Charity on the Edge: How to Handle Looming Insolvency

December 10, 2008

The economic downturn has hit charities with a perfect storm – donors are retrenching and endowments have been crushed at a time when the need for services is increasing. To weather the storm, charities must make hard decisions concerning personnel and programs. Even after painful cuts, some charities still struggle to stay solvent. Following are a few steps directors and charities should consider so that financial struggles do not also become legal struggles.

Fiduciary Focus. Meeting your obligations as a charitable corporate director is always important – especially as a charity struggles for solvency. A few steps to help meet your obligations are:

Face Facts. Bad news does not improve with age. It is important that officers regularly communicate to the Board about a charity’s financial condition. The Board and the charity’s management must work closely to restructure the charity’s operations to reflect financial reality. Charities (especially those with large boards) should consider use of a committee to facilitate prompt action. If a committee is used, be sure it has been delegated the necessary authority. And be sure the committee lets the whole Board know about major decisions. To avoid missteps, involve the charity’s professional advisors early.

Take Care. Every director owes a duty of care to the charity. This duty requires that you act in good faith and exercise the care an ordinarily prudent person would exercise under like circumstances. Some steps to assure that you meet the duty of care are:

Be Loyal. Nothing generates scrutiny like conflicts of interest – or the appearance of a conflict – especially during times of financial stress. While it is best to avoid conflicts of interest, in the real world, some conflicts are inevitable. Be sure to understand where conflicts might arise and address them up front.

Document. It is important to fulfill diligently your duties as a director. Proof that you fulfilled those duties is also important. Corporate minutes are a vital (and often the only) tool in documenting the Board’s deliberations. Be sure the charity treats minutes as important documents. Minutes need not be a transcript of Board meetings – and are usually more effective if they are a thoughtful summary. Be sure to read the minutes and, if needed, ask for corrections.

Do D&O. Be sure that you keep D&O insurance in force. Insurance is not an area to cut as a cost savings measure. And be sure to comply with policy requirements concerning notification of potential claims. Work with your insurance professional to be sure the charity retains the protection for which it paid.

Borrowing from the Past. Charities fortunate enough to have an endowment may be tempted to use endowment assets to fund current operations. Endowments are investment assets the use of which has been restricted by donors – either on the donor’s own initiative or as a result of the charity’s promises to donors about the use of their contributions. Restrictions might limit when the endowment can be spent (e.g., do not spend principal) or the purpose for which the endowment can be spent (e.g., only for scholarships) or both (e.g., only income for scholarships). Unrestricted investment assets or investment assets voluntarily restricted by the Board are not endowments.

Care needs to be taken with endowment assets. Violating endowment restrictions can have several bad results, such as third-party claims to the endowment, demands for personal restitution by directors and officers and, in a worst case, criminal prosecution. Before using endowment assets to fund current operations, directors should insist on a number of steps, including:

Census. An important first step is understanding which assets are restricted, the nature of the restrictions and the identity of major donors. Take a census of investment assets to determine those assets that are restricted and those that are unrestricted as well as the nature of the restrictions. The census should involve a review of the terms of endowment funds, bequests, gift letters and promises made to donors in solicitation material.

Legal Limits. In most states, a charitable corporation’s ability to spend an endowment is governed not only by the limits set by donors but also by laws that provide guidance about endowment spending. Remember that endowment assets might be protected in a bankruptcy – a protection that is lost if those assets are used to cover current expenses. Court approval or notice to regulators (typically the State Attorney General) is the safest course before a charity spends beyond what is permitted by an endowment.

Structure. Consider how endowment assets will be used within the legal limits. Will the assets be spent to fund current operations? Will the assets be borrowed from the endowment and on what terms? Or will the assets be pledged as security for a bank loan? Each of these options has different legal ramifications. Ask what plans exist to repay the endowment. If the use of endowment assets merely puts off an inevitable collapse, consider whether a sale, merger, reorganization or orderly dissolution will better serve the charity’s mission. Continuing to incur debt after a charity is insolvent might open directors to claims from creditors.

Public Relations. Violating endowment restrictions lays the groundwork for legal and public relations battles. Donors (or their heirs) who learn of the violations may decline to provide future support or challenge the new use through legal action. If the endowment is comprised of large gifts, the charity should consider securing donor consent, if possible, to an alternative use of endowment assets.

Regulators. Consider discussing the charity’s circumstances with the appropriate regulator (typically, the State Attorney General) prior to finalizing a course of action. Initial discussions can occur without revealing the name of the charity. Remember, regulators react better if they have heard from the charity prior to reading about problems in the paper or hearing from disaffected donors. If the charity is going to seek court approval, the Attorney General should be involved at an early stage.

Robbing Peter to Pay Paul. As an employer, charities withhold funds from employees for a number of reasons, including payment of federal, state and local taxes, retirement plan contributions and health insurance premiums. A distressed charity should never use funds withheld from employees to pay for current operations. Use of withheld funds can result in personal liability.

End of the Line. Despite best efforts, a charity may need to declare bankruptcy. Unlike for profit organizations, in most cases, charities cannot be forced by creditors into involuntary bankruptcy. (Some states permit creditors to force charities into state receivership.) Charities may, however, take advantage of voluntary bankruptcy.

Charities considering bankruptcy should keep in mind that courts will usually protect endowment assets from the claims of creditors. Protection of the endowment from creditors might not be available if the charity has pledged the endowment as security for a debt. Courts will only protect endowments and restrictions established by third party donors. Attempts prior to bankruptcy by a charity to treat unrestricted investments as an endowment will be disregarded.

Serving as a director of a charity struggling for solvency may require that important decisions be made quickly. Understanding the special rules that govern charities is a key step to protecting both the charity and yourself.