Are Your Reserve Funds Being Properly Handled?

The most important aspect of being on the board of a cooperative or condominium is to act in a fiduciary capacity and make certain that the building’s assets are properly maintained and protected. This is particularly true with regard to the reserve funds.

Those funds, which are held for long terms, must be managed and handled in a prudent and businesslike manner. It is particularly true these days, with many cooperative corporations and condominium associations holding substantial amounts of money in their reserves.

That money comes from: (a) refinancing the indebtedness on the property as a result of current low interest rates; (b) the huge increase in transfer fees (i.e., flip taxes) arising from the appreciation in the value of all apartments; and/or [c] selling air rights or other assets.

Who should invest these funds and how should the investment be monitored? In general, professional money managers and others familiar with this area should be handling it. The funds should be maintained in various instruments – i.e., tradable assets of any kind, such as cash, evidence of an ownership interest in an entity, or a contractual right to receive or deliver cash – with differing durations based on how secure they are and the return available.

However, what if a professional money manager sits on the board of the building in which he or she resides? Should the board member-investment adviser make the investment decisions? How much risk should that person assume? Should the board member actually invest the money and receive a commission?

Not all boards are lucky enough to have investment professionals as shareholders or unit-owners who wish to become involved in building politics, so they leave the investment decisions to others. But how does the board handle the situation if it does? What does a board member do if there is no investment professional sitting on the board? Regardless of who manages the cooperative or condominium funds, however, every board should have a written investment policy.

When you give complete control to a board member it should be a warning sign. Even if he or she is the best money manager in New York, it is dangerous to give this person complete discretion over the investment of the reserves. The issues are appearance and abuse.

Appearance. The old proverb states that “Caesar’s wife must be above suspicion” and it applies to board members also. The appearance of impropriety is almost as damaging as actual impropriety; giving a board member control over the reserve fund is a mistake because it just looks bad. There is a possible exception to the rule: an investment advisory firm should not be eliminated as a possible candidate just because a board member works at the firm, as long as the board member obtains no benefit.

Abuse. If the market goes in the wrong direction and the corporation or condominium either does not get the return it expected or if all or some of the principal is lost, everyone on the board is in the line of fire. But, frankly, it’s a no-win scenario. You’ll get abuse if things go wrong – and if things go right. Why? Human nature; even if the principal is properly invested and the return is good, some shareholders or unit-owners will invariably have someone who “could have done it better” – a broker, an attorney, an accountant, a best friend, a person who “knows a little bit about money,” or even a butcher who has an investment tip. A friend of mine refers to that as the “I Got a Guy” syndrome.

Have a Written Investment Policy

Generally, if a cooperative or condominium has reserves, the board should have a written investment policy. The investment objective should be to provide liquidity. The funds should be invested in a prudent manner, providing funds to either build the reserves or supply income for the annual operating budget, while supporting the corporation or the association’s ability to pursue long-term growth. The oversight of the investment portfolio should be the responsibility of an investment committee, whose members are appointed by the board. It should administer the portfolio in compliance with written guidelines approved by the board (called the “Investment Policy Statement,” or IPS).

The purpose of the IPS should be to detail the authority, discretion, and responsibilities for the effective investment management, safekeeping, and preservation of the portfolio’s assets. The IPS should be applicable to any investment manager or adviser of the portfolio. The IPS should (a) establish a clear understanding of the objectives of the portfolio; (b) provide guidance and direction to the committee; and (c) provide a basis to monitor and evaluate the portfolio’s investment performance.

Set Up a Team to Manage Money

The IPS should also identify the responsibilities of the parties involved in the investments. These would include an investment committee, an investment manager, and provide for communications with the board.

The committee should exercise reasonable business care and prudence under the facts and circumstances prevailing at the time of any action or decision when it carries out its responsibilities. It should be responsible for the recommendation of investments of portfolio assets and can, among other options, authorize the board to contract with independent investment managers, investment plan administrators, banks, portfolio companies, insurance companies, or mutual fund companies, for the purpose of investment of portfolio assets.

In doing so, it should devise and monitor the strategy for the investment and reinvestment of the portfolio assets in a manner consistent with the overall guidelines as approved by the board. The committee should consider long-term responsibilities and short-term needs of the board, its current and anticipated financial requirements, expected total return on investments, and price level trends and general economic conditions in making its recommendations.

The board should retain one or more investment managers to manage the funds and keep them invested.

The investment manager(s) should provide the committee with quarterly updates of the portfolio’s performance and meet with the committee at least annually or when market conditions or investment performance warrant. The meeting and quarterly updates should include, at a minimum, a review of investment management and performance. An economic and market outlook along with an investment strategy should also be provided.

The investment committee should contain authority for the investment manager to invest the portfolio. These criteria could include the following:

Fixed-income investments, either in the form of individual securities, exchange-traded funds, or mutual funds. The portfolio shall maintain broad diversification, with no single fixed-income investment (cost value) representing more than five percent of the portfolio’s total fixed-income holdings. Additionally, there is a three-year maximum maturity on the portfolio with an average maturity of two years or less.

Direct cash equivalents should be limited to U.S. treasury bills, U.S. government agency notes, and money market funds.

The portfolio should not directly invest in the following: futures contracts, short sales, and option contracts (none of which are meant to hedge specific transactions) and derivatives, when used for speculative purposes; and equities.

The policy should include a requirement that the board review the guidelines periodically to determine if modifications are appropriate. Any modifications must be communicated to the committee, which, in turn, should communicate them to the investment manager(s). Of course, any modifications of the investment guidelines may be made only with the written recommendation and consent of the committee and approval by the board.

Remember, warning signs are there so you can consider the consequences of an action. Boards cannot be too cautious regarding their reserve funds.