Conflicts of Interest: Dealing with Foundation Investments
This article focuses on conflicts of interest around foundation investments. May foundation board members (or other closely affiliated individuals or businesses) manage foundation investments? May they be paid for this service? What factors should foundation managers consider before they select an investment manager who has a close relationship with the foundation? When is it a bad idea? What special procedures should be followed when a board member or other close affiliate is also an investment manager.
It is often tempting to look close to home for foundation investment expertise. Family foundations may wish to retain children of the charity's founders to manage the foundation's portfolio. Foundations sponsored by corporations, especially financial institutions, may consider putting their assets under the watchful eyes of corporate investment managers. Community foundations that work with local investment advisors may seek to tap the money management abilities of board members who are professional investors. While federal law is fairly permissive in that area, it is not always wise to mix investment management with those close relationships.
The Tax Code generally allows both public charities and private foundations to retain and compensate individuals and businesses with close connections to the charity that manages the charity's investments. If the entity is a private foundation and the investment manager is a "disqualified person,” the label the Tax Code uses to describe major donors to the foundation, foundation directors, family members of both of those groups and businesses in which they are large stakeholders, the private foundation must avoid committing an act of selfdealing. To comply with the rules, the manager may be compensated only for personal services that are reasonable and necessary to the foundation's work, and the compensation may not be excessive.
Investment management services are expressly included in the definition of personal services in the Internal Revenue Service's (IRS) private foundation regulations. An example in the regulations discusses a private foundation manager who owns an investment counseling business and provides investment management services, for a fee that is not excessive, to the foundation. Under the relevant rules, the example concludes, the arrangement does not constitute an act of self-dealing.
Assuming the investment manager's services are necessary, what's a rate of compensation that's not excessive? The IRS's position is that the amount similarly situated people are paid for similar work will be considered reasonable compensation. If the investment manager customarily bills clients similar to the foundation
at the rates it proposes to charge the foundation, this may serve as evidence of the reasonableness of the rates. Ideally, a foundation would periodically compare the rates it pays with other similarly sized foundations or bid out its investment management work.
If the grantmaker is a public charity, such as a community foundation, the relevant legal rules on compensation for an investment manager with close ties to the foundation come from the Tax Code's intermediate sanctions provisions. For more information on intermediate sanctions, see Intermediate Sanctions Checklist.
Intermediate sanctions rules penalize excess benefit transactions, in which charity insiders (such as directors) receive more value from an organization than they have provided to it. Charities must pay no more than fair market value for services provided by insiders. They may establish a rebuttable presumption that the investment manager's compensation meets this standard by having an independent committee consider data on comparative rates and approve the compensation, being sure to fully document this determination. Ideally, community foundations would periodically put their investment management work out for competitive bids.
Community foundations face an additional requirement in connection with investment management. Compliance with Treasury Regulations requires that they establish a target standard for investment performance and that they retain the right to fire investment managers who do not meet these goals.
In all cases, an investment manager who is also a board member should not participate in decisions relating to the retention or compensation of his or her investment firm. The manager may participate briefly in the discussion leading up to the vote in order to answer any factual questions, but should then leave the room to allow the remaining board members to discuss and decide the issue. The investment manager should refrain from participating in board discussions of investment performance and should not be named to the investment committee if the board has one. The foundation should avoid having its investments managed and evaluated by the same individuals or firm.
Like any other foundation fiduciary, investment managers should disclose other potential conflicts of interest. For example, where a grantee requests an endowment grant and the foundation's investment manager/board member has a contract to manage the grantee's funds, this tie should be disclosed.
Beyond the Law
Just because the Tax Code allows an action doesn't necessarily make it a good idea. Before selecting a disqualified person to manage a foundation's portfolio, foundation managers should consider not only legal but also ethical and other factors.
Having an investment manager with close ties to the foundation does present ethical challenges. Will foundation managers feel comfortable firing an investment manager whose performance is not satisfactory? Will they delay terminating a relationship, to the detriment of the foundation's finances, because of the investment manager's other work on behalf of the foundation or because of his or her relationship with other foundation managers? No one wants to be the private foundation CFO who has to tell a major donor that his child's investment performance is terrible. Similarly, if a community foundation's investment manager is a also a big fundraiser for the organization, how likely is it that foundation executives will immediately pull the foundation's assets from her company when she fails to meet benchmarks?
Other conflicts can arise when foundation investment managers are also family members of a donor or hold positions in the donor's business. Loyalty to family or the family business could lead the investment managers to retain a foundation's large stake in an enterprise when a more objective investor might diversify.
Finally, a foundation should consider the public relations aspect of hiring a closely affiliated individual or firm as an investment manager. If the foundation's assets decline in value, it will be tempting for reporters and other commentators to assume that it was the investment manager's personal or other ties that earned her the privilege of mismanaging the charity's funds. Even when assets increase in value, reporters and others may try to argue that foundation insiders received excessive compensation for their work.
Despite those concerns, many foundations will still choose to select investment managers with close ties to the foundation. To ensure that those relationships are legal, ethical and publicly defensible, foundation managers should document:
- The selection process by which the manager is picked
- The professional skills and achievements on which the selection of the investment manager is based
- The benchmarks used to set the manager's compensation
- The performance standards used to evaluate the manager's work
- The contract or other agreement under which the manager can be fired, and
- The procedures, including policies and disclosure forms, that the foundation has adopted to avoid conflicts of interest.
When a foundation's assets increase, the foundation's ability to effect positive change also increases. Good investment management can help this happen. But foundations need to ensure that the deals they make with money managers are wise investments as well.