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Charity Investment in the UK: Some Contemporary Issues for the 1990s
by
Debra Morris
Lecturer in Law, University of Liverpool< djm@liverpool.ac.uk>
Copyright © 1995 Debra Morris.
First Published in Web Journal of Current Legal Issues in association with Blackstone Press Ltd.
Summary
The investment duties of charity trustees have been highlighted recently due to the termination of the investment function of the Official Custodian for Charities (who previously held investments worth about £1.25 billion for over 40,0000 charities) together with the increased awareness of trustee responsibilities generally. In April 1995, the law relating to charity investment changed so that now charity trustees are less restricted in their investment decisions. The Charity Commissioners have also issued a number of recent policy statements concerned with investment powers. This paper examines these recent developments and argues for an even less restricted legal regime.
Web JCLI | [1995] 3 Web JCLI | Download this file
Contents
- Introduction
- Duties on investment
- Statutory Powers of Investment
- Duties on investment
- Additional Powers Under The Act
- A New Split for Charities
- Abandon the Split?
- A New Split for Charities
- Common Investment Funds
- Common Deposit Funds
- Speculative Investments
- Traded Options and Derivatives
- Underwriting New Share Issues
- Subsidiary Trading Companies
- Underwriting New Share Issues
- Charities Using Investment Managers
- The Future for Charity Investment
- The Future for Charity Investment
Introduction
In the last decade the number of charities has grown significantly, whilst their social, economic and political importance has taken on a new dimension. Their role and responsibilities have changed out of all recognition. Under what has been termed the contract culture (see Warburton and Morris 1991) charities are now being relied upon to deliver a host of services previously provided by the state. There are over 350,000 voluntary organisations in the United Kingdom and around 178,000 of these are registered charities operating under the regulation of the Charity Commission ([1994] Ch Comm Rep 6).
The Charities Act of 1992 (s 29) terminated the investment function of the Official Custodian for Charities. This led to a major programme of divestment whereby all the investments (other than land) which had previously been held by the Official Custodian were transferred back to around 40,000 charities. At the outset of 1994, for example, the Official Custodian had responsibility for 700 different securities belonging to 21,216 charities. By the end of the year those figures were reduced to 64 and 1,877 respectively. The remaining divestment was expected to be completed by March 1995 ([1994] Ch Comm Rep 22). This means that many charities who had previously had free safe custody and administrative services, and who possibly never really gave a thought to their investments, now have to do so.
The collapse of Barings Bank in early 1995 and the profound effects on the charitable world also served to focus the concern of many charity trustees upon investment decisions. Charities suffered a double blow; one of the top 10 grant making trusts, Barings Foundation had its income reduced by millions of pounds, whilst many charities had investments with Barings Bank which were feared lost.
Recent statistics reveal a 2% decline in income amongst the medium sized charities (Saxon-Harrold and Kendall 1995, 137). Such charities are struggling to adapt to a more competitive fund-raising market where increased efforts must be made in order to attract substantial funding. Charities can no longer rely on legacy income and general donations. They must maximise their funds by sensible investment policies. The proportion of charities' investment income illustrates the central importance of maximising the returns to be made from investment opportunities. The total income of registered charities in 1991 was approximately £9,100 million of which £1,400 million (15%) came from investments (Saxon-Harrold and Kendall 1995, 23). It has been estimated that charities own in aggregate some £26 billion worth of investments, excluding property (Cambridge Market Intelligence 1995, 164).
Duties on investment
One of the most difficult roles of charity trustees is the responsibility that they have for investment of charitable funds. It is the duty of every trustee, whether of a charitable trust or a private trust, to invest trust funds and, in general, the law applying to charity trustees is the ordinary law of trusts relating to investment.
Trustees are not necessarily immune from liability for breach of trust merely by showing that their investments are authorised. Having established the authority to invest in a specific investment, whether it be due to a statutory power or a power in the settlement, trustees are then under further duties. In Nestle v National Westminster Bank [1993] 1 WLR 1260 Dillon LJ approved the words of Lindley MR from a nineteenth century case:
"The duty of a trustee is not to take such care only as a prudent man would take if he had only himself to consider; the duty rather is to take such care as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide." (Re Whiteley (1886) 33 Ch D 347, at 355 per Lindley MR)
The principle remains applicable however wide, or even unlimited, the scope of an investment clause in a trust instrument may be.
The Trustee Investments Act 1961 (TIA 1961) also imposes upon trustees a general duty, in the exercise of their powers of investment, whether statutory or otherwise, to have regard to:
(1) the need for diversification of investments of the trust, in so far as is appropriate to the circumstances of the trust; and,(2) the suitability to the trust of investments of the description of investment proposed and of the investment proposed as an investment of that description.
Charities should draw up concise investment policies which are formally adopted by trustees.
Statutory powers of investment
It is important that trustees of every charity know exactly what their investment powers are, since trustees must only invest funds in the ways which these powers allow.
In the absence of any extension of powers by the governing instruments, all trustees, including charity trustees, have the powers of investment conferred by the Trustee Investments Act 1961. Many older charities only have these statutory powers of investments. Express powers of investment are much more common in modern trust deeds.
Before the TIA 1961, trustees did not have the power to invest in shares, unless specifically given that power in the trust instrument. This became a significant restriction on the ability of trustees to make appropriate investments. The TIA 1961 (sched 1, part III) therefore gave trustees the power to invest inter alia in shares and debentures of large UK companies that have been paying regular dividends. Originally a liberating measure, the Act soon became a severe restriction, since, under it, only half of the value of the trust fund could be invested in these "wider range" investments (TIA 1961, s 2). In making the division, a valuation in writing from a person believed by the trustees to be qualified to make it (usually a stockbroker) is conclusive (TIA 1961, s 5). The other half must be invested in "narrower range" investments which consist of fixed interest securities, such as government stock (TIA 1961, sched 1, parts I and II). The Act contains other provisions whose aim is to ensure that the two funds remain divided (TIA 1961, ss 2(3) and 2(4)). There is, however, continuing debate concerning the exact maintenance of such a ratio once a charity is operating its investments - it is arguably possible to increase the value of the initial proportion which was directed towards equities, thereby shifting the ratio over time.
The TIA 1961 (s 6) also requires that trustees should obtain and consider expert advice before investing in either wider range investments or the narrower range investments requiring advice. As is always the case with trustees, although they should be guided by the advice given, the final decision is theirs. They should consider the advice and not follow it blindly.
As investment practices have changed over the years, the powers given in the TIA 1961 have for long been considered to be unsatisfactory. For example, the Act has been described as:
"tiresome, cumbrous and expensive in operation with the result that its provisions are now seen to be inadequate. Furthermore, careful investment in equities is perhaps more likely in the long run to protect and benefit both income and capital beneficiaries than is investment in fixed interest securities." (Law Reform Committee 1982, para 3.17)
The Deregulation Task Force on Charities and Voluntary Organisations published their proposals for reform in July 1994 and, in relation to the TIA 1961, said:
"The Act interferes unwarrantedly in trustees' exercise of their discretion, and prevents them from maintaining the real value of their assets and investment income. The loss in under- performance of investments since 1963 has been estimated at £450 millions per year." (Task Force on Charities and Voluntary Organisations 1994, p 22.)
The Task Force recognised four main problems with the Act: it is bureaucratic; it is costly to administer; it is arbitrary in its controls; and it goes beyond what the state ought to regulate. The principal issue has been the stipulation that a charity must maintain a basic 50/50 split between wider range and narrower range investments in order to minimise the risk to charitable investments.
Additional Powers Under The Act
Additional powers of investment were introduced through the Trustee Investments (Additional Powers) (No 2) Order 1994 (SI 1994, No 1908) which came into effect in August 1994. The Order makes no change to the requirement for division. The changes relate purely to the permitted investments within each ranges. For example, authorised gilt edged unit trusts may be classified as narrower rather than wider range investments. Also, direct investments in securities of other members of the European Union and the European Economic Area (which encompasses Austria, Finland, Iceland, Norway and Sweden) and in UCITS (European unit trusts) are now permitted.
The New Split for Charities
In relation to charitable trusts specifically, the Charities Act of 1992 made provision for the restrictive application of the TIA 1961 to be relaxed somewhat. The 1992 Act (see, now, Charities Act 1993, s 70) introduced a provision which gave power to the Secretary of State for Home Affairs to vary the proportions so that more than half the funds of a charity can be put in wider range investments. After much lobbying by charities, the Prime Minister announced in January 1995 that the ratio would be changed to 75/25 for wider range and narrower range products respectively. In April 1995, The Charities (Trustee Investments Act 1961) Order 1995, (SI 1995 No 1092) came into force, which enables charities to invest 75% of their funds in equities. Charities with fund managers are now be entering into dialogue to determine how they can benefit from the new terms.
Abandon the Split?
The TIA 1961 governs a large number of charities in their investment activities and obviously the desire of legislators at the time was to protect charitable funds from being mismanaged and possibly lost in a too adventurous position in the stock markets. But, recent activity has shown that even the best credit rating and regulatory system can fail occasionally. Barings Bank, for instance, had an A1 credit rating and charities could not have been expected to doubt the investment performance of that institution. Without a split, trustees would nevertheless be under a duty to exercise prudence and to obtain advise from regulated professionals.
Clearly, charities bound by the provisions of the TIA are at a significant disadvantage. Yet, whether trustees are bound by the Act is entirely a matter of chance as to whether or not a trust has been created with wider investment powers. There are still many areas that need to be addressed to bring the investment powers into line with present day market opportunities. Why is it, for example, that direct investment in the USA and Japan (the two largest markets in the world) is excluded, whereas investment in the European area is now authorised? Trustees can now invest directly in the emerging markets of Greece and Iceland. Also, there is a restriction which only allows investment in companies with a five year dividend history. This excludes all the recent privatisations together with many new companies, such as Vodaphone and Abbey National. Yet, many of the largest corporate failures - shares in Maxwell Communications, Polly Peck and British & Commonwealth Holdings - were acceptable investments immediately before their collapse.
Trustees may apply to the court to widen investment powers under various statutory provisions. For example, in the case of Trustees of British Museum v Attorney-General [1984] 1 WLR 418 Megarry VC sanctioned a very wide investment power and in Steel v Wellcome Custodian Trustees Ltd [1988] 1 WLR 167 Hoffman J approved a Scheme giving trustees power, subject to several safeguards, to apply a fund (worth more than £30 million) in the acquisition of any property whatever as if the trustees were absolutely and beneficially entitled. Similarly, the Charity Commissioners may grant wider powers of investment by a Scheme. They have recently announced (Charity Commissioners 1995, p 22) that unrestricted powers of investment without the requirement for any division will be conferred only in very exceptional cases and where the property available for investment is very substantial, normally in the region of £20 million. Restricted wider powers of investment will only be considered generally for a fund worth at least £1 million. This means that the powers granted in these cases are simply not available to smaller charities. For this reason, inter alia, the use of common investment funds is particularly appropriate for smaller charities governed by the TIA 1961.
Common Investment Funds
The Charity Commissioners suggest ([1989] Ch Comm Rep para 116) that following divestment by the Official Custodian, it may be advantageous for trustees to consider the advantages afforded by charitable common investment funds (CIFs) as an alternative investment medium. These are particularly appropriate for charities whose total assets are too small to justify having their own portfolio of single holdings, let alone the services of professional financial advisers.
CIFs are established by Schemes made by the Charity Commissioners (under Charities Act 1993, s 24) for the exclusive benefit of charities. They can afford a solution to many practical problems associated with investment management and can provide a sound basis for charities' investment needs. All charities are given the power (under Charities Act 1993, s 24(7)) to invest in a CIF, unless the governing instrument specially prevents this. As "special range" investments, all CIFs (irrespective of whether they are equity based or fixed interest based) sit outside the narrow/wider range division of the TIA 1961, with the result that a charity can invest any proportion of its funds in special range assets without the requirement to make a division. This allows charities greater exposure to equity related assets than is possible under the Act's division, which is thereby side-stepped (with the active encouragement of the Charity Commissioners).
CIFs enable the funds of otherwise unconnected contributing charities to be pooled and invested in a large and diversified portfolio of stocks and shares. Units in the CIF equivalent to the sum invested are allocated to each charity. The funds are actively managed by professional fund managers. CIFs give advantages similar to those of a unit trust. The benefit of expertise and the ability to spread the investment portfolio over a wider range of investments than may be available to individual charities should secure a safer balance of risk and growth than individual trustees could achieve.
Individual CIFs differ both in their investment portfolio and in the balance between capital growth and income. They do tend, however, to concentrate on either equity funds or fixed interest funds. There is now even an index tracking CIF. It is also possible for CIFs to invest solely in overseas equities but the Charity Commissioners advise that no more than 20% of a charity's portfolio should be used in overseas investments (Charity Commissioners 1993).
The administrative advantages to charity trustees of investing in CIFs are considerable. The investment process is simple and the cost of making investments and withdrawals is low. Transactions can generally be carried out for any amount and without the need to act through a stockbroker. Holdings in CIFs are registered in the name of a charity rather than in the names of individual trustees, which avoids the need to re-register new trustees on any changes in trusteeship occurring. Finally, because CIFs hold only charity funds, dividends and interest are remitted gross automatically, thus avoiding the need to claim any tax relief due.
One disadvantage of CIFs (as with unit trusts) is that investors may not entirely appreciate the nature of their shareholdings. In May 1995, several high profile charities were embarrassed to discover (through the media) that they were investing in firms that were banned from their portfolios. For example, the charity, Imperial Cancer Research Fund, through its investment fund manager, had money invested in two CIFs which had around 5% of their investments in tobacco companies.
The Charity Commissioners have always regulated CIFs on the grounds that they are subject to charity law. However, since their primary function is that of an investment vehicle, it was one of the Deregulation Task Force's recommendations (Task Force on Charities and Voluntary Organisations 1994, p 24) that their regulation should be passed over to an appropriate self regulating organisation, to be governed by the Financial Services Act 1986. The Home Office response was that the matter is under review. If the proposal is implemented, it is possible that new types of CIFs would be created more quickly and easier than in the past, as an SRO, with its broad investment experience, may be more willing to allow new types of funds, compared with the traditionally conservative Charity Commissioners.
The increased significance of CIFs as practical and effective investment vehicles cannot be underestimated. It is likely that, in the future, their role will develop even further. The Barings experience has taught investers to diversify. The CIF facility is, therefore, a considerable boon to the charitable sector - minimising risk by maximising the spread of investments.
Common Deposit Funds
Before 1992, there were doubts as to whether the Charity Commissioners could make a Scheme restricted solely to the deposit of money at interest (see [1989] Ch Comm Rep paras 120-122). With the aim of increasing the investment opportunities available to charities, the Charities Act 1992 permitted the setting up of common deposit funds which can be established along the same lines as a CIF (see now, Charities Act 1993, s 25). Similarly, all charities now have the power to participate in common deposit funds.
Speculative investments
The borderline between what constitutes an investment and what constitutes speculation for charity trustees is narrow.
Traded Options and Derivatives
The Charity Commissioners are of the view that traded options represent short term speculation, which, if mistaken, could result in early loss of capital (see [1985] Ch Comm Rep paras 65-68). They consider that traded options are not investments in the usual sense of the word and that even an investment clause giving charity trustees powers of a beneficial owner would not authorise them to purchase options. The Commissioners take this view notwithstanding that Megarry VC in the British Museum case empowered the trustees to invest in traded options. The Commissioners are of the opinion that this decision should not be taken as authority for all trustees with wide powers of investment to speculate part of their endowment in this way. The safer view is therefore that, except where specifically authorised, the purchase of options is not permissible by charity trustees, even though they may have the investment powers of a beneficial owner.
The Commissioners will not confer any general power upon charities to participate in the derivatives market, even with a limitation as to the amount which they can hazard (see Charity Commissioners 1995, pp 25-26). However, they do now concede that there may be individual cases in which the use of a particular form of derivative may be of advantage to a charity. The Commissioners' approach is a cautious one. They are willing to consider each such case on its merits and then may authorise each individual action by an Order under Charities Act s 26, rather than by way of a Scheme conferring a general power.
Underwriting New Share Issues
The Charity Commissioners have adopted a similarly cautious approach in relation to underwriting of new shares (see [1985] Ch Comm Rep para 69). They have expressed the general view that underwriting is too speculative and that it is inappropriate for charity trustees to underwrite share issues, even if possessed of investment powers akin to that of a beneficial owner. However, the Commissioners subsequently (see [1986] Ch Comm Rep paras 80-81) acknowledged that, where it is necessary and desirable for a charity which is a substantial institutional investor to obtain a significant allotment of new shares, and the trustees are receiving and acting upon investment advice of a high quality, there will be no objection to participation in underwriting arrangements, subject to certain safeguards. The Commissioners believe that there is a clear distinction between such participation and underwriting undertaken as a form of speculation with a view to making a quick profit.
Subsidiary Trading Companies
The Charity Commissioners have expressed the view that investment in a subsidiary or connected trading company may be too speculative and therefore not appropriate for a charity (see Charity Commissioners, 1984).
Charities Using Investment Managers
The general principle applying to all trustees is that they must act personally and must not delegate their duties or powers. Responsibility for a charity's investments rests entirely with its trustees. However, under Trustee Act 1925, s 23, trustees have a general power to employ and pay agents to transact business in the execution of their trusts. In the past, the Charity Commissioners interpreted this power as permitting trustees to enter into discretionary investment management agreements where the actual choice and timing of investment transactions was delegated to investment managers, but the trustees retained ultimate control by setting policy guidelines (see [1978] Ch Comm Rep Appendix C, where a former leaflet on investment of charitable funds was reproduced). However, in 1993, the Commissioners, having obtained legal advice, revised their view. It was considered that the previous interpretation was too liberal and that s 23 enabled a trustee to delegate only to a very limited extent ([1993] Ch Comm Rep paras 21-24). For example, a trustee who employs a broker to buy certain securities may leave to the broker's discretion precisely how the securities are to be acquired, but the charity cannot leave it to the broker to decide which securities are to be acquired. This means that, in the absence of an express power in the trust instrument or the authority of the court or the Charity Commissioners, (under Charities Act 1993, s 26) trustees cannot delegate the investment of trust funds to someone such as an investment manager. The Commissioners have indicated that they would normally be prepared to make an Order under Charities Act 1993, s 26 to authorise trustees to enter into an investment management agreement where the value of the charity's investment portfolio (usually over £100,000) and the frequency of transactions justify delegation. The Commissioners have published a Model Order under section 26 which allows for delegation to an investment manager (see Charity Commissioners 1994, pp 31-32).
The Future for Charity Investment
Many charities whose investments are governed by the TIA 1961 believe that it is time either to abolish the legislation entirely or to produce a new piece of draft legislation for wide consultation within the sector. The division required under the TIA 1961, whilst improved for charities by the Order earlier this year, is still administratively difficult and inhibitive. Many would argue that trustees should be given full responsibility to make their own investment decisions as long as they receive competent professional advice.
The responsibilities of charity trustees have been highlighted over recent years, following the enactment of the Charities Act 1992 and the On Trust Report in 1992 (NCVO/Charity Commission Working Party on Trustee Training, 1992) which revealed that many trustees take on trusteeship with insufficient understanding of their responsibilities. Since then, much has been done to impress upon trustees their important role. However, in the area of investment, it seems as though trustees are still not sufficiently trusted to make appropriate unrestricted decisions. This does not fit comfortably with current trend to encourage trustees to shoulder their responsibilities.
No matter how wide their authorised powers of investment, trustees will never be absolved from the necessity to obtain professional advice, to ensure that there is a reasonable spread of risk and, above all, to avoid investments of a hazardous or speculative nature. The changes in April 1995 were enacted 34 years after the passage of the original Act. It is hoped that less time will pass before charities are given complete freedom to invest where they choose.
Cambridge Market Intelligence (1995) Charity Finance Handbook 1995 (London: Cambridge Market Intelligence)
Charity Commissioners (1984) Fund-Raising and Charities, Leaflet CC20.
Charity Commissioners (1993) Investment of Charitable Funds, Leaflet CC14.
Charity Commissioners (1994) Decisions of Charity Commissioners, vol 2.
Charity Commissioners (1995) Decisions of Charity Commissioners, vol 3.
Law Reform Committee (1982) The Powers and Duties of Trustees, 23rd report, (London: HMSO)
NCVO/Charity Commission Working Party on Trustee Training (1992) On Trust: Increasing the Effectiveness of Charity Trustees and Management Committees, (London: NCVO)
Task Force on Charities and Voluntary Organisations (1994) Proposals for Reform: Deregulation Report, Deregulation Task Force.
Saxon-Harrold, S and Kendall, J (eds) (1995) Dimensions of the Voluntary Sector 1995, (Tonbridge, Kent: CAF)
Warburton, J and Morris, D (1991) "Charities and the Contract Culture" 55 Conveyancer 419.