Collecting Charitable Pledges: Yet Another Hazy Legal Zone in Philanthropy

Donor pledges of financial support are so commonplace at charities today that many people do not give them a second thought. There are many assumptions about the legal status of these pledges and, as usual, this area is more complex than one would think.

It is so complex that I am going to split this into three posts. Today, I will cover the most unusual question: Must the charity work to collect the pledge? Is the charity obligated to attempt to collect a pledge and exercise as much effort as possible in doing so? Must a charity act like your mortgage company in trying to collect a pledge?

My next two posts will address the legal enforceability of the pledge agreement and the subject of collecting a pledge after the death of the donor. To be truthful, when I began the research on this subject, I thought the only issue in this area was going to be the enforceability of the pledge agreement. Believe me, there is more here than you ever thought.

First, some of the basics: A charitable pledge is a contract between a donor and a charity in which the donor promises to make a contribution in the future. Pledges may be oral or in writing. The key word here is that a charitable pledge is a “contract.” Contracts are very specific legal documents. If you went to law school, you would spend a semester or more studying contract law. So a contract is not something that is to be taken lightly.

A properly executed pledge (whether written or oral) is an asset that the charity received and accepted. According to the Financial Accounting Standards Board (FASB), charities are required to record enforceable pledges as assets when they are made, just like any other asset. (In the next post, I will talk about enforceability. For now, let’s assume we are only talking about enforceable pledges.)

If a pledge is not fulfilled, the charity must write off the unpaid amount of the pledge. But wait: Does this happen as easily as the donor calling the charity and claiming to have fallen on difficult economic times? In most cases, yes, this is exactly what happens. The donor says they cannot pay, and the charity officers feel badly, but say they understand.

Most people believe that a charity does not have an absolute duty to sue a defaulting donor. So far, no court has held a charity liable for refusing to enforce a pledge. In addition, the costs of pursuing such legal action and the damage such a lawsuit might do to relationships with other donors and one’s public image are sufficient for the board to conclude that doing nothing is the best course to follow.

Remember, however, that the FASB said that pledges are assets. In general, directors and trustees have a fiduciary duty to protect and preserve assets. This means they have an obligation to act prudently in protecting and preserving the entity's assets. This duty encompasses the collection of debts owed the entity that are legally enforceable. If a donor has declined to fulfill a pledge and clearly has adequate resources to fulfill the pledge, the charity has a fiduciary duty to enforce the pledge. A breach of fiduciary duty can result in personal liability for the director or trustee.

Who might bring a breach of fiduciary duty action against a director or trustee? Anyone who is harmed by the economic shortfall caused by the uncollected pledge. This could be any of the charity’s creditors or, less likely, a beneficiary of the charity’s services. In this litigious society, anything is possible. I was once called upon as an expert witness in a case of a bankruptcy court suing a donor to collect a pledge after the donor stopped making payments in response to the charity's bankruptcy filing. I'll say it again: Anything is possible today.

The attorney general alone is vested with the power to prosecute fiduciaries of charitable entities who fail to perform their duties. As a practical matter, prosecutions are relatively few, given the limited resources of the attorney general's office.

Another surprising issue that arises when a pledge is forgiven—i.e., when the charity is not trying to collect—is an IRS tax issue. As you know, charities enjoy tax exemption granted by the IRS. One of the conditions is that a charity cannot give its assets away except to another charity. Forgiving a pledge could be construed as a gift back to the donor—obviously, an improper action for a charity.

As noted above, once a binding pledge is made, it becomes an asset of the charity in the form of a legal debt obligation. While the IRS has never held directors liable for refusing to enforce a pledge, it has issued rules prohibiting charities from conferring non-incidental benefits on private parties, and this kind of scenario could potentially fall within these private inurement and excess benefit rules. Section 4958 of the Internal Revenue Code addresses and provides for intermediate sanctions in excess benefit situations. The IRS has not clarified whether Section 4958 applies to forgiven pledge agreements.

Charities must be alert to potential conflicts of interest. If a director or officer of the charity is the donor, that person should not be involved in the discussion about whether or not to commence legal action, and should not vote on the matter. Moreover, any directors who have an outstanding pledge to the charity at the time that a pledge enforcement dispute or issue arises should disclose that information to the board and recuse themselves from any discussion of policy regarding the enforcement of pledges. These rules extend to cover spouses, domestic partners and business partners. Total transparency is required, as always.

Last but not least, it's important to think about the Uniform Prudent Management of Institutional Funds Act (UPMIFA). A pledge to the endowment of a charity is an asset of the institutional fund covered by UPMIFA laws (in addition to being an asset of the charity). Under UPMIFA, a charitable organization again has a duty to exercise ordinary business care and prudence in governing its institutional funds. Failure to attempt to collect an endowment pledge could be seen as a violation of UPMIFA.

In conclusion, charities have much to be concerned about if they choose not to enforce pledges: IRS regulations, UPMIFA laws, performance of general fiduciary duty, etc. Unfortunately, there is no case law in this area. How worried should you be that you might be the first?