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May we use margin loan to bail out operations?

Your Legal Questions Answered

May we use margin loan to bail out operations?

You may not have fully understood my question last week about taking a margin account loan secured by our organization’s endowment. The loan was not used to purchase additional securities but was actually used for an operations bailout following some very poor financial management. My understanding is that the board was unable to find a commercial lender and this was the solution. Does this use of the loan proceeds at the time make a difference?

This presents a very different situation than the one I mistakenly understood last week.  I think this one has much more risk for the directors.

I think the unrelated business income tax analysis is the same and any income generated by the account or any unrelated business income generated with property acquired with the proceeds of the loan will be subject to unrelated business income tax (“UBIT”) because the assets are likely to be considered "debt financed property" subject to "acquisition indebtedness."

The issue of fiduciary duty, however, is significantly different.  It is pretty clear that the members of the board could be personally liable to the organization (and perhaps criminally liable) if they simply took funds which were supposed to be held in perpetuity and spent them currently. In Pennsylvania, the CEO of a hospital group was criminally convicted for misusing funds entrusted to the organization for purposes other than those for which they were entrusted.

Several years ago we searched nationally without finding a case precisely on point dealing with personal liability of directors making a "loan" from the endowment to operations.  (It is hard to argue that the loan was a prudent investment when no commercial lender would make it.) We did find cases in which charities had obtained court approval to make an endowment "loan" to their own organization when there was a clear plan to pay it back and the organization might have been lost if it did not obtain an infusion of capital.  Those cases were usually brought before the "invasion" of endowment, not afterwards.

My own analysis is that making a "loan" from the endowment to operations involves a breach of the fiduciary duty of loyalty because the directors have a duty of loyalty not only to their own organization, but also to the people who will benefit from the purpose of the endowment in future years and to the organizations that would potentially receive the endowment if the current organization fails.  Therefore, if the directors breach that duty of loyalty to posterity and fail to repay the "loan," they could be personally liable for the cost of the failure.

That is a long way of saying that I think this is a really bad idea. You should undo it as soon as possible.

Tuesday, October 2, 2012

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