Falling Price of Reader’s Digest Stock Is Big Blow to Wallace Funds

The DeWitt and Lila Wallace-Reader’s Digest Funds were among only a handful of major foundations that saw their assets drop last year despite a soaring stock market.

The principal reason: Both foundations still hold large blocks of stock in the publishing company started by Mr. and Mrs. Wallace. As the company has foundered, partly because its flagship magazine has failed to attract younger readers, the value of Reader’s Digest Association stock has plummeted, from nearly $40 a share early in 1997 to less than $23 a share last summer. (It currently trades at about $25 a share.) That is down from an all-time high of $56 in October 1992.

As a result of the latest drop, the Wallace funds have shrunk 25 per cent in just two years. Worth about $1.9-billion in 1995, they are now valued at $1.43-billion.

The shock waves of the company’s collapse are being felt by many in the philanthropic world — including some of its most prestigious organizations.

That is because the Wallaces, in addition to establishing the two major funds, used Reader’s Digest stock to create seven special funds, called “supporting organizations.” Those funds, which benefit specifically designated organizations — including the Lincoln Center for the Performing Arts and the Metropolitan Museum of Art, in New York, and Colonial Williamsburg, in Virginia — have also seen their Reader’s Digest assets go into a tailspin.

Evaluating the performance of investments at the supporting organizations depends, to some extent, upon what is counted, and when. At their height, in late 1992, the Reader’s Digest shares held by the seven supporting organizations were worth $1.85-billion, but at the end of last year they were worth just $790-million. Counting all investments, over a longer time-frame, however, Wallace officials say, the seven funds have fared better, rising in value from $160-million in 1985 to $1.6-billion at the end of 1997.

The falling value of Reader’s Digest stock is not the only problem for the two funds and seven supporting organizations. Equally troubling was the company’s decision in July to slash its dividend in half, in the wake of falling profits.

Overnight, the two foundations learned that they could count on only half of the more than $15-million they had received annually. And the seven supporting organizations saw their anticipated annual dividend payments drop from more than $59-million to less than $30-million.

Officials at the main Wallace funds say the full effect on the charities they support will not be felt immediately. They say that they are committed to maintaining grant distributions at current levels — about $57.5-million a year — through 1998. But after that, the situation looks uncertain.

Investment managers say the case of the Wallace funds illustrates the great financial risks involved when foundations do not diversify their portfolios.

“A basic principle of modern investment management is that you should have a diverse portfolio — and these foundations are clearly not diverse,” says James J. Fishman, a professor at the Pace University School of Law. The two main foundations have 43 per cent of their assets in Reader’s Digest stock, including 71 per cent of the voting shares in the company, while the supporting organizations had about 51 per cent of their assets in Reader’s Digest until they sold a large portion of their non-voting shares this month.

Mr. Fishman’s view on diversification is not held by everyone, however. Some foundation managers believe that holding a large amount of a single stock can be advantageous. And other foundations often hold on to the stock they were given and fail to diversify their portfolios because the donors want it that way.

Those certainly were the wishes of Mr. and Mrs. Wallace, who went to great lengths to insure that there were lasting ties between the company and the foundations that they created. From the beginning the funds were designed as a way for the charitable institutions to keep control of the company. For example, the Wallaces made certain through their wills that trustees administering the charitable funds were drawn from the high ranks of their company.

Normally, foundations are not allowed to maintain such links. In 1969, Congress passed a law that put strict caps on how much stock in a single company foundations could own. Lawmakers were concerned that business leaders had abused the tax exemption by setting up foundations to avoid paying estate taxes but still maintaining control of their businesses. But the Wallaces were able to get around those rules, with their foundations holding a larger stake in the company, because the funds were created by wills that were signed just two months before the 1969 law went into effect.

That voting-shares percentage must come down to 50 per cent or below by 2000 or the foundations will have to pay hefty tax penalties. (Tax rules give foundations 15 years after the death of a donor to dispose of excess business holdings, and Lila Wallace, who survived her husband, died in 1984.) But Wallace fund officials say that they intend to hold on to no less than 50 per cent of voting stock in Reader’s Digest — a controlling share and considerably more than the 20 per cent allowed in funds that were set up after the 1969 law was enacted.

In the case of the Reader’s Digest and its associated funds, the ties run far deeper than the ownership of stock, however. All of the Wallace funds’ directors serve or have served on the Reader’s Digest board or have been otherwise paid by the company. And George Grune, who last summer came out of retirement to return to his post as chairman and chief executive officer of the company, also serves as head of both the Wallace funds and the supporting organizations.

The unusual arrangement stimulated questions about management and governance from the outset, with some observers pointing to the potential conflicts that could arise if the company’s fortunes were to take a turn for the worse. When Reader’s Digest stock was soaring, however, the conflicts didn’t seem to matter, since everybody’s financial interests were being served.

But now, many foundation-law experts and private investors argue, the foundations’ continuing control of the company — and the presence of company officials on the boards of the two funds — is not serving the best interests of the charitable beneficiaries.

“They created a fabric into which they wove lots of complicated knots, and now the knots have come unraveled,” says Daniel Kurtz, a New York lawyer and former head of the Charities Bureau in the New York State Attorney General’s office.

From the outset, Mr. Grune has denied that there are any conflicts in running the company and the funds simultaneously. He argues that the best interests of charitable beneficiaries, private investors, and the company are all the same — to rebuild Reader’s Digest into a strong company.

But some investors who hold Reader’s Digest stock charge that conflicts of interest are keeping the company from being properly managed. They also claim that the dividends — even though half of what they had been — are too high when compared with earnings.

In a letter to the boards of six of the seven supporting organizations, Richard Grubman, managing member of Corporate Value Partners, an investment company that owns about 1.3 million shares of stock in Reader’s Digest, wrote: “Our view is that all shareholders . . . would benefit dramatically from (a) new, better governance and executive leadership for the Company, or (b) a sale of the entire company to a strategic buyer who is better equipped to maximize the value of the Company.”

He urged the organizations to “immediately and aggressively hold the Board and Management more accountable for their stewardship of the Company.”

So far, however, none of the trustees of the supporting organizations has been willing to take any action or to speak out publicly against Mr. Grune and his management of the company.

Mr. Fishman says it appears that Mr. Grune is using the foundations to maintain an iron grip on the company. The Internal Revenue Service may have approved the structure of the funds when they were formed, Mr. Fishman argues, but they probably would not pass muster today. “That is like getting a building permit to build a factory and then dumping toxic waste,” he says.

Some investors, including Mr. Grubman’s group, have called for the New York Attorney General to take a hard look at whether the directors of the Wallace funds and the supporting organizations are exercising their fiduciary responsibilities and looking out first and foremost for the public interest. The Attorney General’s office would neither deny nor confirm the existence of an inquiry.

Under pressure from several of the supporting organizations, which had come to rely on the dividend income, the company this month executed a special sale of about 11.8 million shares of non-voting stock that had been held by the supporting organizations. It was the first time those groups had been authorized to sell their stock since 1991.

Under terms of the complex deal, the stock was sold in the form of a hybrid security known as a traces offering, in which the selling charities get just 75 per cent of the market value for their shares.

The securities, all of which were snapped up, will automatically be redeemed for shares of common stock when they mature in three years. But in the meantime, the supporting funds will continue to receive any dividends that are declared for the next three years, and they may share a portion of any appreciation the stock may see over that time.

Critics argue that such a strategy was orchestrated by Mr. Grune to ease pressure on management to consider dramatic reforms or even a sale of the company.

But officials at the Wallace funds say that Mr. Grune has been a good steward of their assets in his capacity as head of the company. And they point out that it was under his leadership that the company’s stock value soared in earlier years, rising from $20 a share in 1990 to more than $56 a share in 1992. As the price of the stock soared, so did the value of the funds themselves — as well as the payoffs for many charities.

Officials at one of the beneficiaries — Macalester College in St. Paul, which disposed of half of its nearly six million shares in the company — were philosophical.

Michael S. McPherson, president of Macalester, emphasized that the college was much better off for having received the gift from DeWitt Wallace. Mr. McPherson conceded that there may have been times over the past five years when it would have been advantageous to sell the college’s shares. But, he added, “one of the things I have learned as an economist is that worrying about the past prices of stock is not a productive activity.”