Abstract
This article compares three recently completed or ongoing U.S. nonprofit law reform projects drafted by three different models of nonprofit institutions: the American Law Institute, the American Bar Association, and the Uniform Law Commission. These projects are not themselves law; rather, success depends on enactment by state legislatures or application by practicing attorneys, regulators, and judges. Moreover, this entrepreneurial and sometimes competitive model of law reform means that a true unified “charities law” in statutory form is unlikely to emerge in the United States. Finally, future law reform might focus less on nonprofit organizational form and more on subsectors or activities in which certain nonprofits (and perhaps also government and businesses) operate.
Introduction
Reflecting a recognition of nonprofit law as a distinct field worthy of clarity and consistency, the last decade has brought an astonishing array of projects to reform the U.S. legal treatment of charities and other nonprofit organizations. Perhaps surprising to those who think “Internal Revenue Code” when they hear “nonprofit law,” most of this activity has occurred at the state level (for federal developments, see Barber, 2007). After all, the states provide the various organizational laws of charitable trusts, nonprofit corporations, and unincorporated nonprofit associations, as well as the law of charitable gifts. While a substantive review of recent legal reforms might be useful, institutionalists might find more interesting a study of the central role of private bodies in the process of developing (or, at least, proposing) U.S. nonprofit law. 1
Table 1 arrays the most significant recent reforms along a continuum ranging from new legislation (state and federal) to “peer regulation” of nonprofit governance. (Some projects are directed to charities only, although others sweep up charities only as part of broader initiatives. Beyond the scope of this article are industry- or profession-specific regulations.) Between these poles, we find administrative efforts to improve nonprofit governance, the most legally important government agencies being the state attorneys general and the Internal Revenue Service. The Independent Sector’s Panel on the Nonprofit Sector (2005) helpfully grouped their recommendations on federal tax requirements and good nonprofit governance by whether implementation required action by Congress (i.e., legislation), by the Internal Revenue Service (i.e., administrative guidance), or by charitable organizations themselves (i.e., voluntary adoption).
Highlights of Recent Legal Developments
Note. Current through March 26, 2012.
Table 1 also indicates, when applicable, which private bodies drafted which law reforms. 2 State-law projects designed for widespread use usually originate in one of three groups, or collaborations among them. These national bar association and other nonprofit organizations are so venerable that they have effectively carved out unchallenged turf. Thus, templates for consistency in state statutes come from the Uniform Law Commission (ULC), a body created and funded by the states, and from the Business Law Section of the American Bar Association (ABA), a voluntary professional association. With respect to organizational statutes, the ULC traditionally develops legislation relating to trusts and other unincorporated associations, whereas the ABA Business Law Section produces the various versions of the Model Business Corporation Act and the Model Nonprofit Corporation Act. The American Law Institute (ALI), an elected-membership organization, has long published “restatements” of the common law. More recently, on certain topics the ALI has been synthesizing judicial decisions, statutes, and perceived needed reforms into “principles of the law” to guide legal practitioners, regulators, and judges. Jenkins (2007) attributes the influence of these three groups in developing nonprofit law to the lack of expertise and staffing in most state attorneys general offices (pp. 1130-1131). He also found that “the current level of attention recently paid to nonprofit organizations is unprecedented,” revealing “a broad level of interest in charity governance” (p. 1135).
Regrettably, as private reformers proceed simultaneously, little coordination has occurred across projects. (At the same time, several of the players have participated in multiple projects. 3 ) Moreover, few people outside the drafting bodies are aware of these projects, much less following developments closely. No doubt this explains why not all goes smoothly in the laissez-faire market of U.S. law reform: As Table 1 shows, many statutory projects fall on fallow legislative soil. Although a self-appointed group can work more efficiently, lack of buy-in from affected persons can stymie enactment; worse, an uninformed project risks providing the wrong answers—or even addressing the wrong questions. Moreover, the credibility of a project can depend on whether the participants have “checked their clients’ (and other) interests at the door.” 4 Even some “unsuccessful” projects, though, can be useful: Given the lack of judicial precedents and statutory clarity, most attorneys, enforcers, and judges welcome guidance in any persuasive form, and discussion of reform projects at bar association meetings and regulatory conferences, and in academic publications, can have outsized influence.
The three case studies in this article examine one project produced by each of the three major groups to illustrate that there is no best way to privately initiate law reform. We begin with the ALI’s project—for which I am the reporter—to set forth Principles of the Law of Nonprofit Organizations. While such a survey project can bridge the different threads of current U.S. law, it acknowledges that some reforms can be assured only through the enactment of legislation. Next, we consider the Model Nonprofit Corporation Act, Third Edition (2008) and the limits of starting from a business-corporation statute. Finally, other forces can work at cross-purposes to legal reform, as illustrated by confusion over the accounting treatment of endowment funds pre- and postenactment of the Uniform Prudent Management of Institutional Funds Act (UPMIFA; 2006).
The ALI’s Nonprofit Principles Project
Development of ALI Projects
The ALI, a nonprofit formed in 1923 by a group of leading judges, practicing lawyers, and legal academics, functions as an organization of elected members. The ALI
is the leading independent organization in the United States producing scholarly work to clarify, modernize, and otherwise improve the law. The Institute (made up of 4000 lawyers, judges, and law professors of the highest qualifications) drafts, discusses, revises, and publishes Restatements of the Law, model statutes, and principles of law that are enormously influential in the courts and legislatures, as well as in legal scholarship and education. (See www.ali.org.) The ALI gauges success of its nonstatutory projects, in part, by tracking citations in judicial opinions and academic publications.
The ALI’s website describes how a project begins with approval by the Council, the ALI’s governing body. One or more legal experts (usually an academic) is appointed reporter. The reporter researches and produces successive versions of the material, in digestible bites. First comes the Preliminary Draft, for discussion by a small group of designated advisers and by ALI members who join a consultative group. Next, the reporter revises the material into a Council Draft, for presentation to and consideration by the Council. Following the Council approval, the reporter presents a Tentative Draft at the annual membership meeting for discussion and debate. If necessary, at any stage, this process repeats. While approved Tentative Drafts, which appear in the LEXIS and Westlaw databases, can be cited as the voice of the ALI, official publication requires one last round of revision, if necessary, and approvals by the Council and the membership.
A restatement or principles project looks like a treatise, many hundreds of pages long. Each proposition appears as a (hopefully brief) “black letter” statement of what the law is—or, occasionally (and after much debate), what the law should be. Next comes commentary, with illustrations (often the most useful part of the project). Appended to each section are reporter’s notes, representing the reporter’s views only. The two-decades-long Restatement (Third) of Trusts (completed in 2011) and the decade-long Principles of the Law of Corporate Governance (completed in 1992) serve as two—sometimes difficult to reconcile—models for the Principles of the Law of Nonprofit Organizations.
The Nonprofit Principles project began in 2000 with the intellectual encouragement of and financial support from Atlantic Philanthropies. Each stage of development presents challenges as well as opportunities. The project is blessed with an unusually large group of advisers (about 25), because of the cross-cutting nature of the material. In addition to an economist and a charity executive (who are not lawyers), we have experts in constitutional, trust, property, corporate, and tax law, as well as judges and in-house counsel. More than 200 ALI members have signed up for the consultative group, although the core group participating in meetings and sending in suggestions is much smaller. (Separately, I try to reach out to as many professional associations, practicing and academic lawyers, and nonprofit groups as I can—like the Ancient Mariner, I “stoppeth one in three”—to describe the project and ask for help on particular issues.) In theory, as a reporter, I am free to draft language that I believe best reflects law and policy; however, I must still persuade the Council and the membership to adopt my positions. Moreover, floor amendments are binding upon affirmative vote of the membership. When I find myself pushed back from a policy I favor, I remind myself that, after all, I am writing only principles, and the commentary setting out the debate can be more important than the black letter.
This extensive feedback from within the ALI obviously improves the end product, but the “institute’s work requires patience and is sometimes excruciatingly slow” (Liebman, 2008, p. 220). When I have prepared more material than the assembled group can complete, the remaining portion is held over until that group’s next meeting, no earlier than a year hence. In the meantime, I revise the material not yet considered or I push ahead and start a new chapter (or both). After 10 years of preliminary work and drafting, the Nonprofit Principles project is over half-finished. So far, nearly three of five contemplated chapters have received tentative approval from both the ALI Council and the membership: These are the chapters on governance (ALI, 2007 & 2008), gifts (ALI, 2009b), and enforcement (ALI, 2011, the first 7 of 10 sections receiving approval). The first chapter, on the relationship between charities and the state, has been drafted and discussed by Council, but not voted on. The final chapter will address organizational issues, including use of membership (individual or institutional) and “life events” (extraordinary transactions and structural change). If Council decides to confine the project to charitable nonprofits, the name of the project might change to Principles of the Law of Charities.
Issues Faced by the ALI Nonprofit Principles Project
The initial—and continuing—challenge is defining the project’s scope and organization. Moreover, while I expected to find missing links as I set out the legal landscape, I’ve been surprised by the numerous legal lacunae. Mindful that some questions have not been answered because they are unimportant, my guiding mantra is practicality: “What is the problem for which this principle is the solution?” In addition, the draft includes more educational material than is typical for the ALI, because few lawyers and judges specialize in charities—and not every problem requires a “legal” solution. Hopefully, the project will also provide guidance to nonprofit board members, executives, state regulators, and the Internal Revenue Service.
Throughout, the project draws on the best principles from the distinct threads of charitable trust and nonprofit corporate organizational law. (Unincorporated nonprofit associations, despite their numbers, are subject to relatively primitive law; a nonprofit that reaches a significant size or level of property ownership typically incorporates.) Among the most important potential differences between trusts and corporations are (a) fiduciary standards and consequences for breach of duties; (b) control by the trust settlor and the donor of a restricted gift, versus decisional autonomy for the governing board; and (c) state (and federal) supervisory regimes. Fortunately, trust and corporate law have largely been conforming in these areas, albeit with three distinct results. In general, for governance issues, the corporate duties of loyalty and care apply to both trustees of charitable trusts and to nonprofit corporate board members. By contrast, trust law—including the venerable trust doctrines of equitable deviation and cy pres—usually applies as well to recognizing and modifying restrictions on gifts made to corporate charities. Finally, the enforcement powers of state attorneys general (and the Internal Revenue Service) typically are the same regardless of a charity’s organizational form.
Nevertheless, with little precedent to go by, it can be hard to state precisely what “the law” is. Even in focusing on nonprofit corporate law—given that the overwhelming percentage of U.S. nonprofits take this form—I have encountered and struggled with many issues that have no clear or good answers. For example, as explored in Brody (2007a, pp. 523-524), we find several key gaps between corporate law and practice, including the following:
Duty of loyalty to whom? Corporate law provides that fiduciary duties are owed to “the corporation.” A hard enough concept for business corporations, what does it mean in a world without shareholders? Reflecting debate by the project’s advisory groups, the ALI principle obligates each governing board member “to act in a manner that he or she reasonably believes to be in the best interests of the charity, in light of its stated purposes.” Commentary under ALI (2007) § 310(a) explains that this formulation “combines the trust and corporate language to declare an affirmative obligation of the fiduciaries to govern for charitable purposes, and not for the benefit of board members, executives, donors, or other private parties.”
Role of charity members: Commentary to § 8.30 of the Model Nonprofit Corporation Act, Third Edition states, “The term ‘corporation’ is a surrogate for the enterprise as well as a frame of reference encompassing the body of members.” Indeed, most nonprofit corporation statutes simply substitute the word “members” for “shareholders” in sections dealing with elections of board members and providing an additional check on the board (usually for approving extraordinary transactions). However, the Model Act does not require a nonprofit corporation to have voting members, and, in contrast to mutual-benefit nonprofit organizations, most U.S. charities lack members in this sense. Should the law worry about charities with self-perpetuating boards, or membership charities whose members are not really the right people (or the only people) who should have say-so over fiduciary behavior or major transactions? (See Brakman Reiser 2006.) The ALI project is currently drafting principles on membership organizations. See further discussion below, in the context of the Model Act.
Board responsibilities: Nonprofit corporate statutes declare that the corporation is “managed by or under the direction of” the board of directors, but—probably wisely—do not say much about how the board functions (or the functions of officers, or the relationship between the board and management). To provide guidance, § 320(b) of ALI (2007) lists the typical board’s functions (subject to law and the organizational documents), including, monitoring implementation of the charity’s purposes and bylaws (and modifying them as necessary and appropriate); constituting the board and hiring the chief executive, and monitoring performance; adopting the budget, setting investment and spending policies, seeking appropriate resources, and exercising oversight; overseeing appropriate communication with the charity’s constituencies and the public; and overseeing the establishment of appropriate procedures for internal controls, including financial controls, legal compliance, and information flow to the board.
Individual monetary liability? Corporate law empowers the board to act only as a group, yet imposes sanctions for breach of fiduciary duties on board members only as individuals. Moreover, corporate law holds each board member responsible for governance, even though in practice they bring a variety of attributes that benefit the organization. Should the law specially handle “Mr. Checkbook” and others who want to be on the board but who do not want to participate in governance? ALI (2007) takes the position, essentially, that “if you’re on the board, you’re on the hook,” while encouraging greater use of advisory board or committee positions, when appropriate. (Compare the discussion below of the “designated body” in the Model Nonprofit Corporation Act, Third Edition.) Of course, the burden generally falls on the plaintiff to prove who caused harm to the organization and to quantify that harm, so the risk is slight that a board member will suffer personal monetary liability in the absence of self-dealing—but nonmonetary sanctions, including board training, could be appropriate for breach of the duty of care. See further discussion of sanctions in the context of the Model Act, below.
Who can and must enforce fiduciary duties? In matters of breach of duty by charity fiduciaries, the attorney general can sue the wrongdoer (as indeed can the charity itself). ALI (2009b) § 660 not only adopts the corporate law’s grant of standing to a board member to bring a derivative suit on behalf of the charity, but also invokes the trust-law obligation of a trustee to prevent breach by a cotrustee. If the charity has members, the project provides that a derivative suit may be brought by enough members (or others) having a meaningful role in governance (compare the Model Act’s requirement for a minimum number or percentage of members). Still being debated is whether to recognize other private parties as having standing under the rubric of persons with a “special interest” (a trust-law concept directed at enforcing charitable purpose).
Needed Legislation
The Nonprofit Principles project identifies those issues that can be thoroughly addressed only through legislation. Notably, the gift chapter (ALI, 2009b) addresses the “dead hand” problem raised by the centuries-old exception from the Rule Against Perpetuities for charitable trusts and restrictions on a charitable gift. Section 440 suggests,
In general, after the passage of a significant period of time following the creation of a charitable trust or gift instrument, the policy of adhering to the terms in the trust or gift instrument increasingly weakens, regardless of whether those terms relate to particular charitable purposes, means of administration or other secondary terms, or procedural rights granted to the settlor or donor (or other private party).
While acknowledging the lack of explicit common law precedent for this proposition, the commentary observes that “some courts have adopted, or have seemed to follow, a variety of rationales for taking the passage of time into account.” Identifying social and economic policy grounds, the comment observes that the more time that passes, the more likely: (a) will the benefactor’s scheme have lost its relevance; (b) will public benefits arise that the benefactor could not have anticipated; (c) will the benefactor have “recovered” most if not all of the restriction’s present value; and (d) will it be that the donor (or, for an institutional donor, that the original decision maker) has died.
Legislation would also be needed to thoroughly address the issue, discussed above, of private standing to enforce fiduciary duties. Too-wide open a door to the courthouse risks wasting charitable resources and improper influence by (or benefits to) the plaintiff, particularly in a settlement. Corporate law protects nonprofit corporations from improper derivative suits; trust law could helpfully embrace similar protections (see ALI, 2011). Separately, for gift-enforcement issues, the ALI’s recent modernization of the Trust Restatement (2009a) generally recognizes settlor standing to enforce a gift restriction, but (except in rare cases) denies standing to other private parties unless specified in the instrument. Should the result be the same for donors of restricted gifts to corporate charities? The final portion of ALI, 2011 (which the ALI has not yet considered) is being revised; as drafted, it requires judicial oversight of whether the suit is in the best interests of the intended charitable beneficiaries. Statutory guidance could clarify parameters such as whether the court should require the disputed amount to be “material.”
The ABA Model Nonprofit Corporation Act, Third Edition (2008)
The Model Act Through Three Versions
All 50 states and the District of Columbia have enacted legislation enabling the creation of nonprofit corporations. Most of the states base their statutes on either the Model Nonprofit Corporation Act (1957) or the Revised Model Nonprofit Corporation Act (1987); the Revised MNCA has been enacted in almost half the states, in whole or in slightly modified form (see Fremont-Smith, 2004). 5 These model acts are drafted by a task force of the Business Law Section of the ABA to serve as a template for state legislatures. Standardization among the states has obvious advantages, especially for those corporations that operate across state lines. A common legislative framework also allows a judge in one state seeking interpretative guidance to look to case law from other jurisdictions. As a result, the common law—particularly with respect to fiduciary duties—tends towards isomorphism.
Reflecting on the original Model Nonprofit Corporation Act, Hansmann (1988-1989) charged that the drafters “simply took the Model Business Corporation Act and deleted from it all provisions that seemed inappropriate for nonprofits, such as those dealing with the issuance of stock. The result was a rather empty enactment” (p. 814). The reporter of the Revised MNCA (1987) was the drafter of the then-recently completed California Nonprofit Corporation Code. He spread the blame:
[Earlier] nonprofit laws are the poor stepchild of the state business statutes. Legislators have paid little attention to the structure, activities, needs, and role of nonprofit corporations. Scholars, too, have devoted relatively little time and effort to the study and analysis of nonprofit statutes. The body of statutory and case law applicable to nonprofit corporations remains sparse and undeveloped. (Hone, 1988-1989, p. 759)
Hone (1988-1989) wrote that he provided over a thousand copies of an exposure draft “to nonprofit organizations, the Internal Revenue Service, academics, accountants, and others for their comments. The input received from nonprofit organizations was crucial in shaping the law” (p. 760).
The Model Nonprofit Corporation Act, Third Edition (2008) is the product of a 13-person Task Force, under the direction of a law professor (as chair) and a private practitioner (as reporter). In closing its drafting sessions to other members of the Nonprofit Organizations Committee, the Task Force cited the prior process: The 1987 Revised MNCA was adopted only by the Subcommittee on the Model Nonprofit Corporation Law of the ABA Business Law Section. The Task Force issued an exposure draft for public comment in 2006. In February 2008, the Task Force posted the MNCA Third for “roll out” at the Business Law Section’s upcoming April meeting; however, following requests, the Nonprofit Organizations Committee briefly postponed adoption to allow for final comments. 6
In August 2008, that committee adopted the MNCA Third in a form that did not vary in substance from the February 2008 draft. Like its predecessor, the MNCA Third was not approved by the Business Law Section (nor vetted by either the ABA Tax Section or the ABA Real Property, Trust and Estate Law Section). Nevertheless, these model acts are widely identified with the ABA as a whole, and legislatures and practicing lawyers likely view the MCNA Third as carrying the ABA imprimatur. As of March 2012, the MNCA Third has been enacted in the District of Columbia, and is under consideration in Vermont and Iowa.
Going forward, the Nonprofit Organizations Committee has established a subcommittee, open to all Business Law Section members, to take into account comments and developments in a process of ongoing revision of the MNCA Third. A major re-examination is not planned, though. A useful undertaking would be to revise the official comments, which are drawn largely from analogous comments to the Model Business Corporation Act 7 and do not reflect or criticize the growing body of state appellate and Supreme Court cases involving nonprofit corporations. Note that, as a corporation statute, the MNCA Third does not address charitable trusts or trust-law principles, and so does not attempt to serve as a comprehensive U.S. Charities Act. 8
Substantive Critiques of the Model Nonprofit Corporation Act
Since the 1987 publication of the Revised MNCA, the nonprofit sector has exploded—as have the level and number of sophisticated legal issues needing to be addressed. The MNCA Third, however, has a narrower focus (see also Moody, 2007b). First, the drafters endeavored to “follow the Model Business Corporation Act provisions to the extent possible, considering certain differences that distinguish nonprofit corporations from for profit corporations” (ABA, 2008, Introduction). Second, most strikingly, the MNCA Third eliminates the Revised MNCA’s tripartite classification of public benefit corporations, mutual benefit corporations, and religious corporations. Third, the MNCA Third makes the provisions pertaining to the role of the attorney general optional, suggesting that legislatures might better locate these provisions in the portion of their state code addressing attorney general powers or the supervision of all types of charitable entities. Fourth, the MNCA Third streamlines nonprofit corporations’ ability to engage in fundamental transactions, adopting transformations available under the business-corporation act (adding a new one—“membership exchanges”—for nonprofit corporations other than charities).
Finally, the project’s Introduction explains, in expanding the availability of “alternative governance arrangements” the MNCA Third authorizes the use of a “designated body”—a concept so unusual that the Task Force’s chair expressed reservations about it. 9 Specifically, § 8.12(a) begins, “some, but less than all, of the powers, authority or functions of the board of directors of a nonprofit corporation under this [act] may be vested by the articles of incorporation or bylaws in a designated body.” The comment explains, in part, “the concept of a designated body recognizes that it is sometimes desirable for a nonprofit corporation to depart from the traditional governance structure based on a board of directors and, in appropriate circumstances, members.” 10 The statute further provides that the members of the designated body—and not the board—have fiduciary duties with respect to powers that would otherwise be exercised by the board. As a threshold concern, it appears that a one or two-person designated body could conflict with the minimum of three board members required elsewhere in the Act. Separately, case law reflects the problems of having “dueling boards.” Commentary in ALI (2007, § 320) asks three fundamental questions about this concept:
Most important, what does it mean to say “[s]ome, but less than all, of the powers” of the board can be assigned to a designated body? Assuming the board has the power to amend the bylaws or even the articles without member approval, could the board itself establish such a body and thereby divest itself of legal responsibility and liability for some matters? What are the powers and liabilities of the board and the designated body when both bodies claim authority over an issue—or both disclaim it?
In comments to the Task Force on the 2008 draft, I identified some fundamental and important deficiencies with the Revised MNCA that remain unaddressed by the MNCA Third. In addition to the issues set forth in the ALI discussion above, I discussed (as updated) the following:
Change of charitable purpose: Under the Model Act, a nonprofit corporation that is a charity can adopt a change in purpose in the same manner as any other amendment to its articles of incorporation. (What use may be made of the accumulated assets is a separate question; restricted gifts are generally protected from a change in corporate purpose.) An amendment adopted by the board typically requires the approval of members, if any; in a charity lacking anyone else with voting rights, the decision falls to the board alone. By contrast, a charitable trust cannot be varied without court approval (unless the trust instrument provides a nonjudicial process). Is this feature of corporate law desirable? Is any alternative—notably, an increased role for the attorney general or court 11 —worse? This issue raises strong feelings on both sides, as reflected in recent litigation over the decision by a few women’s colleges to go co-ed. 12
Nonfinancial “dualities” of interest; constituency board members: When (if ever) do dualities of interest—as distinct from financial conflicts of interest—implicate a board member’s duty of loyalty? For example, the same person sitting on the boards of multiple charities might be asked to fund-raise for more than one. See ALI (2007, § 310, Comment d). What are the fiduciary duties of board members elected by specific charity constituencies? (see Veasey & Di Guglielmo, 2008, discussing, under the Model Business Corporation Act, constituency directors elected by employees or venture capitalists). The nonprofit context offers broad potential for classifying and electing directors by different constituencies, such as in federated charities having geographic classes of members. (Compare the MNCA Third’s provisions for a designated body of organization members and for voting groups.)
Fiduciary duties of members? When (if ever) do members of the organization owe fiduciary duties to the charity? 13 A sole member or a small number of members (or a designated body of members) raises concerns comparable to those of a designated body charged with board authority. More generally, while shareholders of a business corporation may act in their self-interest, membership in a charitable corporation has an oversight function without a financial interest (see ALI discussion above).
Range of sanctions for breach of fiduciary duty: In an improvement over the Revised MNCA (which offered fiduciaries a monetary shield only if set forth in the articles of incorporation), MNCA Third § 8.31 provides a statutory monetary shield for charity fiduciaries (if not engaged in self-dealing or acting in bad faith). While supporting such an automatic financial shield for good-faith breach of the duty of care, the ALI project (2007, Intro. Note to Topic 2) supports “a higher level of appropriate activism by charity regulators and the courts in crafting nonfinancial remedies to wayward fiduciary behavior.” Specifically, the draft Principles endorse
Increased settlements and injunctions mandating governing board and management training, and adoption of “best practices” policies and procedures; removal of fiduciaries; and even the closing down of charities and the transferring of assets from charities that will not adopt and follow appropriate safeguards to those charities that will. (ALI, 2007) Although MNCA Third identifies a few nonmonetary remedies—judicial removal of a director, judicial dissolution of a nonprofit corporation, and receiverships and custodianships—it could usefully have set forth a more complete list of available judicial remedies against the charity or a charity fiduciary.
14
Coordination with other laws: Finally, the MNCA Third could have assisted attorneys who are not expert in representing charities by referencing other statutes or common law doctrines applicable to charities (if not proposing needed changes to other statutes). Notably,
Attorney general authority: Even though not all charities take the corporate form, most (and the largest ones) do. Thus including attorney-general provisions in the MCNA Third would have offered the largest group of charities and their advisors a one-stop supervisory regime—as well as alert the attorney general’s office to its responsibilities in charity oversight. (Now, however, a state can separately enact the ULC’s most recent product, the Model Protection of Charitable Assets Act, 2011, a project drafted with input from state charities officials.) Substantively, the Task Force could have saved charities money by providing a nonjudicial dispute process for appropriate matters that may be resolved between the charity (or a fiduciary) and the attorney general. Jurisdictionally, nonprofit corporation law is unclear about how the “internal affairs doctrine” might limit the attorney general’s authority over board members of out-of-state corporations operating instate.
15
The ALI will address the “choice of law enforcer” issue to ensure that that there is neither an enforcement vacuum nor duplicative (and possibly inconsistent) state attorney general enforcement of charity fiduciary duties. Trust law: The ALI project, as discussed above, calls for importing into corporate law certain trust law requirements (notably, that a fiduciary has the duty to prevent a breach of fiduciary by a cofiduciary) and other trust doctrine (notably, relating to restricted gifts made to charitable corporations), with appropriate modification (see Brody, 2007b, proposing a law of “giftracts”). In addition, the MNCA Third or the Uniform Trust Code (or both) could usefully have addressed the legal effects of incorporating a charitable trust, a transformation commonly authorized by the trust instrument. Internal revenue code: The MNCA Third would have saved unnecessary delays by requiring the articles of incorporation of a corporation that will be seeking federal income-tax exemption to contain purpose language satisfying the desired subsection of Internal Revenue Code § 501(c)—for example, that a public charity must include language ensuring the proper distribution of assets upon liquidation. Separately, the safe harbor for approving conflict-of-interest transactions set forth in MNCA Third § 8.60, should have, at least in the case of charitable corporations, tracked the board-approval procedures for the rebuttable presumption of reasonableness under the intermediate-sanctions (Treasury Regulation § 53.4958-6; see Brody & Fremont-Smith, 2008). Instead, the MNCA Third’s official comment states, “A contract or transaction subject to this section may be permissible under this act yet be prohibited as an excess benefit transaction or otherwise under standards applicable to charitable corporations under the Internal Revenue Code.”
UPMIFA: Law Versus Accounting for Endowments
The ULC, established in 1892,
provides states with nonpartisan, well-conceived and well-drafted legislation that brings clarity and stability to critical areas of state statutory law. . . . ULC is a state-supported organization that represents true value for the states, providing services that most states could not otherwise afford or duplicate. (see “About the ULC” at www.uniformlaws.org; funding comes through the nonprofit Uniform Law Foundation)
The ULC’s 300 members, known as commissioners, typically are named by the various governors (a few state legislatures also select some commissioners). While a state may select as many commissioners as it likes—and can pay expenses for—each jurisdiction has one vote. Commissioners, who must be lawyers, include practicing attorneys, judges, and law professors, as well as legislators and legislative staff. Kobayashi and Ribstein (2009) observe that the ULC “was created out of a concern for the continued vitality of state law against the onslaught of ‘federal common law’ . . .” (p. 329).
The admirably transparent ULC sets forth on its website a “Statement of Policy Establishing Criteria and Procedures for Designation and Consideration of Uniform and Model Acts,” as well as all drafts and submitted comments for each ongoing project, and a legislative tally for completed acts. Each project drafting committee consists of a small number of commissioners who direct the work of an appointed reporter, usually an academic. Although committee members appreciate issues of enactability, they are not necessarily expert in the subject at hand. The technical quality of the project benefits from input from liaisons from other legal organizations (such as the ABA and ALI) and appropriate observers (such as academics and state charity officials). Once the ULC adopts a project (typically, after readings at two annual meetings, with revisions approved there by the membership), the commissioners are expected to “work toward enactment of ULC acts in their home jurisdictions.”
As for organizational law, as mentioned in the introduction, the ULC traditionally focuses on unincorporated entities. However, with respect to nonprofits, the ULC has leveraged its trust-law experience into drafting uniform acts that apply broadly to charities. Table 1 sets out the most significant: the Uniform Trust Code (2000, as amended); the Uniform Management of Institutional Funds Act (“UMIFA”; 1972) and its successor, the Uniform Prudent Management of Institutional Funds Act (“UPMIFA”; 2006); the Revised Uniform Unincorporated Nonprofit Associations Act (2008); and, most recently, the Model Protection of Charitable Assets Act (2011), the comprehensive successor to the sparsely enacted Uniform Supervision of Trustees for Charitable Purposes Act (1954).
Even more successful than the near-universally adopted UMIFA, UPMIFA was rapidly enacted in every state (albeit with occasional minor variations, most significantly in New York) except Mississippi (where it was introduced in 2011) and Pennsylvania. This welcome legal reform, however, threatens to be undermined by the accounting treatment promulgated by the Financial Accounting Standards Board (FASB). (FASB, too, operates under a nonprofit entity, the Financial Accounting Foundation.) Given that UPMIFA was drafted, in part, as a response to FASB’s treatment of endowments under UMIFA, the continued gap between these legal and accounting bodies is frustrating.
Unhappiness Over UMIFA and the Accounting Treatment of Endowments
Key to UMIFA’s spending rules for endowments—those gifts designated by the donor to be spent over a period of years or to last in perpetuity—was the concept of “historic dollar value” (HDV), where HDV is the gift’s value when contributed. UMIFA permitted trustees to spend a prudent portion of appreciation above HDV (some states set forth formulaic presumptions of an imprudent spending rate). The UMIFA drafters, though, addressed only investments that increased in value: The statute was silent on spending from a fund that fell in value below HDV (an “underwater” endowment). Of course, for a fund to last into perpetuity, its managers would have to achieve an ideal mix of investment return and spending rates. Importantly, the donor could always override the statute by terms in the gift instrument—for example, by providing that the charity may spend only in excess of inflation-adjusted HDV or may spend reasonable amounts from an underwater fund. (Note, too, that Internal Revenue Code § 4942 requires a charity classified as a private foundation to make annual minimum distributions equal to, generally, 5% of the value of investment assets—even if that value falls below HDV.)
UMIFA’s focus on historic dollar value had two significant weaknesses. On the upside, the fund might have appreciated so much that the statute does not add anything to the charity fiduciaries’ general obligation to spend prudently. On the downside, UMIFA’s failure to address underwater funds confounded charities after the dot-com bubble burst and in the recent recession. Charities debated whether they could make expenditures at all from a gift whose total return was minimal or, worse, negative. Some charities, believing that pretotal-return prudence law survived enactment of UMIFA, skewed their investments to produce spendable income (interest and dividends), returning to the circumstances that prompted UMIFA in the first place. 16
Charities’ difficulties traced, in large part, to the accounting treatment of endowments. Both board members and external constituents need financial statements that give a clear and accurate picture of the charity’s assets and liabilities. Even when not required by statute or funders, a charity of any significant size prepares financial statements in accordance with generally accepted accounting principles promulgated by FASB. To understand the discussion to follow, consider a US$100 million gift to endowment: How much should be available to spend currently if the market value of the gift increases to US$110 million or falls to US$90 million?
In 1993, FASB adopted Statement 117 (FASB, 1993), 17 requiring charities to categorize their assets as permanently restricted, temporarily restricted, and unrestricted. The appropriate category is determined by law, which provides that a restriction binds the charity only if imposed by the donor. Thus, FASB classifies “board-designated endowment”—also known as quasi-endowment—as unrestricted, because the board can always change its mind. Two years later, FASB Statement 124 (1995) addressed the accounting treatment of endowment funds. With respect to funds worth less than HDV (as defined by UMIFA), FASB 124 requires that, “[i]n the absence of donor stipulations or law to the contrary, losses on the investments of a donor-restricted endowment fund shall reduce . . . unrestricted net assets” (and “gains that restore the fair value of the assets of the endowment fund to the required level shall be classified as increases in unrestricted net assets”). For appreciated funds, FASB treated endowment value above HDV as unrestricted unless the gift had a purpose restriction in addition to its temporal restriction.
This accounting treatment, unfortunately, contributed to misunderstandings about the law. The financial statements of a charity with highly appreciated gifts could mislead donors, regulators, and the public—as well as the board itself—into believing that the charity had more unrestricted assets than the law recognizes. But matters were more serious on the downside (a situation, as mentioned above, not addressed in UMIFA). “In the past,” observes Siegel (2008), “some accountants have gone so far as to create an interfund liability, showing the unrestricted assets as owing money to the now underwater restricted fund” (pp. 36-37).
Moreover, while endowment gifts legally may be invested on a combined basis, spending restrictions apply gift by gift. Thus, a charity’s net endowment value might exceed net aggregate HDV, but particular gifts might be underwater. A charity lacking a sufficient amount of unrestricted investment assets could find its spending severely curtailed if the law were read to prohibit spending from underwater gifts. According to one study, 58.1% of university endowments were true endowments (National Association of College and University Business Officers [NACUBO], 2005, table 29). 18 Another study found that “underwater funds accounted for an average of 22.4% of the total value of true endowment funds held by colleges, universities, and affiliated foundations in fiscal year 2009” (Association of Governing Boards of Universities and Colleges & Commonfund Institute [AGB], 2010, p. 5). Public institutions and foundations, at 26% and 36%, were in a worse situation (only 16.9% of private-institution endowments were underwater). “This reflects the fact that many public institutions have more recently established endowment funds that have had less time to appreciate in value” (AGB, 2010). Charities with significant endowment gifts made in 2000 and in 2007, market peaks, are particularly vulnerable.
Contested Relevance of Historic Dollar Value After UPMIFA
Confronted with the shortcomings of UMIFA’s spending rules, in crafting the replacement act the ULC scrapped the lodestar of HDV. UPMIFA § 4(a) instead adopts an across-the-board prudence standard for making endowment spending and accumulation decisions, and provides factors for the board to consider. Commentary explains, “In some years, accumulation rather than spending will be prudent, and in other years an institution may appropriately make expenditures even if a fund has generated no investment return that year.” Thus, in the example above, the board must decide each year how much is prudent to spend out of the endowment, whether its current value is US$110 million or US$90 million. The flexibility of a prudence standard, however, discomfits those who prefer bright lines: Reportedly, during the UPMIFA drafting process, some accountants and at least one state charity regulator communicated strong opposition to eliminating HDV. To accommodate concerns, UPMIFA contains an optional provision—included in the statutes of over one fourth of the states—creating a rebuttable presumption of imprudence for spending at rates above 7%. Note that there is no corresponding presumption of prudence for spending below 7%.
A separate improvement in UPMIFA allows a charity to modify an investment restriction—and not just have it released, as under UMIFA—with the consent of the donor. Accordingly, charities can (and do) try to contact donors for consent to spend from underwater endowment gifts. If a donor has died, is otherwise unavailable, or refuses consent, resort to court would be required unless the gift instrument provides flexible spending terms.
In 2008, FASB approved staff guidance, FSP 117-1 (FASB, 2008b), for interpreting UPMIFA. FASB followed an open process of soliciting and posting all the comments it received 19 (although the comment period was brief). Unfortunately, though, the Board did not revisit the key policy decisions made in FASB 117 and FASB 124, and a staff position cannot deviate substantively from that form of guidance. As a result, financial statements must be presented in a way that still risks being materially misleading.
The new FASB staff guidance requires not-for-profit organizations to classify as permanently restricted that portion of the fund that the board determines is legally permanently restricted—which the staff believes is likely the original gift amount (HDV). To a lawyer, FSP 117-1 defies the law. (Ironically, charities themselves, as reflected in reports in the popular press, emphasized HDV in beseeching legislatures for relief from UMIFA’s asserted prohibition on spending from underwater funds.) In a memorandum to the Board, the FASB staff invoked the desire for certainty by some state charity regulators and financial-statement preparers:
While the UPMIFA statute eliminates a distinction of original gift amount from the rest of the fund, the staff thinks it may be too early to predict how spendability of that amount under UPMIFA will actually be interpreted and enforced in the various states. . . . Letters from regulators generally stressed the importance of knowing the amount of the original gift as a key data point for those charged with enforcing UPMIFA. (Some preparers highlighted its importance as a benchmark in administering funds under UPMIFA.) Furthermore, in other discussions with regulators, the staff learned that because of powers reserved for the judiciary in some states and case law precedents they cited, it isn’t clear at this time whether organizations could actually spend below original gift amount without court and/or attorney general involvement and approval in all jurisdictions. (FASB, 2008a, p. 5, memo para. 8)
20
Accordingly, FSP 117-1 continues to require that market declines (and not just expenditures) below HDV generally represent a target to be made up by the charity. The guidance’s Appendix explains,
The Board noted that UPMIFA seemingly does not require an affirmative obligation to restore the endowment fund to its original gift value, even if the organization were facing liquidation. Nonetheless, under the assumption that the organization is a going concern, the fiduciary duty remains in perpetuity absent judicial relief (cy pres action). That is, for financial reporting purposes, no release from restriction has occurred. (FASB, 2008b, p. A13)
For appreciated funds, FSP 117-1 makes a change that, while imperfect, at least moves in the right direction. Under UPMIFA, appreciation is classified as temporarily restricted (rather than unrestricted, as under UMIFA)—unless the donor additionally imposed a purpose restriction, in which case the appreciation, as under UMIFA, is permanently restricted. That is, the FASB staff views all of the appreciation on a perpetual gift for a particular purpose (e.g., “to endowment for scholarships”) as permanently restricted, but treats a mere temporal restriction (e.g., “to endowment”) as only temporarily restricted. In either case, signaling that none of this gift is unrestricted should comfort some regulators who worried that UPMIFA’s prudence standard leaves a financially distressed charity vulnerable to claims of creditors.
Accountants applying this guidance will resist the view that if a US$100 million gift falls in value to US$90 million, only US$90 million is permanently restricted, because of the FASB staff’s belief that US$100 million remains as a target value. However, under the prudence standard set forth in UPMIFA, regardless of whether the gift rose in value to US$110 million or fell in value to US$90 million, the entire gift (at its current value) is permanently restricted until the board appropriates a prudent portion for expenditure.
FSP 117-1 further requires the annual financial statements to disclose information that will enable users to understand board policies related to the endowment funds, and to describe the board’s interpretation of the law that underlies the charity’s classification of donor-restricted endowment funds. Thus, disclosures (and classifications) can vary. 21 For the benefit of the board itself, as well as for the charities’ donors, creditors, and other stakeholders, a charity’s financial statements might need to provide additional explanation of the organization’s true position—that is, to make clear how much of restricted gifts may be spent when. 22
In 2009, FASB established a Not-for-Profit Advisory Committee “to serve as a standing resource the FASB in obtaining input from the not-for-profit sector on existing guidance, current and proposed technical agenda projects, and longer-term issues affecting those organizations.” 23
Conclusion—and the Future?
This article examines three recently completed or ongoing U.S. nonprofit law reform projects drafted by three different models of nonprofit institutions: the ALI, the ABA, and the ULC. The work of these organizations is not itself law, but rather achieves success only to the extent enacted by state legislatures or applied by practicing attorneys, regulators, and judges. The influence of each project depends in large part on institutional features, which vary among the sponsoring organizations. While the group drafting the Model Nonprofit Corporation Act was small and nimble, its focus on conforming to the Model Business Corporation Act reflects the nonprofit statute’s development under the auspices of the ABA Business Law Section. In crafting UPMIFA, the ULC operated transparently and welcomed the views of outsiders, but in focusing on legislative enactibility the ULC was unable to bridge the gap with the accounting profession. Even with the ALI’s long and deliberative process, consensus cannot always be reached; the project on Principles of the Law of Nonprofit Organizations might more expeditiously provide guidance just by describing the debate around such issues.
As a result of the way broad law reform arises, a true unified “charities law” in statutory form is unlikely to emerge in the United States. In evaluating the prospects of additional bottom-up reform, we should keep in mind two overarching principles. First, the law is a relatively weak force in influencing the behavior of nonprofits and their fiduciaries. Often the better answer is not new law, but rather enforcement of existing laws, or, better yet, improved voluntary practices. Second, the concept of “the nonprofit sector” for the last 40 years has clearly been a successful organizing device, for scholars as well as for practitioners (see Hall, 1992). But, public/private partnerships have been weakening the border between nonprofits and government; and competitive pressures and the emergence of limited profit, social-enterprise hybrids weaken the border between nonprofits and business. As a policy and regulatory matter, a single legal rubric for religious, educational, hospital, social service, cultural, and advocacy organizations might no longer make sense. We might find future law reform to be postsectoral, focusing less on organizational form and more on specific activities.
Footnotes
Author’s Note
Current through March 26, 2012. The author is grateful to Putnam Barber, Marion Fremont-Smith, Myles McGregor-Lowndes, and two anonymous reviewers for comments on earlier drafts, and to attendees of her presentation at the 2011 ARNOVA annual conference. All views are the author’s except for material tentatively adopted by the American Law Institute, as described in the text.
Declaration of Conflicting Interests
The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding
The author(s) received no financial support for the research, authorship, and/or publication of this article.