In community associations, the collection of assessments is the primary source of revenue for the operation and maintenance of the community. Boards of Directors, with excess capital not currently allocated or needed in the immediate future, are turning to investment and financial planning as a means of maximizing these fixed, limited resources. Putting idle money to use can preserve the association’s purchasing power, increase its asset base and act as a hedge against the imposition of burdensome special assessments.
The current success of the nation’s economy and its various investment markets have encouraged many boards to consider investing as a means of improving an association’s financial position. Any cautious board, however, will want to consider the duties and ramifications of investing association money prior to undertaking such an endeavor. Two areas of concern, the standard of care associated with investing association money and the development of an association investment policy, have been addressed by recent legislation in Colorado.
Standard of Care
For many years, the operative rule governing investments by fiduciaries (boards of directors are fiduciaries of the association) was the Prudent Man Rule. This legal doctrine can be traced to an 1830 case heard before the Supreme Judicial Court of Massachusetts. In that case, the judge wrote that when investing, a trustee (or other fiduciary):
. . . is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.
Narrow judicial interpretation of the Prudent Man Rule led to severe limitations in the types of investments that could be made. First, nothing was more important than the preservation of capital; as such, the primary responsibility of a fiduciary was never to lose money while investing. Additionally, investments were expected to generate income, which rendered non-income producing assets (i.e., a valuable painting) suspect, if not inappropriate. Lastly, to determine whether a fiduciary acted prudently, each investment was judged independently, irrespective of the performance of other investments.
By judging investments independently, board members could be held liable for losses incurred in a portfolio, even if the portfolio’s overall performance was excellent. The standards of preserving capital, realizing income on every investment and judging each investment independently made it difficult for fiduciaries to invest in anything other than U.S. governmental securities and high-grade corporate bonds. Today, however, the mandates of the Prudent Man Rule are no longer the standard in evaluating prudent investing.
The Prudent Man Rule fell into disfavor in the 1960s and 1970s with the dramatic increase in inflation and academic studies concerning the use of portfolio theory investing, or controlling risk by combining diversified assets (a “portfolio” is simply a collection of assets). State statutes and judicial interpretation of those statutes have reshaped the way in which fiduciaries approach investing. The arcane Prudent Man Rule eventually gave way to the Prudent Investor Rule.
In Colorado, the Prudent Investor Rule is codified at C.R.S. §15-1-1101, et. seq., known as the “Uniform Management of Institutional Funds Act” (“UMIFA”) and at C.R.S. §15-1.1-101 et. seq., the Uniform Prudent Investor Act (“UPIA”). The purpose of these acts was to counter the stagnant effect on investments embodied in the Prudent Man Rule.
Under the UMIFA, specifically C.R.S. §15-1-1108, the standard of care in making investments is as follows:
. . . members of a governing board shall exercise ordinary care and prudence under the facts and circumstances prevailing at the time of the action or decision, and in so doing they shall consider long- and short-term needs of the institution in carrying out its . . . purposes, its present and anticipated financial requirements, expected total return on its investments, price level trends, and general economic conditions.
The standard of care for UPIA is similar. Specifically, C.R.S. §15-1.1-102 states:
(a) A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust….
(b) A trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.
These standards of care, unlike the Prudent Man Rule, focus on the investment process, as opposed to classifying an investment or course of action as prudent or imprudent per se. In other words, hindsight is no longer a component of the investment standard. Moreover, a board is to consider “expected total return on its investment.” The effect is that capital gains are placed on an equal footing with dividends and income.
Collectively, the standard of care allows a board to include riskier investments in its portfolio without fear of being held liable, after the fact, for the losses on any one investment. The “risk” one often assumes is that of market risk, or the risk that all investments will decline in value. Risk, however, is a broader concept, including individual investment risk, liquidity risk and inflationary risk, to name a few.
Inherent in UMIFA and UPIA is the requirement that a fiduciary follow the portfolio theory of investment. The portfolio theory of investment is a hedge against some risk, however some measure of risk will always remain. However, the ability to encounter risk is not carte blanche to engage in solely speculative or high-risk/high-yield investments. Combining some elements of risk with traditionally conservative investments (the portfolio approach) is what is envisioned in the Acts’ protection from liability. In evaluating anticipated returns, the Acts acknowledge the importance of protecting a portfolio against inflation. UMIFA provides that a board is to consider “the long- and short-term needs of the institution,” as well as “price level trends and general economic conditions.” UPIA provides that an investor shall consider “the possible effect of inflation or deflation” among other circumstances.
Another significant change embodied in the UMIFA is the express authority for a board to delegate investment authority. A board can now “delegate to committees, officers, or employees of the institution or the fund” and “contract with independent investment advisors, investment counsel or managers, banks, or trust companies.” This new authority is a reflection of the tremendous complexity associated with modern investing.
In order to delegate investment authority, a board must use reasonable care and skill in selecting the advisor, directing the advisor and reviewing the advisor’s performance. If the board delegates authority to an outside advisor, it must convey to that advisor the Association’s investment policy objectives. The effect of this provision is that if a board delegates investment authority in a prudent manner, they may not be liable for the actions of those to whom they delegate or for any investment losses. Conversely, a board retains full responsibility and liability if they fail to delegate or do so carelessly.
Effective May 26, 2006, members of a board in Colorado are subject to the standard of care set out in section 7-128-401 of the Colorado Revised Nonprofit Code when investing association reserve funds. This section of the Nonprofit code addresses the general standards of care required by directors and officers of nonprofit corporations. The standard now requires the board to invest reserve funds in good faith and with the care of an ordinarily prudent person in like circumstances would take.
Investment Policy
Written investment policies are a critical tool for community associations. Effective January 1, 2006, investment policies concerning the investment of reserve funds were required by law. An investment policy helps the board, the membership and outside advisors understand the association’s goals and the level of risk the association is willing to expose itself to in order to achieve those goals. More significantly, they provide a guiding document that translates the association’s objectives into action.
Some considerations to make in formulating an association’s investment policy include :
- Delegation of authority to a financial committee and/or outside advisor.]
- The primary investment objective of the association.
- A description of the assets that may constitute the association’s portfolio (i.e. equity securities, fixed-income securities and short-term cash investments) and that an outside advisor is authorized to purchase such instruments. The assets in the portfolio should reflect the association’s return expectations, liquidity requirements, toleration to risk and the length of time the association is intending to invest capital.
- Asset quality.
- Asset diversification.
- Investment manager accountability. A statement with regard to an outside advisor’s conduct should address transactions the association does not want the advisor to participate in (i.e. all purchases of securities shall be for cash and there shall be no margin transactions, short selling or community transactions, etc.), social or moral concerns ( i.e. no investing in Corporation X because it pollutes the environment), reporting and cash flow.
- Potential tax consequences of investment decisions or strategies.
A board can combine these and other considerations in formulating its investment policy. Reducing an association’s investment policy to written form provides a clear understanding of an association’s investment philosophy and offer many safeguards while investing association capital.
Investing idle association capital is a good way to strengthen an association’s financial position. However, prior to making investment decisions, a board will need to make informed decisions with regard to how to allocate those excess resources. Observing the standard of care embodied in the Colorado Revised Nonprofit Code and establishing a clear investment policy is required by law and will help to ensure that the association’s capital is wisely invested. In today’s complex investment world, an outside financial advisor is also recommended for any association considering investment as a means to increasing its asset base.