05/05/2016 03:55 EDT | Updated 05/06/2017 05:12 EDT

Foundation Culture Requires A Revamp To Achieve Best Operating Practices

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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.

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 fundraising 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.

In worst case scenarios, investment committees often form cozy relationships with both administrators and 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 independence, 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.

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 to 12 per cent 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 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. 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' 29 red flags. If true, 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.

Final Words

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.

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