Nonprofit Law Prof Blog

Did Nonprofit Investment Strategies Worsen Economic Crisis?

A report by the Tellus Institute argues that risky investment strategies by big nonprofit endowments played a role in making the economic crisis worse.

The report studied the investment strategies at six privately endowed New England colleges and universities: Boston College, Boston University, Brandeis University, Dartmouth College, Harvard University, and MIT. The report finds that the aggressive investment strategies used by the managers of the endowments at these institutions exacerbated the economic crisis.  Here are a few of the reports' conclusions:

• By engaging in speculative trading tactics, using exotic derivatives, deploying leverage, and investing in opaque, illiquid, over-crowded asset classes such as commodities, hedge funds and private equity, endowments played a role in magnifying certain systemic risks in the capital markets. Illiquidity in particular forced endowments to sell what few liquid holdings they had into tumbling markets, magnifying volatile price declines even further. The widespread use of borrowed money amplified endowment losses just as it had magnified gains in the past.
• College governing boards have failed to guarantee strong oversight of the Endowment Model by relying heavily upon trustees and committee members drawn from business and financial services, many from the alternative investment industry.  . . . To take only one example, Dartmouth’s board has included more than half a dozen trustees whose firms have managed a total of well over $100 million in investments for the endowment, over the last five years. Even when there are not potential conflicts of interest, the oversight abilities of many trustees and investment committee members seem to have diminished because of their professional connections to the shadow banking system or their corporate directorships.
• Although they had little responsibility for endowment management or oversight, students, faculty, staff, alumni, and local communities are bearing the brunt of the Endowment Model’s consequences: from widening pay inequity to demoralizing layoffs, hours and benefits cuts, and hiring and pay freezes; from program cuts to reduced student services; from construction delays and stalled economic development to forgone tax revenues. Because these six schools are among the very largest employers in their communities, the widening pay gap between over-compensated senior administrators and more modestly compensated staff not only distorts pay structures on campus but also deepens social inequality within surrounding communities.

Perhaps more surprising is that the report directly attacks tax-exemption as part of the problem. In essence, the report argues that tax-exemption and its related tax benefits (e.g., the contributions deduction) facilitated the risky investment strategies.  Again, a few quotes:

• As major property holders in their communities, the six schools in our study own tax-exempt real estate worth more than $10.6 billion, yet collectively they made negotiated payments in lieu of taxes (PILOTs) totaling less than 5% of the $235 million in taxes they would owe if they did not have the privilege of their tax-exempt status. Some schools make no PILOTs whatsoever.
• Gifts to endowment are tax-deductible to donors, and investment gains and income that endowments generate are tax-exempt. Endowment managers can therefore rapidly trade without considering the potential tax consequences of their investment decisions.
• Tax-exempt bonds have allowed colleges to borrow at low interest rates while keeping their endowment assets fully invested in high-risk, high-return investments. Endowments pocket the difference in yields tax free, while investors in tax-exempt bonds also receive favorable tax treatment on income. Congressional leaders and the Congressional Budget Office are exploring how colleges benefit from this indirect tax arbitrage when they use tax-exempt bond proceeds for operating expenses in order to use other investments to chase higher rates of return. Because of the excessive levels of illiquidity in their investment portfolios, colleges have increasingly turned to the bond markets for cash.

Not surprisingly, the report recommends wholesale changes in endowment investment strategies. "Endowments need to foster greater resilience in times of crisis by investing in assets with greater liquidity and lower volatility, and a portion of excess returns generated during good times needs to be set aside in rainy-day funds for the bad. But more fundamentally, endowments need to pursue “responsible returns” that remain true to their public purpose and nonprofit mission as tax-exempt institutions of higher learning. By integrating sustainability factors into investment decisions and becoming more active owners of their assets, endowments can begin to seize the opportunities of long-term responsible stewardship."

While I don't necessarily agree with all the points made in the report, it does generate a lot of food for thought.  For example, the decline in value of endowments has been reported to death, but the press has generally ignored the collateral consequences (layoffs, salary reductions, etc.) that the endowment "crashes" caused in their local communities.  On the other hand, the big profits made in the boom years almost certainly helped create a boom in the local economies at the time.  So, I wonder: should tax-exempt organizations adopt more conservative ("sustainable" in the words of the report) investment strategies because of their quasi-public role?  I frankly don't know about this one; I'll have to cogitate on it some . . . 

JDC

Massachusetts Towns Taxing Empty Church Properties

This story in the Boston Globe details how nine cities and towns in the Boston area are forcing the Roman Catholic Church to pay property tax on closed church and school buildings, under the theory that these properties are no longer being used for exempt religious purposes.  Although the Church is fighting these communities in some cases, the law in Massachusetts seems to be on the side of the tax assessors.

Indeed in most states, property tax exemption is based on two separate, though related requirements.  First, the owner of the property must be a charity, and second, the property must actually be used for charitable purposes.  Mere ownership by a charity generally is not enough for property tax exemption in most states - for example, in Illinois, at one time the thrift stores operated by the Salvation Army were considered taxable property because the courts had held that the stores were commercial enterprises, not used for charitable purposes.  Another common example of this doctrine in applications is that tax-exempt hospitals often pay property taxes on office buildings rented to doctors, again under the theory that the use of such property is commercial, not charitable.

While property owned by charities but used for commercial purposes is not exempt in most (perhaps all, though I haven't done a 50-state survey lately) states, it is less clear whether property that is unused would fail the charitable use test.  For example, it is unclear how most states would treat a vacant lot owned by a Church that was adjacent to the church building and essentially held for future expansion.  Given the reality of the demands on local taxing bodies, however, I expect to see more examples of the "unused property is taxable" approach in other jurisdictions.

JDC

IRS Requests Comments on Nonprofit Hospital Provisions in Health Care Reform Act

In Notice 2010-39, the IRS is requesting comments on new section 501(r), added to the Internal Revenue Code (Code) by section 9007(a) of the Patient Protection and Affordable Care Act (otherwise known as the health care reform legislation).  We previously blogged about the new provisions of the Act here and here.

The notice is interesting because it quotes the Joint Committee on Taxation's Technical Explanation of the law's provisions.  For example, with respect to the community health needs assessment requirement, the Technical Explanation states that the CHNA “may be based on current information collected by a public health agency or non-profit organizations and may be conducted together with one or more organizations, including related organizations.”  On the financial assistance policy requirement, the Technical Explanation finds that “[t]he policy must prevent discrimination in the provision of emergency medical treatment, including denial of service, against those eligible for financial assistance under the facility’s financial assistance policy or those eligible for government assistance.” 

Perhaps most interesting are the Technical Explanation's comments about the provisions relating to limitations on charges and billing/collection.  With respect to the former, the Explanation notes that “[i]t is intended that amounts billed to those who qualify for financial assistance may be based on either the best, or an average of the three best, negotiated commercial rates, or Medicare rates.”  On the latter, the Explanation states that “extraordinary collections include lawsuits, liens on residences, arrests, body attachments, or other similar collection processes.”  The Explanation also finds that “[i]t is intended that for this purpose, ‘reasonable efforts’ [e.g., the part of the bill that prohibits extraordinary collection efforts before "reasonable efforts" have been taken to determine whether the individual is eligible for assistance under the hospital organization’s financial assistance policy] includes notification by the hospital of its financial assistance policy upon admission and in written and oral communications with the patient regarding the patient’s bill, including invoices and telephone calls, before collection action or reporting to credit agencies is initiated.”

I expect the American Hospital Association will have its members commenting in force; it will be interesting to see what other comments the IRS gets on these provisions.  Comments should refer to Notice 2010-39 and be submitted by July 22, 2010, to:

Internal Revenue Service CC:PA:LPD:PR (Notice 2010-39) 
Room 5203 
P.O. Box 7604 
Ben Franklin Station 
Washington, DC 20044

JDC