Frequently Asked Questions

The Frequently Asked Questions provide answers to questions and issues that have consistently been raised in our discussions with non-profit organizations and their professional advisors.

From an organizational standpoint, the following questions have been separated into two distinct categories – those of a nontechnical nature versus questions that usually originated from professionals such as lawyers, advisors, accountants, etc. While we have attempted to be as clear and forthright in our answers as possible, please keep in mind that there will always be areas that require further clarification. Also, it is impossible to answer everything in a single document, especially when there are volumes of data related to each subject.

CATEGORY ONE – GENERAL QUESTIONS

• The concepts you have proposed seem too good to be true; and further, if these concepts are so good, why haven’t they been done before?

There is an old adage that most of us have heard: “If something seems too good to be true, it probably is.” While it is wise to use this statement as a reminder to be cautious, we would also like to point out that the statement does not say “If something seems too good to be true, it never is.”

If you are going to give consideration to the statement, “it seems too good to be true,” perhaps you should also consider this simple statement of fact: “Since we are not asking for anything up front, you can determine the validity of our proposals upfront without taking any risk.” Thereafter, one of two things will happen. Either you will find that the concepts are faulty, in which case you don’t have to do anything; or you will find out that the concepts are real, in which case you can choose what to do next. We welcome inquiries, have no problem talking to legal counsel, and finally, are willing to take the time to go through a due diligence process as we discuss ideas openly.

As far as answering the question as to why the concepts haven’t been done before, there are many reasons that we address in the following material.

• Are these concepts new?

No, they are not new. Every concept described in this report has been done before – although almost exclusively in the for-profit world.

 

• Why haven’t these concepts been utilized by the non-profit world?

We believe that biggest reason comes down to a simple fact – the industry is cloistered. For example, when an industry first comes into existence individuals will tend to look to any area for ideas. However, as it matures it begins to attract “specialists” who are educated or trained only in that specific industry or discipline. The pattern of developing a concept internally and then tweaking the ideas over and over without regard to concepts or strategies that may be available from other industries eventually leads to a decline in creativity. In the non-profit gift giving world this means finding out what everyone else in the industry is doing, and copying the ideas.

There may be a few other reasons as well.

Non-profit organizations typically operate differently than for-profit businesses. Administrators are hired under a different set of criteria and seldom have rigid performance requirements tied to their employment. In such an environment one is less likely to be fired by maintaining the status quo, even if it is less than successful, than attempting to make changes that might not go well, but might also solve problems. It is very similar to politics.

 Additionally, it is rare that an administrator will be aggressive on his own. Most of the time, Boards of Directors are the only ones who can effectuate real change, and seldom do they agree unilaterally to do so. Instead, the same fears that cripple administrators crop into their thinking. The decision-making mentality is centered on how not to lose versus how to win.

Also, many organizations that support non-profits are slow to embrace new ideas, and without their approval many non-profits will not act. A vicious circle begins when the non-profit administrator wants to initiate a new idea but has to seek approval from a bureaucratic Board, who then seeks opinions from outside advisors – who normally resist change. Since the advisors don’t like approving anything that hasn’t been done before, they take the safe route and recommend rejection. Since the Boards feel decisions are too risky without advisor approval, they also reject the idea. And, finally, without Board approval the administrators will not act. Over time, everyone learns – don’t take chances and/or wait until everyone else in the industry is doing what was proposed, so that no one can be judged as reckless.

 Finally, as you can probably tell by now, while the concepts themselves are fairly simple and there is a wealth of information available to back up what is being proposed, these are not ideas commonplace in the non-profit world. In order to even get to the implementation stage there is a fairly lengthy process that is required. Unless there is a commitment to learn, investigate, prove, and plan, nothing will occur. Perhaps if we were the John Hancock, Hartford Life, or AXA Equitable life insurance companies, selling a prepackaged product like an annuity, things would be different. But that is not the case.

• How come I’ve never heard of using Restricted Stock for a donation?

We can’t tell you why someone hasn’t heard of using Restricted Stock as a donative tool. What we can tell you is that there are many large institutions in the non-profit world that do have Restricted Stock donation programs and have raised large sums as a result. Just within the educational world, Harvard, the University of Southern California, Penn University, Notre Dame, and a host of other major colleges too numerous to mention have well defined RS departments. Look up “Restricted Stock donations” on the Internet. You might be surprised.

• Do these concepts require the non-profit organization to manage money or become an investment advisor?

None of the strategies discussed require the non-profit organization to manage money or become an investment advisor, any more than using an insurance product in a donative plan requires the non-profit organization to be licensed to sell insurance.

• How does such a small group of individuals come up with viable ideas when major institutions, with thousands of employees, have not even scratched the surface of offering fund raising solutions for the non-profit world?

We believe there are three primary reasons.

First, major financial institutions are busy with the business at hand and seldom have time to brainstorm new ideas, especially for unrelated industries. Like any organization that grows into a large institution, they tend to become bureaucratic in nature and the creation of new ideas becomes less important than the maintenance of current business.

Second, most large organizations will tend to pursue areas that produce the largest profits. It is the reason so many brokerage firms promote mutual funds when there are better vehicles available. In looking at many of the concepts we found attractive, we noticed the commissions and fee structures of the underlying products were relatively low in comparison to other products marketed by the large financial institutions. Asking secular companies to relinquish areas of high profit potential in favor of areas that require substantial development expenditures while producing low profit margins, is asking for more than most are willing to do. Add to that the difficulty of getting non-profits to act on any new proposals and it becomes clear most secular companies simply don’t have an interest in pursuing ideas and programs for entities that produce little profits or are difficult to penetrate.

Finally, if one goes back in history, many innovative ideas have come from individuals, not big corporations. For example, the greatest leap in computer growth came about from ideas by a small group of Harvard University students working out of their dorm rooms, not the biggest corporations of the time – Xerox, IBM, Univac, or Honeywell. (Hint: the same group eventually founded Microsoft.) In another example, in 1973, the Chicago Board of Options Exchange was founded by a small group of businessmen – not Merrill Lynch, Prudential Bache, Paine Webber, or Dean Witter – the big financial giants of the time. Option activities, which were scoffed at by virtually every large institution at inception, now represent nearly 1/3 of all trading activity.

In conclusion, while it would seem logical that big organizations would be looking to develop programs for non-profit organizations, more often than not the best ideas will tend to come from individuals or small organizations that are unencumbered with maintaining a large business enterprise and have the time and motivation to explore new ideas.

• Non-profit organizations do not operate like for-profit business entities. What problems did you uncover and how do you anticipate overcoming the obstacles?

As mentioned earlier, one of the most surprising obstacles we found was how difficult it was to work through the operational structure of many non-profit organizations. Because of the inherent bureaucracy we were usually required to make a series of general presentations to a large group of individuals (such as Board or committee members), many of whom were neither qualified to make a judgment of the concepts due to their specific lack of financial knowledge, or who had preconceived notions as to whether or not something was even worth pursuing.

This process was further exasperated when Board or committee members had been appointed based upon aspects other than their financial knowledge; i.e., individuals who had influence in the community, gave large contributions, or were recognized for their moral authority. In addition, most non-profit organizations we interviewed failed to recognize a very simple but important point – that being a lawyer, accountant, doctor, successful business owner, wealthy individual, or large-scale donor, does not automatically mean the individual has any real financial experience. In other words, just because someone is an expert in one field does not make them an expert in another. Look closely and you will also find that the vast majority of these individuals hire outside advisors.

Our solutions to the problems we encountered were uncomplicated. We resigned ourselves to the fact that no matter how difficult the process, we would simply take the necessary time to explain, educate, and encourage everyone involved to move forward. In some cases we made progress, in other cases we did not.

For example, in those cases where progress was positive, the non-profit organization’s leadership had clear vision, greater control over the bureaucratic elements of the organization, and was more progressive by nature. In those areas where we had the most difficulty, there were a myriad of reasons for delays, ranging from political infighting amongst Board members, misguided edicts, a lack of strong leadership willing to fight for the ideas, the interference of key employees who saw us as a threat to their jobs, and finally, entrenched outside advisors that saw us as competition and a threat to their business.

• Our organization has limited financial expertise. As a result, we rely heavily on outside financial and fund raising experts to assist us in money matters. What is wrong with this?

The answer is there is nothing wrong with using advisors when others within the organization lack the experience. Most non-profit organizations rely on outside advisors. While a seemingly logical solution, a number of problems still need to be addressed.

For example, related to the use of a financial advisor, one of our early test cases was an east coast educational institution in which the President of the college raved about their advisor. We were told the individual was well schooled in high finance, had been a tremendous asset to the college, and was someone we should get to know. Unfortunately, after a short time we found the advisor was neither skilled nor knowledgeable. During a recent market decline, for example, the advisor not only lost money for the college but had a greater percentage loss than the benchmark averages. Further the advisor did not understand the principles of hedging and/or protection, which would have reduced such losses, nor was there any comprehension of the more sophisticated strategies that are commonplace in the financial world. The advisor’s range of expertise was no greater than that of a low level advisor. However, the advisor was extremely gregarious, had known the President of the college on a personal level for a number of years, and finally, had been in the financial business for a significant period of time with all the usual credentials related to education and licensing. To the college President, who had little or no financial knowledge himself, the advisor was experienced, knowledgeable, and professional. Coupled with the personal relationship that had developed over the years, it was practically impossible for the President to make a rational judgment on the skills of his advisor. So the answer to the first part of this question – what is wrong with using an outside financial advisor – is nothing, as long as you have accurately determined the person’s level of skill.

As far as relying on an outside advisor for fund raising ideas, the biggest problem goes back to the cloistered argument previously discussed. A specialist in one area does not always follow concepts in another area. For example, look up the phrases “non-profit gift giving,” “fund raising for non-profit organizations,” “increasing donations,” or a host of other industry terms on the Internet and you will find thousands of sites devoted to each area. What you will not see is any discussion of financial engineering or investment products used by the secular financial community that, once understood, might be applicable to developing programs to increase non-profit gift giving. What you will see is an overwhelming number of advisory companies or individuals with ideas on how to get a donor to give up his or her assets for little in return. You’ll see essays or special fund raising drives that attempt to sell donors on the need to tithe, give-away deals in which donations entitle a donor to a special gift, and event promotions as diverse as flamingo flocking, bake sales, art shows, auctions, and a host of other ideas that have little attractiveness to high-net-worth donors.

Finally, the problems we encountered were not confined to lay persons. We found there were even problems in dealing with recommended attorneys. In one case, we were asked by the same east coast educational institution mentioned above to make a presentation to their law firm in order to secure answers to some of the legal issues that had surfaced. To reduce the time spent “on-the-clock” we submitted information describing our proposals a week in advance. When the meeting took place there were three attorneys present, none of whom had read the submitted material in detail and had only skimmed parts of the reports an hour or so before the meeting. Additionally, once the meeting began, and before we were even afforded an opportunity to provide an explanation of our proposals, one particular attorney made a statement that our “annuity” program must adhere to annuity regulations, including regulations centered on the issue of sharing profits (more on this in the technical section of the Frequently Asked Questions). Despite our attempts to show that we had not proposed an annuity, the attorney continued down the same path – unable to admit he might be wrong and unable to provide a clear direction as to how we might solve the issues at hand. Over the next few months we were able to address the issues in more detail with other attorneys, none of whom called what we were proposing an annuity. However, the damage the law firm created with the university both financially and in creating doubt was significant. Therefore, even when a professional organization or individual is approached it is important that their experience to make valid judgments has been verified.

If all else fails and you are not able to judge the veracity of the attorney, we suggest getting a second opinion. While this is more expensive, it creates a competitive environment that enables the non-profit to sit in the middle and hear comments from each side. In the long run it saves money.

• It seems that the Principal Protected Notes described earlier, in addition to be being a tool to increase donations, would also be a useful tool for non-profits when managing their own investment portfolios. Why haven’t our advisors discussed these vehicles with us?

There are two parts to the answer.

The first is simple and straightforward. Most advisors in the non-profit world have been trained in the use of asset allocation models in which a mixture of bonds, stocks, mutual funds, and other well worn investment vehicles are used to manage money. Due to their training and backgrounds, this is what they are comfortable selling. In addition, choosing a mixture of mutual funds and/or picking stocks as part of an asset allocation model has a long history in the industry. It appears to the uninitiated as sensible and doesn’t require a lengthy educational process. In virtually every case the non-profit organizations we approached used advisors promoting the asset allocation model.

The second reason may be somewhat more insidious. The reason PPNs are sometimes overlooked by advisors has to do with the financial benefits derived by the advisor. The simple truth is that PPNs and other types of Structured Products have fewer related fees, commissions, and turn over than having the portfolio mixture of bonds, stocks, and mutual funds.

CATEGORY TWO – TECHNICALLY ORIENTED QUESTIONS

• Why does the donor need the non-profit to purchase the PPN? Couldn’t the donor simply do the same thing on his own and then give the release of funds to the non-profit?

It is true that Principal Protected Notes are available to individuals. However, when a private individual purchases a PPN there is a problem with what is called the Original Issue Discount (OID). The OID requires the donor to pay taxes on the “phantom” income on the bond portion of the PPN as though it were not a discounted bond purchased without an interest coupon, but instead, was a standard bond that paid a semi-annual interest rate. A private individual could overcome this obstacle by using discounted tax-free municipal bonds for the bond portion of the PPN, but then the security of the PPN could not be “guaranteed” by the U.S. Government. That is why the vast majority of PPNs are used by non-profits as a financial management tool. Non-profits don’t pay taxes on income earned.

Note: Having an individual purchase a PPN through a non-profit is not an attempt to get around paying taxes on income. Because the income that would have been paid to the individual is instead being given to the non-profit, the individual that uses the non-profit Principal Protected Note as a money management tool receives less than he or she could have received on their own. More on this later.

Finally, even if there was no tax write-off allowed for the donation part of the package, a non-profit Principal Protected Note would still offer more benefits than most of the secular investment programs available to investors, not the least of which is providing financial support to worthy causes.

Another reason why donors might find the non-profit PPN attractive, even though they could accomplish a similar result on their own, has to do with the convenience factor. Many investors, who could manage their own money, still rely on outside professional money managers. This is why mutual funds, investment advisors, and wealth managers are so popular. In each case the investor relies on someone else so they don’t have to be bothered, even though the process requires the payment of fees and commissions. We believe many would find the purchase of a non-profit PPN attractive because it’s available, is uncomplicated, produces the desired results, and supports the non-profit’s mission.

Finally, as soon as the non-profit begins to go after Restricted Stock (RS) as a donative tool, this dynamic changes dramatically. Under normal conditions RS owners are proscribed from using RS stock as a means of payment for a Structured Product. However, by giving the stock to the non-profit, that creates the Principal Protected Note from the available cash after the sale of the stock (remember, non-profits can sell RS immediately upon receipt), this problem is solved. The RS owner (a) eliminates potential losses due to a decline in the value of the stock, (b) receives upside potential on the stock (or other asset if desired), (c) ends up with potential tax benefits, and (d) maintains estate flexibility in the future.

• What are the liabilities issues with regards to the non-profit organization that uses or promotes these potential programs?

Because of the up-front and mathematical certainty of the transactions there are no liability issues for the non-profit organization. Similar to creating a trust agreement to produce a legacy gift, all the parties know in advance all the caveats of whatever agreement is formed, before any funds change hands. Further all transactions can be verified by legal counsel and are executed by major financial institutions that have the responsibility of ensuring compliance.

• What were some of the other legal issues raised?

Sharing of Profits

In our discussion with the east coast non-profit educational institution described earlier, there was a concern raised by their legal counsel over the organization entering into an arrangement with the donor to “share profits,” which is not legally allowed.

Our contention is that “profits” are not in any way being shared with the non-profit organization. Once discounted bonds or other types of zero coupon instruments are understood the reason becomes clear.

Zero-coupon bonds differ from regular registered bonds in that they do not make periodic interest payments. One buys the bond at a steeply discounted price which then matures at Par at a predetermined maturity date. This payment at maturity is equal to the principal actually invested at the beginning plus the accumulated interest earned (compounded annually to maturity).

For purposes of this discussion, consider what would happen if an investor chose to invest $10,000 into a Principal Protected Note offered by a major brokerage firm.

The investor would put up $10,000, equaling the face amount PPN which is made up of two components: (a) a zero-coupon bond for an amount substantially less than $10,000 – let’s say for $6,000; and (b) $1,000 worth of options that enables the investor to participate in the future growth of an underlying security. What would be left over (not required to pay for the PPN) would be $3,000. This could then be given to the non-profit in order to receive a tax write-off or to support the non-profit’s worthy cause.

When the bond matures the investor would receive back his original principal ($10,000) plus any appreciation of the options. The income would have been given to the non-profit in return for a write-off and the good feelings of having supported a worthy cause. Now let’s assume the investor did not give the non-profit the $3,000, but instead invested the money into another bond. In this scenario upon maturity the investor would receive a return of principal ($10,000), plus $3,000 or more (representing principal and interest on the $3,000 not needed to buy the PPN), plus profits from the options (if any). Therefore, by giving the $3,000 to the non-profit the investor receives only the principal ($10,000) plus profits from the options.

Even if all this were accomplished by purchasing the PPN instrument through the non-profit, the results would still be the same. There would be no sharing of profits. The principal amount of the PPN would be returned to the investor/donor at maturity at Par (with no income) along with an amount equal to the growth of the option, which would inure fully to the donor and not the non-profit.

Therefore, the only consideration the non-profit would receive in the above scenario would be the income from the bond portion of the PPN that was given as a donation. There would be no profits shared between the non-profit and the donor.

As to why a donor might consider using the non-profit to purchase a PPN, consider the OID argument at the beginning of the section and the added benefits of receiving a tax write-off.

Restricted Stock Regulations – A Scheme for Distribution

To anyone who understands Restricted Stock law, the issue of a “scheme for distribution” is an important area to understand. This part of the regulation attempts to define when a transaction becomes an abuse – in other words, a scheme that allows someone who is a statutory insider to take advantage of his or her unique knowledge of the company, which is not available to the general public.

For example, if an affiliate knew in advance that his company stock was about to decline, or worse yet, the company was about to go bankrupt, he or she might be tempted to use the proposed non-profit PPN program to get rid of the stock while still maintaining the opportunity to receive dollars equal to the principal value of the securities at the time of the contribution. The owner would know that the non-profit would be able to sell the stock immediately (before the disaster hit), a privilege he or she would not be able to do on their own due to their “affiliate” status.

This type of transaction would likely come under the same heading as selling on “insider” news and is clearly illegal. However, that may not prevent someone from attempting the transaction.

We believe that if this were to occur, the non-profit would not have any liability (unless, of course, the non-profit was involved in the scheme with the insider). The way this would likely be handled is similar to any “insider” trading scam. The perpetrator would be required to give back any ill-gotten gains, plus a penalty, to be followed by potential prison time.

What this means to the non-profit is that when it came time to make a distribution to the individual who started this mess, the IRS or SEC would probably step in and secure the distribution so that it didn’t go back to the insider. The funds would then be used to offset any damage that may have occurred to the general public. Now here is the key element. Since the PPN would be making a distribution equal to the original amount of the contribution, and a value equal to the stock price before the fall off, we believe it would create a situation whereby the non-profit – who had no way of knowing what was occurring – would not be required to return funds it may have already spent.

However, let’s take this to a worst case scenario, where the non-profit might be worried that it would be required to return money it received. It could all be avoided by simply holding the stock for a period of time prior to sale, perhaps as long as six months. While not as desirable as being able to sell the stock immediately in order to institute the PPN, it would take away the temptation on the part of the unscrupulous.

Note: One of the tests as to whether a transaction is considered a “scheme for distribution” has to do with the holding period before the new recipient of the securities sells the stock under Rule 144. While there is no regulation that states a specific time that the stock must be held, the courts have viewed a six-month holding period as the test as to whether or not the transaction was initiated as a scheme for distribution.

Keep in mind this is not an issue when Restricted Stock is given as a straight donation. It only has the potential to apply when a non-profit wishes to provide the donor with the added benefits of a PPN program.

As far as what would happen in the event of a market fall-off while the stock was awaiting release, by purchasing a protective put on the stock, or requiring the RS owner/donor to “mark-to-market”, the stock’s value would be stabilized at the point it was contributed.

“Mark-to-Market” is a term that designates an individual being required over time to come up with more stock should the market decline or less stock should the market advance.

• Why hasn’t West River formed itself as a corporation, LLC or other legal entity?

A concern has occasionally been voiced over the fact that West River has not been formed as a legal entity such as a corporation, Limited Liability Company (LLC), Partnership, etc. While we understand the concerns, the reason West River has not been formalized is simple. We have no need to form any legal entity until such time as it is necessary to do so. Internally we operate on a handshake, and formal contracts or legal entities offer no more protection than our word to each other. However, when we do enter into a financial arrangement or form relationships with outsiders in order to develop a specific project, we do form a business entity for that purpose.

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