Investments

Q1: When should a foundation's board seek expert advice regarding investment decisions and payout policies?

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This is part of "What Every Grantmaker Should Know & Frequently Asked Legal Questions."

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The governing board of a foundation has a legal obligation to manage the assets and income of the foundation prudently. If a foundation is not a "pass-through" foundation but instead holds assets that it invests to produce income for grantmaking or operational purposes, the board members have a fiduciary obligation to establish and monitor prudent investment policies and oversight functions. The board can rely either on internal board or staff expertise, or it can obtain outside expert advice, depending on the foundation's size, complexity and internal resources. A board member is entitled to rely upon information, opinions and reports from staff, board committees, and outside professionals and experts the board member reasonably believes to be reliable and competent.

Q2: What is the legal standard by which a foundation's investment decisions are judged?

In general, the board members of a foundation must perform their duties, including their investment duties, with the care an ordinarily prudent person in a similar position would exercise under similar circumstances. Various laws governing the investment of charitable assets — including the Uniform Prudent Management of Institutional Funds Act (UPMIFA), the Uniform Prudent Investor Act (UPIA) and the Third Restatement of Trusts — all embrace the concept of modern portfolio theory. Under modern portfolio theory, prudent investment policy is based on diversification of assets, long-term performance benchmarks and the importance of a portfolio's total return on investment.

Q3: What special rules apply to investments by a private foundation?

In addition to state corporate or trust law, and UPMIFA or UPIA, private foundation investments are also subject to federal tax law regulations.

Federal tax law provides that certain risky investments or investment strategies may constitute "jeopardizing investments" that subject the foundation to private foundation excise taxes. The "prudent trustee" standard under federal tax law emphasizes the need to consider the current and future needs of the foundation, investment risks and the importance of diversification. The regulations also list several categories of investments that will be subject to "close scrutiny" by the IRS, including trading in securities on margin; trading in commodities futures; investments in working interests in oil and gas wells; purchase of puts, calls and straddles; warrants; selling short; junk bonds; risk arbitrage; hedge funds; derivatives; distressed real estate; and international equities in developing countries.

Private foundations are also subject to "excess business holdings" rules that limit the percentage interest a foundation, together with all its "disqualified persons" (see Private Foundation Self-Dealing Q2), holds in a given business enterprise.

Q4: What special rules apply to donor-advised fund investments?

Donor-advised funds are subject to the same rules that apply to private foundations (see Endowment Funds Q8).

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See also What Every Grantmaker Should Know: Investments.