Sunday, August 21, 2011

Which Owner Interests have Priority?

Do the interests of owners which are essentially short-term conflict with the interests of other owners who are in it for the long term or with the overall interests of the association itself? If so, what should boards do when that happens? Community association boards which cave in to political pressure to avoid developer claims or to keep assessments low from investors seeking to flip properties or from owners who have their homes listed for sale, are depriving the remaining and future owners of leadership.[1]

We hear it all the time, especially now with home sales so hard to close. Members of a community association who have their property listed for sale or those who are seeking alternate financing, complain that their association’s board is taking actions that are contrary to their interests. What actions are these? Raising assessments to comply with the recommendations of a reserve study, for example. Imposing a special assessment or applying for a bank loan to raise funds for long-deferred repairs. Initiating an investigation of the condition of the project that might lead to a claim against a developer for construction defects. No owner likes any of this, but owners who have a short-term interest in the project like it least of all. Higher assessments will mean it may be harder for a prospective buyer to qualify for a loan. A pending special assessment may have to be reflected in the sales price. Bank loans for repairs will undoubtedly lead to higher assessments. The results of an investigation may have to be disclosed to prospective buyers. But these are—or should be—the realities of managing a community association and are often very important to the long-term financial and operational stability of the development. While actions like those above may be seen as contrary to the short-term interests of certain owners, they are consistent with the long-term interests of the association itself, and so, whose interests have priority?
            Boards of directors face this dilemma every day, especially if they are contemplating something that will create new disclosure obligations or raise assessments. Just like the dilemma that is faced by boards when certain long-term owners who live on fixed incomes cannot afford new assessments[2], they face a similar conflict when owners with short-term interests—investors, owners trying to sell or refinance—complain that actions on behalf of the association are contrary to their more immediate interests.
            No two owners have identical interests. Young couples anticipating a family know that they will not remain in a 1-bedroom condominium for years to come. Temporary workers, or employees on short-term assignments, know that when their assignment is over, they will be moving on. Retirees know that they may have to look for other living arrangements when they reach an age when independent living is no longer possible. Each owner of a property in a community association has both short and long-term interests that vary depending upon their individual situations. Can a board of directors charged with the operation and maintenance of the entire project take each and every individual’s interest into consideration when making important decisions? Of course not. To do so would most likely mean that no decisions would ever be made. The board of directors of a community association represents the association of owners—not any one individual owner—and must, by statute, place the long-term interests of the association as a whole ahead of any one owner’s individual interest.
            The statutory framework that governs most homeowner associations assumes perpetual existence for the corporate association. And, while that is likely not true for most communities,[3] it is the premise the law is based upon in virtually every state and that law in turn defines the responsibilities of the board of directors. So what obligations of a board are most likely to come into conflict when comparing the short-term with the long-term interests of owners? The reserve program comes immediately to mind. Most states mandate adequate reserves, but have little, if any, method of enforcing the mandate, so boards are largely left to rely on the advice of others and upon their own discretion to set the level of reserves. Since the funding level of reserves translates directly into the amount of the monthly homeowner assessment, the decision of whether to “fully fund” reserves (or to fund them at some lesser level) will have an immediate short-term impact. But of course, reserves, by definition, if not by statute, are intended to defray the long-term maintenance and repair obligations of a community association. They have little to do with anyone’s immediate short-term interest except, of course; to that rare prospective buyer who truly understands how an inadequate reserve account impacts the value of a home. The amount of the current monthly assessment is usually what has the greatest impact on buyers.
When short-term interests prevail—e.g. by keeping assessments low—the long-term interests of the association and not co-incidentally, the interests of later owners, are sacrificed for the here and now. It is very possible to defer funding for later maintenance projects by simply not funding reserves to recommended levels, thus artificially keeping assessments low. Unfortunately I suspect that this is more often the rule than the exception, especially today when the economy has robbed so many associations of regular assessments due to owners facing foreclosure or sustained unemployment. Current operational expenses are harder to avoid. The fire insurance premium has to be paid. The landscaper has to be paid. Management fees have to be paid. Reserves for projects that won’t be undertaken for years are easier to ignore. The assessment level necessary to properly fund reserves is geared, essentially, to a long-term interest—often with a 10 or 20-year horizon. But the personal interests of some owners may only have a 1-2 year horizon, or less, setting the stage for conflict between their interests and the interests of the association. How should a board respond?
Another example is a board’s pursuit of a claim against a newer project’s builder for construction problems. These claims frequently expose a completely unplanned and unreserved future liability for repair. Missing firewalls; the effects of gradual and long-term water intrusion from inadequate flashings; improperly installed windows that slowly leak water into an interior wall cavity; and other relatively invisible problems. There are only a handful of options for funding the inevitable repairs. Either raise regular assessments sufficiently to repay a bank or reserve loan; impose a special assessment; ignore the problem until it becomes a crisis; or pursue the developer for the necessary funding. Not surprisingly, the choice is often to initiate a claim. Why should the owners of a newer project want to foot that bill themselves? But when that happens, owners with their homes on the market may be adversely affected—buyers and lenders can shy away even when the scope of the problem is well disclosed, putting pressure on boards to back off of the claim. Should they do it?
But we also see this problem in the crisis that arises when long-deferred maintenance has to be undertaken, often without adequate funding, many years into a project’s life. Or worse, a project undertaking a planned-for repair, uncovers severely rotted framing during the course of that project, or discovers a plumbing system that has reached the end of its service life with no reserves to replace it. In each case hundreds of thousands or perhaps millions of dollars are required to address these unexpected issues. Can a board ignore these unexpected and probably well-developed problems?
There are limited sources of funding for unexpected repairs so it is understandable why responsible boards have a natural inclination to prepare for future contingencies by at least funding reserves and pursuing available claims. The conflict that arises from those decisions, however, is that the interests of those owners with more immediate needs to sell or re-finance may suffer. They will have to disclose the results of any investigation. The increase in assessments may limit the number of potential buyers who can qualify for a loan with which to buy the home. The very existence of a claim, regardless of its nature or size, can scare off some lenders.[4] And so a board will receive complaints from those owners and in some extreme cases, will hear demands that the problems be ignored or the claims dismissed. But most boards do understand that they are responsible for the long-term care and maintenance of the entire project, not just one owner’s interest, and that responsibility always means funding adequately for the future.
But it is clearly not just the interests of present owners that have to be considered. The interests of future members of the association are at stake as well. When a board decides, for political or other reasons, to bend to the will of short-term interests, it sacrifices not only the interests of other owners, but also the interests of future owners who will have to pay for any present decision to underfund long-term reserves or to ignore a potential problem. Future owners have no vote in present decisions and their interests are often compromised in abstentia. Prior boards, which have failed to comply with statutory mandates for years, deprive later owners of the benefits of the law requiring adequate reserve contributions. They often do this by ducking the problem and passing on to future owners and future boards the results of the political pressure asserted by some present owners who are only interested in the near horizon.
            Pay now, or pay later? Investigate now, or risk a funding or construction crisis later? It’s a tough love situation. Most owners whose long-term interest is at stake would agree that the problem and the funding should be dealt with sooner rather than later. Imposing assessments is never fun, and keeping them artificially low is relatively easy, but boards which cave in to the political pressure from investors seeking to flip properties, or owners with their homes listed for sale are depriving other and future owners of leadership. That’s not what the law and good management require.

[1] Full disclaimer: Berding|Weil litigates developer claims. We also assist associations that are trying to deal with deferred repairs and rehabilitation without adequate funds. We have seen the conflict we describe in this article first hand.
[2] Berding, The Board’s Dilemma, 2009.
[3] Berding, The Uncertain Future of Community Associations, 2005.
[4] More and more, however, various lenders are finding that ongoing claims are not a sufficient reason, by themselves, to deny a loan application and are willing to look at an application for a loan to purchase or re-finance a home in an association pursuing developer claims.