I. Understanding the Three Perspectives on Endowments

Legal practitioners must recognize that "endowment" carries distinct meanings depending on the stakeholder:

1. Donor Perspective: A sum given to charity where "income" is spent while "principal" is preserved. This is not the best approach from a total return perspective under modern portfolio theory
2. Accounting Perspective: Assets with donor restrictions (under current FASB standards)
3. Legal Perspective: An institutional fund not wholly expendable on a current basis under the terms of the gift instrument

Let us examine the legal perspective under the Uniform Prudent Management of Institutional Funds Act (UPMIFA) of 2006, which has been adopted by all states, either wholesale or slightly modified. In California, it is codified under Probate Code Sections 18501 - 18510. 

II. UPMIFA: The Modern Framework

B. Modern Portfolio Theory Integration

• Eliminating "historic dollar value" constraints
• Embracing total return investment strategies
• Allowing prudent appropriation of both appreciation and original value
• Focusing on overall portfolio performance

The elimination of historic dollar value represents a fundamental shift in endowment management philosophy. Under previous approaches, charities were forced to maintain the original dollar value of gifts regardless of economic conditions or institutional needs. This often led to absurd situations where organizations would struggle to maintain programs during economic downturns, even while sitting on substantial appreciated value above the original gift amount.

The embrace of total return investment strategies marks UPMIFA's recognition that modern portfolio theory has rendered obsolete the traditional distinction between income and capital appreciation. Investment managers can now construct portfolios optimized for total return rather than being forced to chase current yield at the expense of long-term growth. This allows for more sophisticated asset allocation and potentially better long-term results.

The prudent appropriation standard acknowledges that preserving purchasing power may be more important than preserving nominal dollar value. It enables organizations to make spending decisions based on real-world needs and circumstances rather than artificial accounting constructs. This flexibility proves particularly valuable during periods of market volatility or economic stress.

C. Required Investment Considerations

1. General economic conditions
2. Inflation/deflation effects
3. Tax consequences
4. Portfolio context of investments
5. Expected total return
6. Other organizational resources
7. Distribution needs and preservation goals

UPMIFA's investment considerations reflect a sophisticated understanding of modern portfolio management. Rather than focusing solely on individual investment decisions, the Act requires a holistic analysis that considers multiple factors affecting long-term sustainability.

The emphasis on general economic conditions and inflation/deflation effects requires boards to think broadly about macroeconomic factors that might impact their endowments. This might mean adjusting investment strategies during periods of high inflation to preserve purchasing power, or modifying spending policies during economic downturns.

Tax consequences must be considered not just for individual transactions but in the context of the organization's overall tax position. This includes understanding the impact of unrelated business income tax, considering tax-efficient investment vehicles, and managing the timing of gains and losses.

The portfolio context requirement reflects modern portfolio theory's emphasis on correlation and diversification rather than analyzing investments in isolation. Expected total return must be viewed through the lens of risk-adjusted returns and the organization's risk tolerance.

Consideration of other organizational resources and distribution needs acknowledges that endowment management doesn't occur in a vacuum. A charity with substantial current fundraising capacity might take a different approach than one heavily dependent on endowment income. Similarly, distribution needs might vary based on program requirements, alternative funding sources, and economic conditions.

IV. Common Misconceptions and Corrections

A. Investment Pool Confusion

• Misconception: "Endowment" means the collective investment pool
• Reality: Definition hinges on expendability restrictions
• Impact: Investment pooling is administrative, not definitional

This common misconception often arises from the practical reality that many charities combine their endowed funds into a single investment pool for efficiency and better portfolio management. However, this administrative choice has no bearing on the legal status of the individual funds within the pool. A pooled investment approach simply represents a practical management strategy, much like an individual investor might use a mutual fund for diversification.

Legal practitioners must help their clients understand that each fund within the pool maintains its distinct legal character. Some pooled funds may be true endowments, others quasi-endowments, and still others current-use funds invested for the short term. The mere fact of being part of the investment pool neither creates nor eliminates any legal restrictions on the funds' use.

B. Building Fund Error

• Misconception: Capital project gifts are endowments
• Reality: Construction funds fail the UPMIFA test
• Key: Time restriction is essential

The building fund misconception illustrates how the term "endowment" has become conflated with any significant charitable gift. Construction or capital project funds typically fail the fundamental test for endowment status because they are intended for relatively immediate expenditure. Even when a building project might span several years, the underlying intention is full expenditure rather than permanent preservation of capital.

This distinction becomes particularly important when advising donors and charities on gift documentation. A building fund gift instrument should clearly indicate the intended use for construction or capital improvements, avoiding any language suggesting permanent preservation of the gift. This clarity helps prevent future confusion and potential disputes over the proper use of the funds.

C. Annual Giving Confusion

• Misconception: All gifts are endowments
• Reality: Current-use gifts lack required time restriction
• Test: Look to gift instrument restrictions

The confusion between annual giving and endowment often stems from development officers' natural enthusiasm for securing long-term institutional support. However, annual giving programs are specifically designed to provide current operational support, making these gifts fundamentally different from endowment gifts. The distinction lies not in the size of the gift or its restricted purpose, but in the temporal nature of the donor's intent.

Legal counsel should ensure that gift acceptance policies clearly differentiate between current-use and endowment gifts. This distinction affects not only how the funds can be used but also how they should be invested and accounted for. Clear policies help development staff communicate accurately with donors and prevent misunderstandings about gift restrictions.

V. Creation of True Endowments

A. UPMIFA Requirements

1. Gift Instrument

• Must be a "record"
• Can be tangible or electronic
• Must include clear restrictions

The concept of a "gift instrument" under UPMIFA is intentionally broad to accommodate modern communication methods while ensuring proper documentation of donor intent. A record can include traditional paper documents, email exchanges, electronic forms, or other digital communications. However, this flexibility in form should not be confused with flexibility in substance – the restrictions must be clear and documented.

The requirement for clear documentation serves multiple purposes. It provides evidence of donor intent, guides the charity's use of the funds, and creates a reference point for future leaders who may need to interpret the restrictions. Legal practitioners should encourage detailed documentation that anticipates potential future questions about the scope and nature of restrictions.

    2. Documentation Scope

• Institutional solicitations
• Governance documents
• Must be known to both parties

UPMIFA's broad view of what constitutes a gift instrument means that restrictions can arise from multiple sources. Solicitation materials used by the charity can become part of the gift instrument, making it crucial for legal counsel to review fundraising materials for unintended restrictions. Similarly, organizational documents like bylaws or board-approved policies might be incorporated into the gift instrument if referenced or relied upon.

The requirement that restrictions be known to both parties emphasizes the contractual nature of charitable gifts. Hidden or undisclosed restrictions generally cannot bind the charity, nor can the charity later impose restrictions not communicated to the donor at the time of the gift.

VI. Management and Investment Standards

A. Prudent Management Requirements

1. Investment Considerations

• Portfolio-wide perspective
• Risk-return objectives
• Diversification duty

UPMIFA's adoption of a portfolio-wide perspective represents a significant departure from older approaches that evaluated each investment in isolation. This modern approach recognizes that individual investments must be considered within the context of the entire portfolio's risk and return objectives. For example, an investment that might appear overly risky on its own could actually serve as an effective hedge within a properly diversified portfolio.

The risk-return analysis under UPMIFA requires sophisticated evaluation of multiple factors. Boards must balance the charity's need for current income against long-term preservation of purchasing power. This analysis should consider the organization's risk tolerance, time horizon, and specific program needs. Legal counsel should encourage boards to document their reasoning when making significant investment decisions, particularly when approving strategies that might appear aggressive in isolation.

The duty to diversify serves as both a protection against excessive risk and a mandate for professional portfolio management. However, UPMIFA recognizes that proper diversification looks different for different organizations. A small charity with a modest endowment might achieve appropriate diversification through mutual funds or pooled investment vehicles, while a large institution might need a more complex portfolio of directly held investments.

     2. Spending Guidance

• No historic dollar value limit
• Prudent person standard
• Seven percent presumption (in some states)

The elimination of historic dollar value as a spending constraint represents one of UPMIFA's most significant innovations. Instead of an arbitrary accounting construct, spending decisions must be based on a careful analysis of multiple factors affecting the fund's long-term sustainability. This approach provides greater flexibility during market downturns while still protecting the endowment's long-term viability.

The prudent person standard requires board members to exercise ordinary business care and prudence under the facts and circumstances prevailing at the time of the action or decision. This standard recognizes that what constitutes prudent behavior may change based on economic conditions, institutional needs, and other relevant factors.

States like California have adopted a presumption that annual spending above 7% of the endowment's fair market value (typically measured over three years) is imprudent. This creates a safe harbor for boards while still allowing higher spending when circumstances warrant and proper documentation exists. Legal counsel should ensure boards understand that this presumption is rebuttable and should not be treated as a spending target.

B. Delegation Authority

• Permitted with proper oversight
• Requires prudent selection
• Includes ongoing monitoring

UPMIFA explicitly authorizes delegation of investment and management functions, recognizing that modern portfolio management often requires specialized expertise. However, this authority comes with specific duties and responsibilities. The board's role shifts from making investment decisions to selecting and monitoring investment advisors.

Prudent selection requires more than simply choosing a well-known firm. Boards should conduct due diligence on potential advisors, considering their experience with similar endowments, investment philosophy, fee structure, and track record. Legal counsel should help boards develop appropriate criteria for advisor selection and document their selection process.

The ongoing monitoring requirement means that boards cannot simply delegate and forget. Regular review of advisor performance, costs, and compliance with investment policies remains a board responsibility. This monitoring should include periodic meetings with advisors, review of performance reports, and assessment of whether the advisor's strategy remains aligned with the organization's needs and objectives.

VII. Modification of Restrictions

A. With Donor Consent

• Requires written agreement
• Must maintain charitable purpose
• Should document carefully

The ability to modify restrictions with donor consent provides important flexibility for charitable organizations, but must be handled with precision and care. The requirement for written agreement seems straightforward but demands attention to detail. Electronic communications can satisfy this requirement, but casual or ambiguous exchanges should be avoided in favor of clear, formal documentation.

Even with donor consent, modifications must maintain the fundamentally charitable character of the gift. Legal counsel should guide organizations away from modifications that might raise private benefit concerns or stray from the organization's charitable mission. This is particularly important when donors request modifications that might provide them with greater control or influence over fund usage.

Documentation of modifications should be comprehensive, including not only the change itself but also the rationale, process, and any considerations that led to the modification. This documentation serves multiple purposes: providing clarity for future administrators, demonstrating prudent decision-making if questioned, and establishing a record for potential regulatory review.

B. Without Donor Consent

1. Small Fund Exception

• Under $100,000
• Over 20 years old
• Notice to Attorney General

The small fund exception recognizes that smaller, older funds can become administratively burdensome relative to their charitable impact. However, the specific requirements must be strictly observed. The $100,000 threshold is absolute - a fund of $100,001 must use other modification methods. The age requirement runs from the fund's establishment, not from subsequent gifts to it.

Notice to the Attorney General must be properly executed. Most state charity regulators have specific forms or procedures for these notices. The notice should include not only the proposed modification but also evidence of the fund's value and age, and an explanation of why the existing restrictions have become problematic.

Organizations should resist the temptation to break larger funds into smaller ones to utilize this exception. Such actions could be viewed as attempting to circumvent the statutory scheme and might attract regulatory scrutiny.

   2. Court Modification

• Changed circumstances
• Impossible/impracticable standard
• Attorney General notification

Court modification represents the traditional cy pres or deviation approach to addressing problematic restrictions. The "impossible or impracticable" standard requires more than mere inconvenience or administrative preference - there must be genuine difficulty in carrying out the restriction as written.

Changed circumstances can include various situations: programs that no longer exist, methods that have become obsolete, or purposes that no longer serve the intended charitable objective. Legal counsel should help organizations build a strong factual record demonstrating how circumstances have changed since the gift was established.

Attorney General notification in court modification cases typically involves more than simple notice - most state charity regulators actively participate in these proceedings. Early consultation with the Attorney General's office can help identify potential concerns and shape the modification request appropriately.

VIII. Enforcement and Standing

A. Primary Enforcement

• Attorney General oversight
• Organizational standing
• Potential donor standing

Attorney General oversight serves as the primary enforcement mechanism for charitable gifts and restrictions. This reflects the public's interest in charitable assets and the need for an official guardian of charitable intent. Different states structure this oversight differently - some have dedicated charitable divisions, while others handle charity matters through their consumer protection or civil enforcement divisions.

Organizational standing typically extends to officers, directors, and sometimes members of charitable organizations. However, internal disagreements about fund management should generally be resolved through governance mechanisms rather than litigation. Legal counsel should help organizations develop clear internal procedures for addressing concerns about fund management.

The question of donor standing varies significantly by jurisdiction and continues to evolve. Some states strictly limit enforcement to the Attorney General, while others have recognized broader donor standing, particularly where gift instruments explicitly reserve enforcement rights.

B. Standing Variations

• State law differences
• Gift instrument provisions
• Consider enforcement mechanisms

State law variations on standing create complexity for organizations operating in multiple jurisdictions. Some states follow the traditional rule limiting enforcement to the Attorney General, while others have adopted more expansive approaches through either case law or statute.

Gift instruments can sometimes create standing through carefully drafted provisions, though these must be balanced against tax and other implications. Provisions that are too restrictive or create reversionary interests might jeopardize the charitable deduction or create other complications.

Modern enforcement mechanisms might include alternative dispute resolution provisions, regular reporting requirements, or designated third-party monitors. These mechanisms should be carefully structured to provide meaningful oversight without creating undue administrative burdens or restricting the organization's ability to adapt to changing circumstances.

IX. Accounting Considerations

A. Current Standards

• "With donor restrictions" classification
• Enhanced disclosures required
• Board designation reporting

Recent changes in accounting standards have significantly impacted endowment reporting and classification. The shift to a simplified two-category system - "with donor restrictions" and "without donor restrictions" - reflects an effort to make financial statements more understandable while still preserving important distinctions in fund characteristics.

Enhanced disclosure requirements go beyond mere classification. Organizations must now provide detailed information about the nature and extent of donor restrictions, including any board interpretations of relevant law (such as UPMIFA) that affect the classification and reporting of endowment funds. This increased transparency helps stakeholders better understand the organization's endowment structure and available resources.

Board designation reporting requirements recognize the importance of internal restrictions while maintaining the distinction between true donor restrictions and self-imposed limitations. Organizations must disclose the purposes, amounts, and policies regarding board-designated funds, providing stakeholders with a complete picture of the organization's financial flexibility and management priorities.

B. Underwater Endowments

• Disclosure requirements
• Spending policy implications
• Risk management considerations

Underwater endowments - those whose current value has fallen below the original gift amount - present particular challenges under modern accounting standards. Organizations must disclose the original gift value, current fair value, and amount of deficiency for underwater endowments. This transparency helps stakeholders understand the impact of investment performance on the organization's endowment funds.

Spending policies for underwater endowments require careful consideration. While UPMIFA permits spending from underwater endowments, organizations must document their analysis of relevant factors and potentially modify spending rates to protect long-term sustainability. Legal counsel should help organizations develop and document appropriate policies for managing underwater endowments.

Risk management extends beyond investment decisions to include communication strategies with donors and other stakeholders. Organizations should be prepared to explain their underwater endowment policies and demonstrate their commitment to long-term endowment preservation while maintaining appropriate current spending levels.

X. Best Practices for Legal Counsel

1. Documentation

• Clear gift instruments
• Detailed policies
• Regular review procedures

Gift instruments serve as the foundation for effective endowment management. Legal counsel should develop templates and procedures that ensure clear documentation of donor intent, restrictions, and any flexibility permitted in fund management. These instruments should anticipate potential future changes while providing clear guidance for current administration.

Policies should cover all aspects of endowment management, from gift acceptance to investment management to spending rules. These policies should be detailed enough to provide meaningful guidance while maintaining sufficient flexibility to address changing circumstances. Regular review ensures policies remain current with legal requirements and best practices.

Review procedures should be systematic and documented. Annual reviews of endowment restrictions, periodic assessment of investment policies, and regular evaluation of spending rules help organizations maintain compliance and identify potential issues before they become problems.

    2. Risk Management

• Investment policy alignment
• Spending policy compliance
• Regular legal review

Investment policies must align with both legal requirements and organizational capabilities. Legal counsel should ensure these policies reflect UPMIFA's prudent investor standards while remaining practical for the organization to implement and monitor.

Spending policy compliance requires ongoing attention to both donor restrictions and legal requirements. Organizations should document their analysis of UPMIFA factors and maintain clear records of spending decisions, particularly for restricted or underwater endowments.

Regular legal review serves multiple risk management functions: ensuring ongoing compliance, identifying potential issues early, and maintaining appropriate documentation of key decisions and policies. This review should cover not only technical compliance but also broader risk factors such as changes in the organization's circumstances or relevant legal requirements.

   3. Communication

• Clear donor discussions
• Board education
• Staff training

Effective donor communications begin with gift discussions and continue throughout the life of the endowment. Legal counsel should help development staff understand how to discuss restrictions without creating unintended limitations or promises that might be difficult to fulfill.

Board education should be ongoing, covering not only basic legal requirements but also emerging issues and best practices in endowment management. Regular updates help board members fulfill their fiduciary duties while maintaining appropriate oversight of endowment activities.

Staff training ensures that those responsible for day-to-day endowment management understand both legal requirements and organizational policies. This training should be tailored to different roles within the organization, from development staff to financial managers to program administrators.

Conclusion

The management of charitable endowments requires a careful balance of legal compliance, practical administration, and respect for donor intent. Legal practitioners play a crucial role in helping organizations navigate these complexities while maintaining the flexibility needed for long-term sustainability. Success requires attention to detail in documentation, clear policies and procedures, and ongoing monitoring of both compliance and effectiveness. As endowment law continues to evolve, staying current with legal developments and best practices remains essential for effective counsel to charitable organizations.