is intended to replace the well known Uniform
Management of Institutional Funds Act (“UMIFA”), which had been approved by NCCUSL in
1972 and ultimately enacted in 47 states.


        UMIFA was intended to provide greater guidance and certainty to charitable
organizations for purposes of dealing with restricted funds and endowment funds. Specifically,
UMIFA applied modern portfolio investment theory to the context of investments by charitable
organizations (particularly those organized as not-for-profit corporations). Under UMIFA,
charitable organizations were specifically permitted to delegate investment authority to agents
and also were allowed to appropriate for expenditure both realized and unrealized appreciation of
invested assets, without regard to the traditional trust concepts of “income” and “principal.”
Under trust law, trustees and custodians of endowment funds often were permitted to expend
income, but not principal, having significant impact on the trustee’s investment strategy.
UMIFA moved away from the trust income and principal dichotomy for purposes of dealing with
distributions of funds, and replaced it with the concept of “total return.” This was accomplished
by focusing on “historic dollar value” as the “low water mark” above which a charitable
organization could expend realized and unrealized appreciation, whether in the form of interest
and dividends (traditionally “income”) or capital gain (traditionally attributed to “principal”).
UMIFA also allowed the governing board of a charitable organization to revise donor intent with
respect to contributed assets, provided the donor agreed.
        For decades UMIFA provided sufficient guidance to charitable organizations with respect
to investment and appropriation decisions. UPMIFA attempts to update UMIFA specifically by
modernizing rules related to expenditures from endowment funds so as to provide greater
flexibility to deal with changes in the marketplace. Given the recent downturn in the economy,
this flexibility may be especially welcome among investment committees and governing boards
of charitable organizations.


       UPMIFA’s provisions are applicable to funds established before or after June 30, 2009,
except that with respect to funds in existence prior to June 30, 2009, UPMIFA effects only
decisions made or actions taken on or after June 30, 2009.

        UPMIFA applies to “institutions” with respect to “institutional funds.” Essentially, any
charitable corporation, trust or other entity, including private foundation and other tax-exempt
charitable organizations described in Section 501(c)(3) if the Internal Revenue Code is an
“institution” within the meaning of UPMIFA. “Institutional fund” is defined as a fund held by
an institution for charitable purposes, and would include endowments and similarly restricted
funds that are restricted by the donor.

        UPMIFA addresses a broad variety of critical topics: investment standards/fiduciary
duties (Section 3); endowment spending rules (Section 4); delegation of investment authority
(Section 5); and the release and modification of gift restrictions (Section 6). These are all topics
of significance to the nonprofit board generally, and to the investment committee in particular--
and the corporate counsel is well positioned to advise on these matters.


        4.1     Core Concepts. UPMIFA reflects a noteworthy but basically noncontroversial
change from UMIFA as it relates to board obligations for investment management. In so doing it
is intended to provide clearer guidance to nonprofits and their boards on oversight of investment
practices. Subject to specific state law (e.g., UPMIFA or UMIFA), nonprofit board
responsibility for investment management is governed by the traditional duties of care and

        4.2      The UMIFA Prudence Standard. The old UMIFA standard spoke in terms of
“ordinary business care and prudence under the facts and circumstances prevailing at the time of
the action or decision.” This standard was reflective of a trend to hold nonprofit directors to a
standard “nominally similar to the corporate standard” but taking into consideration the fact that
the entity is a charity and not a business corporation.

        4.3     The UPMIFA Prudence Standard – Overview. UPMIFA modifies the UMIFA
standard by directing nonprofit boards to consider investment management decisions in relation
to the entirety of the nonprofit’s financial status and its charitable purposes. It is intended to
apply both to board members, and to officers and employees to whom the board has delegated
investment responsibility. It further requires that board members act “in good faith and with the
care an ordinarily prudent person in a like position would exercise under similar circumstances.”
This is intended by the UPMIFA drafters to be consistent with the business judgment rule as

applied in the context of a charitable organization. In doing so, UPMIFA draws directly from
nonprofit corporate law: the duty of care as articulated in the Revised Model Nonprofit
Corporation Act (“RMNCA”) Section 8.30 (a) (now, MNCA); and from the Uniform Prudent
Investor Act (“UPIA”), i.e., to act with the care of an ordinarily prudent person in a like position
under similar circumstances. Thus, charity managers subject to the business judgment rule
would look to the same factors as those identified by the prudent investor rule.

        4.4     Compare: The Corporate Law Standard. UPMIFA Sec. 3 mirrors the general
corporate law standard of care for directors in the exercise of their oversight and decision-
making roles. It tracks the RMNCA “duty of care” but provides additional guidance for those
responsible for managing and investing institutional funds by incorporating UPIA provisions.
The goal: UPMIFA clarifies that the common standards of prudent investing apply to all
charitable institutions. UPMIFA reflects perspective that “reasonable care, skill and caution” are
implicit in use of “care” in RMNCA. As to key definitions:

       •       “Good Faith” is a subjective requirement, involving a “facts and circumstances”
               analysis. This involves an evaluation of the board member’s state of mind; e.g.,
               honesty and faithfulness to duties or intent to take advantage of the corporation.

       •       “Ordinarily Prudent Person”: applies to board members who balance risk and
               reward, and act with common sense and informed judgment, in making decisions.
               It protects directors who take informed risks and recognizes directors are not
               “guarantors” of success.

       •       “In a Like Position”: recognizes that the “care” under consideration is that which
               would be used by the “person” if he/she were a director of the particular nonprofit

   This means that the charitable nature of the organization affects the decision-making of a
prudent person; i.e., that there is a distinction between goals, objectives and resources of for-
profits and nonprofits.

       •       “Under Similar Circumstances”: relates to the circumstances of the organization;
               the special background, qualifications and experience of the individual director
               and the role the director plays in the organization.

       •       “Reasonably Believe Appropriate”: references the basic range of options that a
               person exercising core fiduciary attributes (e.g., common sense, practical wisdom,
               and informed judgment) would exercise; not anything “removed from the range of

       •       In this sense, it involves both objective and subjective factors. Did the director
               believe the action was in the best interests of the corporation? Was it reasonable
               to do so? Taken together, the standard reflects an understanding that:

               •       The extent of responsibilities will vary;

               •      Decisions depend upon what is known at the time; and

               •      Any special director experience or skills may be relevant.

   Note: MNCA shifts to “person in a like position” standard; clarifying focus not on what a
particular director might believe appropriate, but what a person in a like position and acting
under similar circumstances would reasonably believe appropriate.

       4.5     The UPMIFA Standard: Specifics. UPMIFA expands upon the general corporate
standard/duty of care by incorporating several principles from UPIA intended to guide board
members as they make investment decisions:

               a.     Donor Intent and Charitable Purposes: Give primary consideration to
                      donor intent as expressed in a gift instrument. Also, consider the
                      charitable purposes of the organization and of the institutional fund in
                      making management and investment decisions.

               b.     Duty to Minimize Costs: In managing and investing an institutional fund:

                      (i)     “Reasonable Cost”: Incur costs that are appropriate and reasonable
                              in relation to the assets, the purpose of the institution and the skills
                              available to the institution; and

                      (ii)    “Duty to Investigate”: Make a reasonable effort to verify facts
                              relevant to the management and investment of the fund (i.e.,
                              investigate the accuracy of the information used in making

               c.     Pooling Funds: An institution may pool two or more institutional funds
                      for purposes of management and investment.

               d.     Prudent Decision-Making Factors: Board members and officers and
                      employees delegated investment responsibility must consider:

                      (i)     General economic conditions;

                      (ii)    Possible effects of inflation and deflation;

                      (iii)   The expected tax consequences, if any of particular decisions;

                      (iv)    The role each investment or course of action plays within the
                              fund’s overall investment portfolio;

                      (v)     The expected total return from income and the appreciation of

                      (vi)    Other resources of the institution;

                     (vii)   The needs of the institution and the fund to make distributions and
                             to preserve capital; and

                     (viii) An asset’s special relationship or special value, if any, to the
                            institution’s charitable purposes.

              e.     Portfolio Approach: Make decisions about each asset in the context of the
                     portfolio of investments, as part of an overall investment strategy.

              f.     Broad Investment Authority: May invest in any kind of property or type
                     of investment except as otherwise provided by law or the act (i.e., no
                     “legal lists” restricting fiduciary investing to specific types of investments
                     indentified by statute).

              g.     Duty to Diversify: Diversify assets unless due to special circumstances,
                     the purposes of the fund are better served without diversification. This
                     assumes that prudence requires diversification but allows variation in
                     exceptional circumstances:

                     •       Must reflect needs of charity and not solely benefit of donor.

                     •       Expectation of obtaining additional contributions from donor may
                             be a factor in certain circumstances.

              h.     Dispose of Unsuitable Assets: Imposes a duty to review the suitability of
                     retaining property contributed to the organization within a reasonable
                     period of time following receipt.

              i.     Special Skills or Expertise: Board/committee members with special skills
                     or expertise have a duty to apply those skills/expertise in
                     managing/investing institutional funds. Intent: a person managing or
                     investing institutional funds must use the person’s own judgment or
                     experience, including any particular skills or expertise, in carrying out the
                     management or investment duties.

                     •       E.g., comments on role lawyer/director: identify issues for board
                             but not provide free legal advice; not required to recognize “every
                             legal issue.”

        4.6     Note: Duty of Loyalty Also Applies. UPMIFA adopts the corporate law
(RMNCA) standard for the Duty of Loyalty: to act “in a manner the director reasonably believes
to be in the best interests of the corporation.” As to related duty of loyalty definitions:

       •      “Reasonably believes” is both subjective and objective.

       •      “Best interests …” offers wide latitude in deciding how to weigh near v. long-
              term opportunities and evaluating needs of constituents.

       •       Traditional Conflicts of Interest/Confidentiality/Appropriation concepts apply.

       •       RMNCA concept: “tolerable accommodation between the needs of nonprofit
               organizations and the potential abuses by directors or officers.”


        Unlike UMIFA, which relied upon the concept of historic dollar value, UPMIFA
eliminates this benchmark. UPMIFA replaces UMIFA’s somewhat mechanical concept of
historic dollar value with a general prudence standard to govern expenditures from, “institutional
funds,” such as endowments and restricted funds. Now, organizations are allowed to appropriate
for expenditure or accumulate so much of an endowment fund as the organization determines is
prudent for the uses, benefits, purposes and duration for which the endowment fund was
established. In making a determination as to whether to appropriate or accumulate, the
organization is subject to a good faith prudence standard and is required to consider certain
factors (which also are applied to investment decisions), including the following:

       •       The duration and preservation of the endowment fund.

       •       Purposes of both the organization and the endowment.

       •       General economic conditions.

       •       The possible effect of inflation or deflation.

       •       Expected total return and appreciation.

       •       Other resources.

       •       Investment policy.

       This prudent standard is more fact specific than UMIFA’s reliance on “historic dollar
value.” Moreover, prudent action can be established through evidence, such as written
investment policies, minutes of deliberations, evidence of review of financial information, and
other evidence of measured and thoughtful investment-making processes.


        UPMIFA specifically provides for the modification or release of a restriction placed by a
donor on a gift, provided the donor consents in a written instrument. In addition, UPMIFA
provides that a charitable organization may apply to a court to modify a restriction in a gift
instrument regarding the investment or management of funds if the restriction has become
impracticable, wasteful, counterproductive or, alternatively, a modification will further the
purposes of the fund in a manner not anticipated by the donor. In this case, the Attorney General
has standing to participate in the court hearing. In addition, an organization may seek court
modification of a particular charitable purpose or restriction on the use of an institutional fund, if

that purpose or use becomes unlawful, impracticable, impossible to achieve, or wasteful, in
which case, the court may modify the purpose of the fund or the restriction in a manner
consistent with the charitable purposes expressed in the gift instrument. Like modifications of
restrictions, the Attorney General has standing to participate in any such hearing. Finally,
UPMIFA provides that if an organization determines that a restriction contained in a gift
instrument related to the management, investment or purpose of an institutional fund is unlawful,
impracticable, impossible to achieve, or wasteful, the charitable organization acting on its own
may release or modify the restriction if the fund subject to the restriction has a total value of less
than $50,000, more than 20 years has elapsed since the fund was established, and the
organization uses the property in a manner consistent with the charitable purposes expressed in
the gift instrument. The Attorney General must have notice of any such proposed change.

       generally a positive development for nonprofit hospitals and health systems. Corporate
       counsel of such organizations domiciled in UPMIFA states may wish to recommend the
       following action plan to the investment committee:

               a.      Ensure Committee Diligence: Investment committees are expected to be
                       particularly diligent during the recessionary environment and its
                       aftermath. Such diligence can be manifested by:

                       •       Approaching investment advisors for guidance as to prudent
                               investment strategies in the turbulent (recovering?) market place
                               and for an explanation of past and current economic performance;

                       •       Understanding the ramifications for nonprofit organizations of
                               recent consolidations and reorganizations within the financial
                               services community.

               b.      Full Board Oversight: Full board oversight of, and regular interaction
                       with, the investment committee is crucial during periods of market turmoil
                       (and projected recovery). The board is ultimately responsible for
                       monitoring and understanding the impact of such turmoil/recovery on the
                       organization’s investment portfolio:

                       •       Form a working group composed of members from the board,
                               executive committee and investment committee to more closely
                               monitor the organization’s investment during the period of

               c.      Confirm Compliance: The investment committee should work with the
                       general counsel to confirm that board conduct and investment strategy
                       comply with applicable law (UPMIFA, UMIFA) and to consider the law’s
                       application to investment decisions in a recession.

d.   Committee, Staff Qualifications: The board should join with the
     nominating, governance and investment committees to review the
     qualifications and disinterest of existing committee members and staff,
     and the sufficiency of the selection and hiring processes.

e.   Promote Transparency: The investment committee and staff should be
     prepared to respond to an increase in questions on investment
     performance, as may arise from donors, governmental agencies, the media
     and the public. Consistency in response is important; responses should
     first be “vetted” by advisors and counsel.

f.   Dealing With Extraordinary Loss: If the nonprofit has suffered
     extraordinary investment losses, the board or investment committee may
     wish to recommend major steps to preserve remaining capital and to
     address inquiries from major donors and regulatory agencies; e.g.:

     •      Board inquiry into the performance of existing investment

     •      Whether asset allocation and board and committee procedures
            should be reformed to avoid additional losses.

g.   Dealing With Extraordinary Loss:       Note: Emphasize constant
     communication among the board, investment committee, finance
     committee, and officers about the effects of losses on other obligations
     (e.g., bond financing covenants and pension funding requirements).

h.   Anticipate AG Scrutiny: It is reasonable to expect increased AG interest
     in the investment performance of nonprofits during the current market
     turmoil. Particular scrutiny may be prompted by: disclosures of
     extraordinary losses; exceptionally aggressive investment decisions; lack
     of board oversight of the committee and of investment advisors.

i.   IRS Interest: Investment committees should recognize the relationship
     between investment management practices and preservation of federal tax
     exempt status. The IRS has expressed interest from a compliance
     perspective in:

     •      Investments in “complicated or sophisticated” financial products
            that require financial expertise for oversight;

     •      Written policies and procedures governing such investments; and

     •      Terms of compensation arrangements with investment advisors.

j.   Review current investment strategies and terms of relationships with
     investment advisers with respect to fees and delegation of authority.

               k.      Review terms of endowment funds and restricted funds to determine if
                       there are opportunities to modify the terms of the funds.

               l.      Review endowment fund appropriation policies and decision-making.


1.     National Conference of Commissioners on Uniform State Laws, “Uniform Prudent

Management of Institutional Funds Act” (2006) (with prefatory notes and comments).

2.     American Bar Association, “Model Nonprofit Corporation Act, As Amended” (2008)

(with comment).

3.     American Bar Association, “Revised Model Nonprofit Corporation Act,” (1987) (Hone,


4.     W. Marshall Sanders, “The Uniform Prudent Management of Institutional Funds Act,”

Taxation of Exempts (May/June 2008).

5.     Susan N. Gary, “Charities, Endowments and Donor Intent: The Uniform Prudent

Management of Institutional Funds Act,” Law 41 Ga. L. Rev. 1277.

The author wishes to acknowledge the contributions of his partner, Neil Kawashima, to the

preparation of this article.


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