Are Your Reserve Funds Being Properly Handled?

"When you give complete control to a board member it should be a warning sign," says Stuart Saft, a partner at Holland & Knight. "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." Let's take a look at why.

Appearance. The appearance of impropriety is almost as damaging as actual impropriety. In short, 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," says Saft. "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 cooperative 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? "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," explains Saft, "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 objective should be to provide liquidity. The funds should be invested 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," says Saft. "It should administer the portfolio in compliance with written guidelines approved by the board. This is called the Investment Policy Statement (IPS)."

The purpose of the IPS should be to detail who is responsible 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 and an investment manager.

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, as well as an economic and market outlook along with an investment strategy. The investment committee should contain authority for the investment manager to invest the portfolio.

These criteria could include fixed-income investments, either in the form of individual securities, exchange-traded funds, or mutual funds. The portfolio should 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 is meant to hedge specific transactions; 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, boards cannot be too cautious regarding their reserve funds.