Imagine creating a private foundation which benefits your favorite charity. You carefully craft the purpose to maximize your impact. You set up metrics to measure your impact and have outside professionals at the ready to measure the impact’s quality. You, your attorney, your trusted financial advisor, and a member of a national charity sit on the board of directors for no compensation. The members of the board work well together until your death. After your death, the board appoints a representative of the charitable beneficiary to the board. A short time later, the people you appointed are off the board.
The new board members change the state of incorporation, amend the corporate charter to benefit their favorite charities, and hire the new president’s son as the financial advisor. In addition, the new board terminates any outstanding grants made by the prior board to the charitable beneficiaries you chose.
The board members incur substantial travel expenses, increase their compensation, and make grants to charities with which they have some connection. Your attorney contacts the state attorney general’s office, but no one is interested. Your attorney contacts the IRS, advising that the corporate charter has been changed, but no response. Slowly, it becomes apparent that your foundation has been hijacked, and your attorney is powerless to stop it.
Unfortunately, this situation is not uncommon. For example, the Carl B. & Florence E. King Foundation case, in which the Texas attorney general obtained a judgment exceeding $21 million from the officers, directors, and former officers and directors, is an example of this type of hijacking of a charitable organization. Also consider the sorry state of affairs in Hawaii regarding the charitable trust created under Bernice Pauahi Bishop’s will. That trust had intervention by the IRS (audit settled for $85 million), state attorney general, federal courts, and the Governor.
A similar problem occurs with “mission drift,” in which a foundation’s purposes and activities change over time. Many observers consider the Ford Foundation to be a classic case. After the death of its founder, it undertook a number of projects that would have been antithetical to Henry Ford’s conservative social and political views. If such changes are dramatic or extreme, they can likewise amount to a hijacking.
While the hijacking of the foundations just described may be extreme, hijackings are more common than one would expect. After experiencing a hostile takeover of my client’s charitable foundation firsthand, I resolved to prevent a future hijacking.
Choice of Entity
To prevent a hijacking, one of the most important factors is the choice of entity. For tax purposes, foundations can be created as either corporations or trusts. A number of factors must be considered in choosing the best entity for the foundation, including tax issues such as differences in tax rates if the charity recognizes unrelated taxable income or has unrelated debt-financed income.
As a general rule, corporate charters are easier to amend than a trust. Unlike a corporation, a trust is often difficult to change. Not only will the attorney general be involved, at least in most states, but a court proceeding may also be necessary to amend or modify a trust. The doctrine of cy-près allows courts to change the purposes of a charity upon showing that the charitable purposes are impossible to achieve or unlawful, which requires that a high burden be met. In addition, even if the doctrine of cy-près is applicable, the Trustees named in the trust are usually significantly more difficult to change, thus improving the likelihood of achieving the donor’s goals.
Because irrevocable trusts are generally difficult to change, a foundation formed as a trust has the distinct advantage of being difficult to hijack, unless the Trustee is hijacking the charity and the charitable purpose becomes impossible to discharge. However, the risk of a Trustee hijacking a trust can be minimized by carefully choosing the Trustee and ensuring that sufficient safeguards are built into the trust. The remainder of this article is dedicated to discussing some of the safeguards that can and should be built into a charitable trust to minimize the risk of a Trustee hijacking a trust.
When drafting a charitable trust, consider a trust provision that requires mandatory distributions to a specific charity or for a very narrow charitable purpose. This charitable purpose can be very detailed and should be carefully crafted. In fact, more attention should be given to describing the charitable purpose and the donor’s goals than to almost any other issue. For example, a trust could require that 5% of the trust property be distributed to XYZ school, and that no other distributions be made. In the alternative, the trust could set forth a range for the amount to be distributed.
Another option to consider is a poison pill. A poison pill could be structured such that if the 5% distribution to the XYZ school is not made for a period of time, the trust will terminate or a new Trustee is automatically appointed. In the alternative, the charity could be given the ability to remove the Trustee and appoint a new successor Trustee. While great care must be taken when drafting these types of provisions to ensure the trust qualifies for a charitable deduction, a poison pill should chill any change affecting the distributions to the named charitable beneficiary.
Similar to an irrevocable trust, a charitable trust could name a trust protector. For example, the trust protector could be given the power to veto any change of the charitable beneficiary or any distribution, including fees. The trust should also require that the trust protector be given notice of any proposed modification to the trust, including changes of situs, significant changes in distributions, and approval of any membership dues and other significant expenses.
To minimize the Trustee’s ability to amend the trust, the trust protector could be given the power to alter or amend the administrative provisions of the trust, as the Trustee deems appropriate. It is vitally important that the trust protector not be given the power to change the charitable beneficiaries, unless such change meets some objective criteria.
Consideration should be given to when or if the trust should terminate, liquidate, or merge. It may be best to permit such changes only when it is extremely difficult or impossible to discharge the trust’s charitable purpose. It is important to be mindful that the trust must also be protected from the whims and vicissitudes of the trust protector, as well as the Trustee. Furthermore, if a trust protector is named, it is wise to also name a successor trust protector or a method by which the trust protector can be changed.
Change of Trustee
Consider requiring that the appointment of new Trustees must be by unanimous consent of all the Trustees and the trust protector, if there is one, as well as the consent of the primary charitable beneficiary, if any. Although these provisions increase the complexity of trust administration, they also reduce the risk that a successor Trustee will have ulterior motives. Of course, there are real risks to this particular power. First, a charitable beneficiary, if a Trustee, is unlikely to ever consent to its removal even if such a change is in the trust’s best interest. Second, it may be very difficult to obtain unanimous consent. Finally, care needs to be taken to make certain that the successor Trustees can work together.
Where Only a Corporation Will Work
Sometimes, only a corporation will do (e.g., significant amounts of unrelated business income are expected). Because a corporation will usually result in a lower tax, due to the compressed tax rates of trusts, consideration could be given to a Michigan Trustee corporation, even if you don’t reside in Michigan. A Michigan Trustee corporation is a corporation created by the Trustees of a charitable trust for the express purpose of carrying out the provisions of such trust. A Michigan Trustee corporation has all the powers of a corporation, but is charged solely with carrying out the terms of the trust. In sum, a Michigan Trustee corporation is a hybrid entity. It can have the flexibility and taxation of a corporation, but with the limited scope that can only be provided by a trust.
Great care must be taken in the early stages of creating a foundation. Both the effectiveness of the foundation and an increased likelihood that the foundation will accomplish the donor’s objectives can be achieved with careful drafting. To minimize the likelihood that a foundation will be hijacked, the entity should be a trust. Safeguards, like the appointment of a trust protector, need to be included in the trust instrument to protect the trust from the Trustee. The provisions which can be included in a trust to reduce the risk of a hijacking are limited only by the diligence and imagination of the attorney.