Over the past century, charitable foundations have grown considerably to help meet society’s ever growing demand for assistance. From private to public, they all have one thing in common, they raise funds to support a charitable cause. Glancing through various websites of different foundations there is a common theme when reading their mission statement:
- “…develop relationships and financial resources to support the health care programs, projects and services…”
- “…its primary objective … to provide the community with the highest level of patient and family-centered care…”
- “…oversees all fundraising activities from annual campaigns to special events and corporate fundraising.”
- “…supports the hospital’s mission by raising funds through fundraising activities such as grant development, capital campaigns, special events and direct mail.”
The good work provided by the foundations and the people behind them in raising and distributing funds for worthy causes is indisputable, but what is alarming and unbeknownst to most, is that foundations are managing millions upon millions of dollars without proper oversight. Administrators’ core competency is fund raising and distributing funds to those in need. In fact, most administration teams know very little about investments all together and rely heavily on investment committees.
The funds from the foundations are managed by external managers and overseen by these investment committees, who for the most part, spend much of their time questioning the manager about their front-end strategy as well as their views of the current investment climate. Little to no time is spent on assessing the operational risk of these managers. Considering we are in the post Madoff era, operational risks to the foundations’ capital is not something one can overlook. Good governance includes thorough operational reviews of investment managers and reduces the risk of foundations’ wealth being misappropriated. Foundations need to add this core competency to their day to day management, either internally through the investment committee or administrator, or externally.
In worst case scenarios, investment committees often form cozy relationships with both administrators and investment committees. This is born out of the fact that the managers often make charitable contributions to the very foundations that they manage. Although the gesture is a noble one, it creates a conflict of interest and fosters complacency by all parties involved. To ensure independency, transparency and integrity in the management process, these types of donations should be prohibited. Although they may be helpful in the short-run, the long-term risks are too high and may compromise the foundation’s sustainability. A professional, objective relationship is required in which managers’ are not only judged by their risk-return proposition at the front-end but also by their organization’s culture to strive to achieve best operating practices.
The Need for Operational Due Diligence
Foundations need to become aware that Operational Due Diligence (ODD) is an important process in the monitoring of an existing or selection of a new manager. ODD uncovers whether the manager in question has sufficient controls to ensure that their clients’ assets are safeguarded. Foundations should never feel pressured to make an investment decision without being fully satisfied with the outcome of their findings. An ODD process would require a complete understanding of a myriad of deficiencies and put in place the necessary processes and procedures. These are the four P’s and include (but are not limited to) the following:
|FOUR P’S||Operational controls|
Madoff’s Ponzi Caused Losses for Hundreds of Foundations – All of Whom Previously Presumed They Were Safe
The concerns raised above are borne out of true stories that unfortunately, far too many of us forget and seem doomed to repeat. When the story broke in December 2008 that Bernard Madoff had been orchestrating the largest Ponzi Scheme the world has ever known, his clients were in disbelief. After all, Mr. Madoff was the former Chairman of NASDAQ, he was the father of electronic trading and a generous philanthropist. Many viewed him as having nothing but the highest degree of integrity. When all was said and done, Mr. Madoff had defrauded 4,800 victims of $65 billion. Clients were drawn by his charm and remarkable ability to consistently generate investment returns in the 10-12%-range, and with very little volatility. Down months were few and far between, and his clients felt privileged that he was managing their wealth.
Of the 4,800 clients that Mr. Madoff defrauded, hundreds of foundations were among them and can be found in the following list: http://online.wsj.com/public/resources/documents/madoffclientlist020409.pdf.
Defrauded foundations included:
- Carl and Ruth Shapiro Family Foundation
- Fairfield Town Employees Board and Police and Fire Board
- Foundation for Humanity
- JEHT Foundation
- North Shore Long Island Jewish Health System Foundation
- Steven Spielberg’s Wunderkinder Charitable Foundation
- Tufts University
Once the scandal broke, many of the foundations that were invested with Madoff went out of business immediately because they had invested all of their wealth with his firm. The most unfortunate thing of all is that foundations could have easily avoided placing capital with Madoff had they simply engaged in an ODD process. A proper ODD would have led them to at least some of Harry Markopolos’ twenty nine red flags, seven of which were:
- Madoff did not allow operational due diligence to take place, so with this information investors should have immediately refused making a capital allocation to him.
- Unusual fee structure in which Madoff was only paid in trading commissions at his securities business, which was well below what he was paying feeder funds to bring in client capital.
- Lack of Segregation amongst service providers where functions such as calculation of the fund’s Net Asset Value and Custody of the Fund’s holdings were all performed internally.
- Madoff was not registered with the SEC, thus avoiding any regulatory oversight.
- From a common sense perspective, if Madoff were truly capable of delivering 10-12% per annum as was proclaimed, he would have been better off borrowing money, investing it for himself and then keep all of the profits.
- Madoff demanded secrecy from all of his clients and would return their money if they were caught boasting about being invested with him.
- Madoff’s returns plotted perfectly on a 45 degree angle, with low volatility and few down months. This was too good to be true.
If all of the above evidence existed in addition to twenty-two other red flags, why wasn’t Madoff exposed? Well, when the party is going on no one wants to be known as the one taking the punch bowl away. As well, many investors simply dismissed any accusations because they were enjoying the ride. In the end, Madoff never purchased one stock for his clients, rather he deposited their wealth in his own bank account and used it to finance an incredible lifestyle.
Jack Welch, General Electric’s long-time CEO, provided the following advice: “Change before you have to.” Within this spirit, foundations’ administrators and investment committees must acknowledge that their complacency in proper operational oversight essentially means that they are failing at their fiduciary duty. Performing ODD can significantly reduce the risk of malfeasance. Administrators and investment committees should only partner with managers that are open to being subjected to ODD engagements. Charitable foundations are, in most cases, prime targets for fraudulent perpetrators because they can be counted on to a large degree not to withdraw their money quickly. As such, it behooves them to act with an appropriate amount of caution.PDF version