Legal Brief

You are the CEO of the Beneficent Area Community Foundation. On December 15, 1999, Mary Dotcom contributed $500,000 to the foundation to create a donor-advised fund endowed to continue after her death. The foundation's well-managed investments produced a small positive return in 2000, but the three-year slump in the stock market has caused net losses in both 2001 and 2002. Sadly, the Dotcom Fund is now worth only $440,000. Mary, as the advisor for the Dotcom Fund, just called you to recommend a $10,000 grant to a local charity that provides temporary shelter and counseling for homeless families. What do you do?

With the S&P 500 down by more than a third over the past three years, community foundations and other grantmakers face the troubling question of whether an obscure law known as the Uniform Management of Institutional Funds Act (UMIFA) limits their ability to make grants from endowed funds created when the stock market was flying high.

What is UMIFA?

First promulgated in 1972, UMIFA governs endowment spending by charitable corporations and by some charitable trusts. Although there are key differences from state to state, all states—except Alaska, Pennsylvania and South Dakota—have enacted some form of this law.

Does UMIFA apply to my foundation?

There's no easy answer to this question. As a general rule, UMIFA applies to nonprofit corporations, but not most charitable trusts. However, there are lots of variations among the states on this point. Four states apply UMIFA to community foundations that are charitable trusts. Two more states apply UMIFA to most charitable trusts. Three states exclude all private foundations. Two states apply UMIFA only to educational institutions. Check with local counsel if you aren't sure about your foundation's classification.

Why did the states adopt UMIFA?

UMIFA was a landmark law in many ways. Before UMIFA, charity managers often believed that they could not rely on outside experts for investment advice and that investments had to be limited to the safest possible vehicles—cash, government bonds and, perhaps, a few blue chip stocks. UMIFA not only freed charity managers to delegate investment decisions to outside managers, but also allowed them to invest assets for longterm growth, not just current yields. The law also gave managers the freedom to invest in accordance with strategies that balanced risk and return by allocating investment assets among various classes, usually with a tilt toward stocks. All of this was revolutionary at the time.

So how does that affect grants?

Because UMIFA lets charity managers invest for growth, not just income, UMIFA also allows them to take that growth into account in making spending decisions for endowed funds. As a result, many community foundations have adopted spending policies that typically let endowed fund advisors recommend grants up to a fixed percentage (e.g., 5 percent) of the fund's net asset value. Formulas like this worked fine as long as the stock market posted steady gains. They continue to work well for many older funds—those established before the late 1990s—because accumulated growth in those funds remains sufficient to offset recent losses.

Where does that leave newer funds?

It may sound obvious, but in order to be able to base spending on growth in a fund's asset value, the fund must have actually grown in value. Like the Dotcom Fund, many newer funds now have an asset value that is lower than it was on the date the fund was created (UMIFA calls this the fund's "historic dollar value"). Because an endowed fund that has fallen below its historic dollar value has no appreciation to expend, UMIFA greatly limits the ability to make grants from such a fund.

Does UMIFA affect all grants?

No. UMIFA is an issue only for grants from endowed funds.

How do I tell if my funds are endowed?

This is an important question that often requires review by local counsel. The answer will depend on an analysis of the gift agreement, the circumstances under which the gift was solicited (whether donors were told or led to expect that their gifts were for endowment) and the foundation's organizing documents. UMIFA's limitations do not apply if the fund is not endowed or if another law, the terms of the gift instrument or the foundation's charter allows the foundation's board to use a different spending rule.

Can an endowed fund that is below historic dollar value make any grants?

Before UMIFA, charities could expend the actual income they received from assets held in endowed funds. Most lawyers who have looked at this question have concluded that UMIFA did not displace this rule. In other words, community foundations may still use a fund's natural income—e.g., interest, dividends and royalties—to make grants, even if the fund is below historic dollar value.

Are there other options to continue grantmaking?

UMIFA allows donors to release any restrictions they imposed on funds as long as they do so in writing. Most lawyers who have looked at this issue believe that community foundations may offer donors the option of releasing the restriction that made the fund an endowed fund. In addition, because UMIFA lets a donor release a restriction "in part," as well as in whole, many lawyers think that a donor may release the endowment restriction for a particular period, such as a month or a quarter, while retaining the longterm character of the fund as endowed.

Why do I have to worry about UMIFA if my accountant says all my funds are unrestricted?

Many accountants classify all of a community foundation's funds as unrestricted, based on the community foundation's possession of the variance power. This is an accounting designation, however, and does not affect the legal status of these funds. If the donor imposed a valid endowment restriction at the time of the gift, that restriction is binding on the community foundation.

Who enforces UMIFA?

UMIFA is a state statute. Enforcement lies in the hands of the state attorney general as part of his or her general power to supervise charities. (Find your state attorney general at www.naag.org.)

Is UMIFA a problem for private foundations?

This is a complicated question that depends on several factors, including: whether the foundation is a trust or a corporation; whether the state version of UMIFA includes or excludes them; whether their assets constitute an endowed fund in the technical UMIFA sense; and the foundation's obligations under federal law. Private foundation staff who are concerned about UMIFA should consult counsel.

After you explained all of this to Mary Dotcom, she decided to release the endowment restriction on her fund for one year. Distributions from her fund will follow the foundation's spending policy, currently set at 4 percent of the fund's average balance over the last 12 quarters. Mary recognizes that continuing to draw down her fund creates some risk that her fund will not continue in perpetuity, yet she believes that the community foundation's investment and spending policies are prudent and that, in the long run, her fund will recover. Your board approves the grant request.

Where can I learn more about UMIFA?

UMIFA is a complex subject. To read a much more detailed analysis of these issues, Council on Foundations members may access http://www.cof.org/files/secure/index.cfm?FileID=6689. For more information about UMIFA in your state, contact local legal counsel.

Illustration: Otto Steininger.com