By Michael W. Peregrine, Esq., McDermott Will & Emery, LLP

This article is the seventh in a series on efficient board committee practices (refer to previous issues of E-Briefings to read about the strategic alignment committee, executive compensation committee, audit committee, compliance committee, executive committee, and governance committee).

Once again, the board’s investment committee is at the epicenter of critical board-delegated functions relating to organizational financial strength. As in the recession of recent years, the current economic volatility presents significant challenges to the stability of the investment portfolio of the non-profit hospital and health system. Lessons learned by board and committee members in the dark days of 2007–2009 may prove particularly valuable in the coming months, as uncertainty lingers in the financial markets. At the same time, new, liberal uniform laws now adopted in most states provide fiduciaries with increasing flexibility in terms of management of the investment portfolio and dealing with restricted gifts.

The investment committee is rapidly returning to a position of prominence and leadership amongst board committees. This is especially the case with hospitals, health systems, and similar organizations with substantial investment portfolios and large inventories of restricted gifts, and those that rely significantly on the income generated by those portfolios and gifts. Service on the investment committee should attract the most competent, experienced, and dedicated board members.

For these and other, related reasons, the board and investment committee should work together to revisit the role and function of this important body and the manner in which it operates and administers the organization’s investment portfolio.

Background

Together with the finance committee, the investment committee bears a substantial responsibility for oversight of key financial performance indicators of the organization. These indicators have already been in somewhat of a state of tumult given the massive changes in the health financing care model wrought by the Patient Protection and Affordable Care Act (PPACA). Indeed, recent reports by Moody’s Investors Service speak to the precarious financial situation of many hospitals and health systems, with the prospect of declining revenues and potential downgrades. The current negative impact on U.S. financial markets prompted by the overall debt reduction issue, the Standard & Poor’s downgrading, the precarious nature of the European economies, the overall fear factor in the investment marketplace, and other related factors combine to exacerbate concerns with these indicators. Just as the investment committee was called upon to exercise extraordinary levels of diligence during the economic recession, it is being called upon for a “repeat performance” with the recent crisis.

In a positive development, the investment committee is also the beneficiary of new statutory assistance as it works to address investment challenges, risks, and opportunities. The Uniform Prudent Management of Institutional Funds Act (UPMIFA), now enacted in almost every state, serves to modernize and unify the rules governing investment and expenditure of charitable funds. UPMIFA’s guidance reflects advances in modern portfolio management theory and practice, which have evolved during the last 35 years. UPMIFA governs funds held in any form (except charitable trusts of which the charity is not acting as trustee) whether created before or after enactment of UPMIFA. As such, UPMIFA represents the prevailing fiduciary standard for management of charities’ institutional funds.

Accordingly, the near-term agenda for the investment committee should logically consider both the structural (e.g., matters relating to the organization, composition, and focus of the committee and its workings) and operational (how the committee can best understand and properly take advantage of UPMIFA). In doing so, key agenda items would include the following.

1. Revisit the Charter
As is well understood, the committee charter serves to clarify the role and function of the committee as delegated by the governing board, and the related role of individual committee members. The importance of clarity is especially significant for committees with critical powers and responsibilities such as the investment committee—the role and function of which has also been subject to such substantial external pressure and change. Accordingly, it would be a very useful exercise for the board or its governance committee to work with the investment committee to review the ongoing suitability of its charter. This is especially the case if the charter was not revised in the aftermath of the last recession, and/or since the enactment of UPMIFA in the relevant state.

In revisiting the charter, attention should be given to whether the scope of the committee’s responsibilities help guide committee members away from common pitfalls of investment committee service, for example, nominating board members primarily as recognition for their history of donations—as opposed to actual expertise; being excessively deferential on one or two committee members generally known for their investment or financial expertise; being excessively reliant on investment advisors and not applying common sense business judgment and prudence where circumstances warrant; being vigilant to signs of mismanagement, fraud, or advisor conflict of interest; and making investment decisions primarily in response to the actions of similarly situated organizations.

One important question to resolve when revisiting the committee charter is whether the investment committee is also to have oversight responsibility for all fundraising and other charitable solicitation activities of the organization. This is clearly a task for some board committee, and investment is well suited given the overlap with the UPMIFA and the Panel on the Nonprofit Sector’s “best practices” dealing with “responsible fundraising.”

2. Committee Composition
There is always significant value in revisiting the manner in which the investment committee is structured. The way that the committee is organized and composed should be constantly monitored for effectiveness and consistency with prevailing practice, perhaps even more so than with other key committees. A particularly important composition component is to require that the committee is composed entirely of members who meet the definition of “independent” as should have been previously adopted by the board. If this is difficult to do, at a bare minimum a solid majority of committee members should be “independent.” The sanctity of committee deliberations will depend in part on an ability to establish a clear separation from the committee members and the influence and authority of senior management. It’s not that senior management can’t express their investment management views to the committee, but rather that committee members must not be “beholden to” management and be free to exercise their own independent judgment.

Along the same lines, care should be taken to avoid “constituent representation” on the investment committee (i.e., allocating certain committee membership positions to particular organizational constituencies, such as the medical staff, particular organizational affiliates, or external geographic or market area constituencies). Such a practice can substantially confuse the individual committee member’s perception of loyalty and create significant conflict-of-interest issues.

A third composition issue is to evaluate the potential under state law to include individuals who are not current voting members of the governing board as voting members of the committee. The non-profit laws of many states allow non-board members to serve as voting members of committees with board-delegated powers, as long as a majority of committee members are board members. This may allow the committee to tap particularly qualified candidates not presently serving (or interested in serving) on the main board.

A fourth composition issue is the designation of executive staff members to serve the committee in a non-voting, advisory capacity. Effective practice suggests that such staff should include representatives from the general counsel/ chief financial officer offices, among others.

3. Expertise
The investment committee is one of several committees with board-delegated powers for which specific expertise—beyond the usual qualities of good judgment, commitment, time capacity, integrity, etc.—is of paramount value for all members of the committee (others being audit, finance, and executive compensation). The board’s nominating committee should work with the investment committee and, perhaps, its external advisors to craft specific experience requirements for committee service. In so doing, care should be given not to appoint individuals whose expertise is such as likely to create potential conflicts of interest with committee service (e.g., representatives of investment management or similar firms whose professional services could ultimately be sought by the committee).

4. Conflicts of Interest
Appointing a committee composed entirely of “independent” members will not automatically protect the committee from conflicts of interest. Remember that independence relates to a board or committee member’s relationship with corporate management; conflicts of interest relate primarily to whether a board or committee member has a material financial or personal relationship with an issue coming before the board or committee. Charity regulators are understandably hypersensitive to the risk of conflict of interest on the investment committee due to several notable conflict issues arising from the “Madoff” and similar Ponzi-scheme scandals that plagued non-profit organizations in the recent past, where issues associated with fiduciary conflict or self-dealing exposed several organizations to enormous financial loss.

Experience suggests that the investment committee should expose itself to a standard of conflicts review higher—or at least more frequently—than that of other board committees, given the potential self-dealing risks. Membership on the investment committee should come with an understanding that individual committee members must remain free of external personal or financial relationships that could bias their decision making, and that the existence of such relationships (e.g., providing investment management services to the organization, a material personal relationship with an investment advisor conducting business with the organization) may require resignation from committee service.

5. Best Practices
The investment committee should monitor its organization and operation to align itself as closely as possible with existing non-profit sector “best practices” compilations and other industry guidelines on the role and function of such a committee. Particularly prominent among these is the Panel on the Nonprofit Sector’s Principles for Good Governance and Ethical Practice, which contains several key principles that address the board’s oversight of investment and endowments, and other aspects of strong financial oversight.

6. Confirm UPMIFA Compliance
As noted above, UPMIFA codifies in fairly liberal manner the requirements dealing with prudent investment by charitable organizations. In doing so it presents three specific themes:

• UPMIFA allows broad investment flexibility to the non-profit organization as investment decisions are reviewed with respect to the non-profit’s entire portfolio, based upon the “total return theory” of portfolio management. This means that investment decisions should be based upon a review of the entire portfolio in relation to the organization’s overall resources and non-profit purposes, rather than reviewing decisions or assets in isolation.
• UPMIFA also updates the rules governing spending from endowment funds (i.e., donor-restricted funds that cannot be wholly expended on a current basis. A major change instituted by UPMIFA is to update basic spending rules by eliminating the concept of “historic dollar value” and the related limitation on spending to amounts above the “HDV floor,” and by substituting therefore a “prudent total return standard” for expenditures. This new standard focuses on the donor’s intention to preserve the fund’s real purchasing power, not just the nominal sum of contributions to the fund. UPMIFA identifies specific factors the non-profit must consider in making such spending decisions.
• The third principal change implemented by UPMIFA is to facilitate the release of restrictions limiting the use of endowment funds that have become out of date because of changes in facts and circumstances. UPMIFA allows the non-profit to petition the court to release or modify a restriction that can be demonstrated to have become impracticable or wasteful or otherwise impairs the fund’s investment management.

The investment committee should work with its legal advisors to confirm its awareness and understanding of UPMIFA principles and how they may relate to the investment and management of the organization’s portfolio—including opportunities that UPMIFA might provide for greater asset access and investment flexibility.

7. Regulatory Oversight
The investment committee should work with the general counsel to gain a working appreciation for the regulatory scenario that supervises the investment management activities of the organization. The committee should be particularly sensitive to the perspectives of state and federal charity officials (e.g., the state attorney general and the IRS Exempt Organizations Division) concerning prudent investing and protection of restricted gifts, and their willingness to intervene when there is immediate risk that charitable assets may be placed in jeopardy by imprudent investment practices (see, e.g., the New Jersey Attorney General’s 2009 challenge to Stevens Institute of Technology). It is reasonable for the committee to expect increased charity official interest in the investment performance of the organization’s portfolio during periods of financial market volatility. Particular scrutiny may be prompted by disclosures of extraordinary losses, self-dealing in the investment management process, exceptionally aggressive investment decisions, and lack of board or committee oversight of investment advisors.

The current economic uncertainty and volatile financial markets is sufficient to place the investment committee of the non-profit hospital or health system “on notice” that increased attentiveness to its organization and operation may be in order. By its very nature, the investment committee carries with it particular responsibility given its role in preserving and expanding charitable assets under investment. Accordingly, the committee should be very busy, with an active agenda, making sure that it structured appropriately to respond to these emerging challenges. The failure to do so in view of the existing climate could be viewed by charity officials and donors as a lapse of prudent oversight, particularly if the portfolio suffers extraordinary loss due to developments that could be fairly attributed to lack of full committee engagement.

The Governance Institute thanks Michael Peregrine, partner, of McDermott Will & Emery for contributing this article. He can be reached at mperegrine@mwe.com. Michael Peregrine would also like to recognize the many valuable contributions of his partner Julie Kwon to the preparation of this article.