A few decades ago, endowments and foundations were rarely in the public spotlight for reasons other than their core mission. Now, they are in the glare — a harsh one, sometimes — of regulators, watchdogs, media and constituents.
Endowment and foundation fiduciaries will do well to bear in mind the “aura” that radiates from evolving applications of laws, creating an environment that requires greater uniformity and consistency in governance, oversight and operations than in the past. A phenomenon with far-reaching effects on endowment and foundation investment management and governance has become a little-noticed yet powerful force in boardrooms over the past decade.
Regulation of key aspects of governance and investment for these institutions has, in important ways, ceased to be a matter of unwritten common law and has become primarily a matter of codified statutory law. While interpretation by courts remains fundamental to the application of these laws, standards that previously varied from state to state around a set of core fiduciary principles are now being interpreted against much more uniform statutory requirements.
Just as important, the provisions of two important statutes — the Sarbanes-Oxley Act of 2002 and the Uniform Prudent Management of Institutional Funds Act, finalized in 2006 —increasingly are being applied to situations not directly contemplated in their text, creating an aura that extends beyond their original purpose.
Endowment and foundation trustees should be aware of these trends and their effect on the standards of behavior against which fiduciaries are measured.
Most of the standard laws that govern the endowment and foundation sector are the result of work undertaken over the last century by volunteer groups of attorneys aiming to provide clarity and a measure of uniformity to endowment and foundation governance and trust law. Their application has been more or less as intended, affecting the subjects for which they were drafted but without spilling over into other areas.
Sarbanes-Oxley at the federal level and UPMIFA at the state level, however, are different in that the effects of both have gone beyond their drafters' original scope.
The question of whether this process represents a positive or negative development for the sector as a whole is an important one whose answer depends, in large measure, on how the standardization implied by the process is viewed. While, on the one hand, a more uniform regime can doubtless make claims to efficiency and clarity, some may regret the passing of a world in which personal relations and subjective judgments were held in higher esteem.
These new issues are not only relevant to endowment and foundation fiduciaries. Investment managers, who have a fiduciary responsibility to asset owners, also will need to consider which aspects of these laws might apply to them. Sarbanes-Oxley's requirements regarding financial control and audit standards, for example, will doubtless exert influence on the operations of investment managers. As for UPMIFA, its lists of specific issues to be considered when investing, spending and delegating, its default assumption that a portfolio must be diversified unless its purposes are better served otherwise, and its implied requirement that the purchasing power of an endowment or foundation must be maintained over successive market cycles might well lead to a more specific set of discussions between clients and managers than has been the case in the past.
On how the fiduciary landscape is evolving, to take the example of Sarbanes-Oxley — enacted primarily to address governance issues at publicly listed for-profit corporations — only the prohibitions on retaliation against whistleblowers and on destruction of documents that could be used in an official investigation were intended to apply also to non-profit entities. Other sections, however, have now become essentially universal expectations in the endowment and foundation world, particularly the requirements that the institution have an independent audit committee and certified financial statements, even though Sarbanes-Oxley does not require endowments and foundations to have them.
More broadly, Sarbanes-Oxley set a new threshold for best practice in endowment and foundation governance as it became clear that there would be increased external focus on fiduciary responsibilities, board independence, conflicts of interest, bylaws and investment policies. In this sense, Sarbanes-Oxley effected change as much through its creation of a normative practice as through specific requirements.
To mention just one group of outcomes, the relationship between endowments and foundations and their auditors has changed, as have the independence and responsibilities of board audit committees. The close relationships that once existed between board members and the accounting firms that review and approve their financial statements and tax returns have become less personal. Many endowments and foundations have also adopted Sarbanes-Oxley-style ethics guidelines for their financial officers. Even the major credit-rating agencies have adjusted the way they monitor endowments and foundations. Several — including Standard & Poor's, Moody's and Fitch — now rate endowments and foundations in part on how well they follow Sarbanes-Oxley's prescriptions regarding internal controls, auditor independence and corporate governance.
The potential liability to which corporate directors became exposed as a result of Sarbanes-Oxley also has led to a change in the perception of the endowment and foundation fiduciary's role. While it was always assumed that board members would be involved in and informed about their organizations, the tighter audit, reporting, ethics and financial control standards set under Sarbanes-Oxley have meant an increased scrutiny of the fiduciary function, consistent with the implication that fiduciary responsibility and good governance are linked to organizational effectiveness and compliance with the law.
Sarbanes-Oxley has thus become, in many ways, a de facto default best practice standard for endowments and foundations. Indeed, after its passage, several state attorneys general were quick to propose that some of its elements be applied to endowments and foundations, and both California and New York subsequently enacted comprehensive statutes in the spirit of the Sarbanes-Oxley legislation.
As for UPMIFA, its effects have extended far beyond the specific wording of the act. While generally bestowing greater freedom on boards, UPMIFA also imposed new responsibilities in the form of specific lists of issues to be considered, debated, resolved and recorded in board minutes when investing and spending perpetual funds and delegating responsibilities to external agents or managers.
To take one example, in spending from an endowment that is subject to UPMIFA the fiduciaries must take into account the duration and preservation of the fund, the institution's and fund's purposes, economic conditions, expected inflation or deflation, expected total investment returns, other resources of the institution and the institution's investment policy. And while UPMIFA was designed to apply only to donor-restricted funds (other than those in trust form administered by a corporate trustee), its standards increasingly are being extended by inference to the governance and management of unrestricted and board-designated endowments.
Sarbanes-Oxley and UPMIFA are the most recent milestones in the formal codification of the rules and principles governing endowment and foundation organizations. Endowment and foundation fiduciaries will nevertheless be well advised to take steps to ensure their organizations are seen to be aware of, complying with and, indeed, embracing the new standards. n
William F. Jarvis is managing director and head of research at the Wilton, Conn.-based Commonfund Institute, which houses the education and research activities of Commonfund and promotes the advancement of investment knowledge and best practices in financial management.