With the stock market in turmoil, a growing number of states are loosening restrictions that prohibit charities and other non-profit groups from spending money from endowment funds that have dropped in value.
Most states limit or prohibit non-profits from spending money from an endowment fund that is "underwater," meaning its current market value is below what it was when it was given to the institution, also known as its "historic dollar value."
Over the past year, however, 14 states, including Connecticut, Delaware, Tennessee and Texas, have passed a uniform law giving endowments more flexibility to spend money from funds that are underwater.
A number of other states, including Michigan, Minnesota, Vermont and Kentucky, are considering the legislation.
As of June 2007, 16% of 767 educational endowments had funds that were underwater. The shortfall represented 1.7% of the funds' $341.3 billion in combined assets, according to Commonfund, a Wilton, Conn.-based investment management firm. That's an improvement from 2006, when 28% of educational endowments had funds that were underwater, accounting for 6.2% of their total assets, Commonfund said.
Essentially, the law — the Uniform Prudent Management of Institutional Funds Act — allows managers to spend from a fund even though it is below its historic dollar value provided their spending is "prudent."
The law also redefines the meaning of "prudent investing," making the preservation of the fund the top priority and taking into account other considerations, such as the state of the economy and the needs of the organization, said Barry Hawkins, partner in Shipman & Goodwin of Hartford, Conn., and chairman of the drafting committee for the National Conference of Commissioners on Uniform State Laws, which wrote the act.
Related accounting requirements are still being worked out by the Financial Accounting Standards Board of Norwalk, Conn., which wants to set a standard for how funds' restrictions are defined, and mandate more disclosures from endowments.
The FASB is accepting public comments on those proposed requirements until April 18.
Some who advise non-profits worry that the rule changes give endowment managers too much discretion.
"The act is a blessing and a devil in disguise," said Andrew Grumet, a counsel with Schiff Hardin LLP of New York. "A lot of it will apply to the individuals who are responsible for running the endowment. These individuals are going to have to understand fiscal discipline."
Expanding the definition of "prudence" may not be enough, he said.
"The 'prudent behavior' definition is not a safeguard," Mr. Grumet said. "It comes down to an issue of educating the board members with respect to what it means to be prudent and what their responsibilities are to those funds. That's something that is not easily legislated."
Responding to concerns about removing numerical barriers, the National Conference of Commissioners on Uniform State Laws included an optional provision under which spending more than 7% of a fund's assets is considered imprudent unless an organization can justify doing so.
Six states have included that provision in their law.
An increase in donations of individual stocks in recent years has put many endowments at the mercy of the stock market. In 2003, for example, 54% of educational endowments and 48% of community foundations had funds that were underwater, according to Commonfund.
David Bahlmann, president and chief executive of the Ball State University Foundation in Muncie, Ind., said: "It caused a significant amount of confusion and angst in the field as to how to deal with these funds."
Giving managers more flexibility could be timely given the recent market downturn.
"We're in one of those periods now," said Jeffrey Mechanick, a not-for-profit staff specialist and project manager at the FASB. "And this period may end up being like what we experienced in 2001 and 2002. The act allows them some way to manage during periods of short-term difficulty."
Some advisers see the law as a meaningful update.
"It will provide more investment and distribution flexibility," said Randy Fox, a founding principal of InKnow Vision, a Chicago-based consulting firm that advises clients with net worth of $10 million or more in estate planning and wealth management.
"Times change," he said. "This act still mandates prudence. It just expands what that means in today's economic environment. I don't think the door is open for abuse."
E-mail Sue Asci at email@example.com.