Since the arrest of Bernie Madoff on December 12, 2008, the story of the convoluted dealings that fooled both the financial cognoscenti and the simply greedy has unfolded, and each organization in its own way has struggled to evaluate the impact of the unraveling empire on its own fortunes. And it continues to unravel.
 
On January 16th, 2009, Andrew Cuomo, New York Attorney General, subpoenaed 15 nonprofit organizations that had invested with Mr. Madoff, along with Ezra Merkin (former chairman of GMAC, the financing arm of General Motors), who managed hedge funds that acted as “feeder” funds to Bernie Madoff. Mr. Merkin was on the boards of at least six major nonprofits. “We regulate charities,” Mr. Cuomo pointed out in a statement at the time of the arrest, “so we have a particular interest in that regard.”

Indeed. With regulatory responsibility over tax-exempt organizations, which enjoy the public trust, Mr. Cuomo may invoke the powers of the Martin Act, which allows a case to be brought even without evidence that there was intent to commit fraud. In other words, ignorance will not likely be considered an adequate defense for anyone who, unwittingly or otherwise, steered investments toward Mr. Madoff’s ultimately disastrous funds.

This has important implications, not only for Mr. Merkin, but for anyone with the responsibility for making investment decisions for others, including organizations they serve as board members, whether for- or non-profit. Because the board of directors is ultimately responsible for the activities of an organization, it can become the target for criticism or legal action when things go wrong, and failure to live up to fiduciary responsibility is a serious charge.

As trustees of the organization’s assets, board members must be able to demonstrate that due diligence has been employed in decision making, particularly with regard to the oversight of financial matters. While individual board members are responsible for their own actions, the full board is responsible for the board’s decisions. This means that board members must hold each other as accountable. The existence of an investment committee does not substitute for oversight by the rest of the board, nor does it absolve individual board members from the responsibility to make prudent decisions. Engaging an investment advisor, even on a contractual or periodic basis where a full-time engagement is not feasible, is a strong indicator of a responsible board.

But nothing absolves the board from its single most important responsibility as a fiscally accountable body of trustees – that of acknowledging the responsibilities that come with being a beneficiary of the public trust. Generally speaking, nonprofits are deemed to be holding assets, including investment funds, in trust for the benefit of their constituencies and the charitable purposes for which the organization was formed. In the midst of today’s financial turmoil, certain past decisions look foolish and irresponsible in retrospect. But back when organizations were earning double-digit returns, it may have been more difficult for a board member to speak up. The “culture of comfort” that exists in many boardrooms may implicitly discourage those who question the board “expert.” A board member who challenges the way in which returns are being measured, or suggests that prudent investment demands a focus on long-term sustainability rather than stratospheric short-term results, can be made to feel naïve or ill informed. 

But there is no shame in asking questions; in fact, the best boards make it a habit to do so. The boards of nonprofit organizations now suffering from depleted endowments and that are now embroiled in the legal mess of the Madoff scandal could have avoided the situation by understanding, and employing, the basic rules of investing:

First, it is critical to have an investment policy and strategy to guide decision making.  Second, have access to investment expertise, not just on the board but in a third party.  Third, assets must be diversified, rather than concentrated in one type of investment. Finally and perhaps most importantly, define and understand risk. Ask questions around the board table: “Do we understand the risks we are taking here? Not just the probability of something going wrong but also the consequences for our organization if it does? Are we in compliance with our own conflict of interest policy? The Uniform Prudent Investor Act? How will this transaction appear to others; can we justify our decision? Regulation aside, does this decision pass the ‘sniff test’?”

Regulation, while a necessary constraint on behavior, is very often ill-suited to anticipate and cope with the speed and complexity of today’s financial system. By the time a new regulation has been designed, vetted, and passed into law, the problem it was designed to deal with has long ago been dealt with or “worked around” and an entirely new challenge is already on the scene. What is needed alongside of regulation to prevent abuses like the Madoff case is a strong set of principles, emphasizing oversight and disclosure, that will encourage and reward good judgment.

In the end, it is the responsibility of board members to adhere to these principles, ask prudent and timely questions, and not get too comfortable in their ways. Let the lessons of the Madoff scandal serve as a wake-up call: as foundations have closed and nonprofits are struggling to make up for the losses, let us redouble our resolve to truly honor and uphold our roles as guardians of the public trust, and perhaps all these shocking losses will not be in vain.

By Linda Crompton, President and CEO, BoardSource