Editors’ Note: Brian Mittendorf outlines the stakes of the recently filed lawsuit, Emily and Malcolm Fairbairn vs. Fidelity Charitable, and discusses how it reflects mounting concerns about the rise of donor-advised funds.
The New York Times’ Paul Sullivan recently highlighted an ongoing and prominent lawsuit between a wealthy couple and their financial advisors. The lawsuit features a philanthropic twist: the complaint centers not around how their own money was invested but rather around how the money they donated to charity was handled. This twist provides a window into the evolving and rapidly expanding use of once-niche giving vehicles – donor-advised funds – and in doing so highlights the philanthropic minefield they present.
The Evolution of Donor-Advised Funds
The existence of donor-advised funds can be traced to the early 20th century, though their growth can largely be attributed to the Tax Reform Act of 1969, which drew a legal line between private foundations and public charities. The notion that charitable dollars controlled by private donors demand more scrutiny than those handed over to public control is at the heart of the distinction and the added restrictions that have been placed on private foundations through the years.
Despite the U.S. Congress’ fine line between public and private charities, donor-advised funds (DAFs) have come to represent a blurring of boundaries between the two charitable forms. DAFs are investment funds held by public charities that are, at the donor’s request, kept separate and tracked at the donor level. While the public charity (DAF sponsoring organization) retains legal control over the funds, the donor serves as an advisor who can guide when and where funds should be distributed. With this setup, many view DAFs as mini private foundations organized within public charities – while they are legally distinct from private foundations, they may in practice provide donors the same level of de facto control.
However, the fact that DAFs are legally distinct from private foundations means that DAFs offer advantages to givers, most notably centering around the tax benefits of the gifts going in to DAFs and the (lack of) restrictions on when gifts must later go out. Perhaps the greatest tax benefit is that gifting an asset which has gone up in value to a public charity provides a double benefit: donors don’t have to recognize taxable income from the long-term capital gain of gifted assets – including unusual ones like real estate, private stock or cryptocurrencies – yet they do get to claim a deduction for the full value of the asset given to charity. Unless the gift is of a publicly-traded stock, this double-benefit does not extend to gifts to private foundations; the deduction is instead limited to the asset’s cost.
It is this distinction that has given fuel to the rise of commercial DAFs. The term “commercial DAF” refers to DAF-sponsoring charities that are affiliated with commercial investment companies. Upon receiving the stamp of approval by the IRS in 1991, Fidelity Charitable led the charge for these commercial DAFs. By bringing expertise in accepting a variety of non-cash (appreciated) assets, Fidelity Charitable and its fellow commercial DAFs sparked a new gold-rush for charity dollars. In its most recent giving report, Fidelity Charitable boasts that “[w]hile most charitable contributions in the United States are made in cash, checks or credit cards, more than 60 percent of Fidelity Charitable contributions in 2018 were made in the form of more strategic non-cash assets.” The result of cultivating such more strategic gifts is that Fidelity Charitable and other DAF sponsors now consistently rank among the top recipients of annual giving (so much so that the Chronicle of Philanthropy now excludes DAF sponsors from its rankings because they had come to dominate the upper echelons).
The Case of Emily and Malcolm Fairbairn vs. Fidelity Charitable
Amidst this backdrop of an explosion of commercial DAFs comes the high profile lawsuit filed by Emily and Malcolm Fairbairn against the country’s largest DAF sponsor. The complaint revolves around a donation made to the Fidelity Investments Charitable Gift Fund (Fidelity Charitable) by Emily and Malcolm Fairbairn at the end of 2017. After a rapid rise in the value of their ownership in a company called Energous, the couple decided to donate a portion of their holdings to a DAF sponsored by Fidelity Charitable. Because this donation – estimated to be worth $100 million – amounted to nearly 10% of the company, the couple was concerned that a rapid sell-off of that ownership by Fidelity Charitable immediately subsequent to the donation could put downward pressure on the stock price. The Fairbairn’s complaint alleges that despite promises made by Fidelity that it would slowly unwind the position in 2018, the DAF sponsor quickly sold all of the stock on the last trading day of 2017.
The couple alleges that the rapid sale of the stock led to a more than 30% decline in its value, reducing both the funds available for charity and the tax deduction the couple could claim. (Left unstated but implied is that it also reduced the value of the couple’s retained ownership.) The lawsuit seeks compensation to the donors for the consequences of this sell-off-induced decline in value.
The Critique of Donor-Advised Funds Embodied in the Lawsuit
Donor advised funds have had their share of critics. Concerns about the effects of blurring boundaries between private foundations and public charity; fear that funds will sit in investments rather than be used by operating charities; and worry that fees paid to commercial affiliates will eat into dollars available for the public good have all led to exhortations that Congress intervene and regulate the giving vehicle. Broadly speaking, the critique is that while traditional public charities center around a mission goal, successful commercial DAFs are centered instead around donors or even the commercial entities with whom they are affiliated. This critique manifests itself in a variety of ways in the case of Emily and Malcolm Fairbairn vs. Fidelity Charitable.
One way the concern that commercial DAFs are donor-centric arises is in the competition between sponsoring organizations. The lawsuit alleges that Fidelity Charitable differentiated itself from other charitable options by its “superior ability to handle complex assets,” even stating in correspondence about the possibility of receiving a gift of one particular type of asset that “Vanguard can’t do this but we do it frequently.” The general public may think of competition among charities as focusing on who can best put gifts to charitable use. It turns out this is an antiquated notion: the intense competition centering on seamlessly receiving and converting complex assets for donors presents a stark contrast.
A related issue is that DAFs increasingly are vehicles that provide disposal options to donors for illiquid assets. In the Fairbairn case, the assets donated were technically liquid (they were publicly traded) but the size of the donation would threaten share price if it were a sale instead of a donation, an eventuality that formed the basis for the lawsuit. However, donating such assets permits a tax deduction for the value, even though an outright sale at that value would be problematic. There are other cases of this phenomenon, including transfers of limited partnership interests, pre-IPO stock, and real estate. One stark case is the donation of sales-restricted XRP (a cryptocurrency) to a DAF by Ripple co-founder Jed McCaleb. When donating illiquid assets, a donor gets an immediate tax deduction despite the fact that the recipient charity (here the DAF sponsor) may not be in a position to immediately put the funds to use.
The legal distinction that permits a DAF to reap the benefits of being treated as a public charity is that the sponsor – not the donor – has legal control of the funds upon receipt. Yet, many look past that as a technicality and see the DAF as being “owned” by the donor. The Fairbairn case also exemplifies this concern well. The donors sought not only to retain advisory privileges over where the funds are distributed but also control over when the stock ownership itself was liquidated. And the lawsuit alleges that Fidelity (and other competitors seeking their donations) represented to the donors that handing them such control was acceptable. In such an environment, the question is whether the funds are truly under public control or private control. In this case, the Fairbairn lawsuit may bring some more information to bear about what control donors can and cannot retain when making irrevocable gifts to public charities.
A final issue that surfaces in the Fairbairn case is that some DAF sponsors may implicitly or even explicitly be beholden to their commercial affiliates. Legally speaking, Fidelity Charitable is a distinct entity from Fidelity Investments; as is the case for Vanguard Charitable and Vanguard; and so on. Yet, the shared names and logos underscore a nontrivial affiliation. Critics have argued that the commercial DAFs invest funds heavily in their affiliated investment companies and, as such, generate substantial fees for them. This, in turn, could create incentives to retain funds in investments rather than distribute them to charitable endeavors. The allegations in the Fairbairn case are consistent with this fear. While the incentives and pay arrangements for those within Fidelity Charitable are not publicly known, the lawsuit insinuates that the rapid sale of Energous by Fidelity Charitable on the last trading day of the year was made to meet goals to increase assets under management by Fidelity Investments. Discovery in this lawsuit may provide some evidence that speaks to the concern that commercial DAFs are motivated to support their commercial affiliates.
This lawsuit is one the charity world would be wise to keep a close eye on, as would donors and even Congress. Since DAF sponsors are given a special status as a public charity, the issues raised in this suit may compel Congress to consider if new guardrails are needed to ensure these organizations are truly publicly controlled and not just de facto private foundations that sidestep the attendant regulations.
Brian Mittendorf, PhD, is the Fisher Designated Professor of Accounting at The Ohio State University where he also serves as Chair of the Department of Accounting and Management Information Systems. He holds a BBA in Accounting from Baylor University, and a PhD in Accounting from The Ohio State University. Prior to joining the Fisher College of Business, Dr. Mittendorf was an Associate Professor at Yale University’s School of Management.