BI > FEBRUARY 2006

Handling Member Departures

Investment Clubs Are Like Families

Help! We're a club that originated in 1999. We originally started with 20 members. Last year we lost three members, preventing us from purchasing any stocks for the year (our contribution is $20 per month). Just yesterday we lost three more members. We know we have to pay these members out and without cashing in our stocks, we'll end up not making purchases another year.

To deter members from leaving, we came up with an idea and would like to know whether it's legal: "If said member withdraws, the withdrawal has to be in writing. Said member can continue to pay the monthly payment and will be paid out as of close on Jan. 2 of the following year. If said member chooses not to contribute, the member will be paid the relevant percentage as of the date of the withdrawal; a check will not be issued until Jan. 2 of the following year. We will only allow one member to leave per year."

We're just trying to deter members from leaving. Maybe this is one reason they'll think twice before dropping. (We considered penalizing the member 10 perceent but found out it's illegal to charge more than 3 percent. I was told it was best to charge 0 percent to prevent legal problems.)

Diane Warner

I believe you have the well-being of your club in mind, but to allow only one member to leave per year will likely have the opposite effect of your intent and may even mean your club's demise. Investment clubs are like families, in that some members leave the fold because of a move, divorce or death. There are still 14 members remaining. It's important to focus on the positives and think about how these remaining members should be treated.

Your club could look at the members' departures as an opportunity to improve its portfolio. Are there any stocks with deteriorating fundamentals? Do you have any stocks that your club projects will have a total return that's less than what you could earn in a money market account? These are stocks the club should consider selling anyway, regardless of whether members are departing.

As detailed in the table below, your club has several solutions to its dilemma without using cash on hand to pay withdrawing members (assuming your partnership agreement allows them at the time of the withdrawal requests). Your club can use any combination of the solutions listed. The solutions colored green are generally good for a club, while yellow means caution should be used and red means it should be used only as a last resort.

Click to enlarge.

Your statement about it being illegal to charge more than a 3-percent penalty for a withdrawing member isn't correct. There's no such limitation in IRS Publication 541, which pertains to partnerships.

In addition, the Mutual Investment Club of Detroit was founded in 1940 and currently has a portfolio of about $6 million (which excludes more than $5 million in member withdrawals over the years). Paragraph 20 of its partnership agreement reads in part, "The partnership shall transfer to the partner (or other appropriate entity) withdrawing a portion or all of his interest in the partnership, an amount equal to the lesser of (i) ninety-seven percent (97 percent) of the value of the capital account being withdrawn, or (ii) the value of the capital account being withdrawn, less the actual cost to the partnership of selling securities to obtain cash to meet the withdrawal."

Its partnership agreement also has the flexibility to waive the with-drawal penalty with the approval of its members. To access this agreement in its entirety, visit the BetterInvesting website.

The withdrawal penalty can easily exceed 3 percent depending on the transaction fee charged by your broker and the value of the capital account being withdrawn. For example, Mary just joined your club last year. She has made $240 in contributions to the club and with your club's outstanding stock-picking abilities, her portion of the club's assets has grown to $280.

Unfortunately, Mary is getting a divorce and must liquidate her share as part of her divorce settlement. The club decides to sell a portion of one of its holdings to pay off Mary. The club's broker charges a $17.95 transaction fee. Thus, $17.95 divided by $280 equals a withdrawal penalty of 6.4 percent.

However your investment club decides to pay withdrawing members, it's imperative that your club follow the partnership agreement in effect when the withdrawals were requested.

Ask Colleen your club question by writing to colleen@ColleenMulder-Seward.com. Colleen holds an M.B.A. from Wayne State University. Since 2000 she has served on the board of directors for BetterInvesting's Southeastern Michigan Chapter. Colleen also writes the Retirement Intelligence Information Services newsletter for retirementcalc.com.