The Disclosure Trap—Part 2

Published in the ECHO Journal, July 2010

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The Cast:

Sally, The Association’s Manager

Jones, Recent Buyer

Brown, Attorney For Jones

Steve, The Association’s Regular Counsel

Nancy, The Association’s Litigation Counsel

Ralph, Attorney For The Management Company

Jack, The Association’s Insurance Broker

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When we last left Sally, she was trying to figure a way out of certain disaster.[1] There was not one piece of good news in this sordid saga. A brief recap:

About two and a half years ago, Sally finally got the board to approve a competent inspection of the property. The engineer found damage requiring removal of the stucco and replacement of windows and balconies and, of course, the roof. The total was $3,000,000. Jones purchased in November 2007, after the inspections but before the board notified members of the problems. The 2008 budget and Assessment & Reserve Funding Disclosure Summary, hot off the press, were in the last set of documents he read and approved before closing escrow. These documents did not disclose what the board knew.

After the disclosure and the explosion from the membership, owners approved a $30,000 per unit special assessment due in November 2008; Sally worked out a bank loan for the other half. Attorney Brown notified the association that his client, Jones, would pay neither the special assessment nor that portion of the regular assessment to retire the loan. His basis for this position was simply that Civil Code Section 1365(a)(3)(A) and 1365.2.5, the Disclosure Form, requires disclosure of deferred maintenance and unfunded liabilities. The Disclosure Form did not discuss the stucco or sliding glass doors; these were not classified as reserve items. The roof was listed in the reserve study, but the replacement cost was twice that reported. Brown contented that the board knew, or should have know, of the problems.

Steve, the association’s attorney, stated the board could not forgive the assessment and must take steps to collect from Jones. Everyone understood that Brown would file a lawsuit when the association filed the lien. Sally, looking for a way out of the mess, checked to see if the Association’s Directors and Officers’ policy would eventually pay Mr. Jones’ share. The answer was, as expected, negative.

The heart of the story is that the Board did not look at the property under their care. Sally and the association’s attorney are sure that Brown will present evidence that the board knew of roof and leak problems but failed to investigate. Each member of the board breeched the duty to inquire as set forth in Section 7231(a) of California Corporation Code[2]. Importantly, Section 1365.5(e) requires the board to review the reserve study annual. It appears axiomatic that this review can only be accomplished by comparing the study with the physical condition of the property. When tempers flared and the board blamed Sally, she calmly responded by noting that her management agreement did not include this service and thus the Civil Code settles this obligation on the board.

Under Civil Code Section 1365, the association must prepare and distribute various reports to members. Important to Mr. Brown’s argument is Section 1365(a)(3)(A): “[W]hether the board of directors of the association has determined to defer or not undertake repairs or replacement of any major component with a remaining life of 30 years or less, including a justification for the deferral or decision not to undertake the repair or replacement.” Then Section 1365(a)(3)(B) requires that the board disclose the possibility of a special assessment. The statute settles this as the association’s duty to disclose, but the board’s duty is to make the determination whether to defer or not undertake repairs, along with justification. Brown’s letter indicates that he and his client believe the board did not inspect, did not reconcile the condition of the property to the budget, and did not properly anticipate the special assessment, all to the detriment of his client. His main point: If my client had known, he would not have purchased, or certainly not for the price paid.

So here Sally sits, looking over the various documents and trying to organize this in a way that the board will understand. The board, after months of questioning and legal investigating, feels persecuted and angry. The board is very sensitive about the legal fees (huge); Sally has only charged about a third of her time. Sally is a little haggard and feels the pressure; her operations manager wants to see her in an hour. The company attorney, Ralph, is at the company’s office to evaluate management’s liability. Here is what comes to mind as she thumbs through the stack of papers:

Most of this really isn’t my fault, Sally thinks. The management contract clearly stated that we are only required to inspect the building from the ground. Whether this is a ‘reasonable’ inspection as discussed in her last CACM ethics class caused Sally a bit of sleeplessness. After all, she know that none of the directors has any experience with construction. In retrospect, she really should have pushed much harder for an outside expert. Maybe, Sally hopes, Ralph, the company attorney, can offer a happier perspective.

There is no question that the association was in trouble once Mr. Jones decided not to pay either the special assessment or his portion of the assessments necessary to retire the loan. The association could not forgive the debt and had to proceed with collection. The countersuit brought by Brown, the homeowner’s attorney, was pretty much a foregone conclusion. The really painful part was discovery.

Brown asked for a five-year history of maintenance and maintenance requests. Nancy, the association’s litigation attorney, could find no privilege that would prevent discovery of this information. Nancy further advised that it would be a serious mistake to pretend the information didn’t exist; the interrogatories specifically included information on computers as well as in the files. Brown asked for names and contact information for residents and owners over the last five years. Oh, Oh, Oh, thought Sally, what will these people say.

When Sally copied her emails, she realized how loose she and the board had been in their conversations. Cavalier statements, akin to ‘we don’t have time for your (leak) problem,’ will certainly prejudice a jury, maybe even a judge. Some remarks were slanderous, and that was the nice way to look at them. This would not be pretty. Some clearly contradicted subsequent ‘sanitized’ versions of the board’s decision-making process. And, Sally realized, she did nothing to stop these practices and even participated.

Brown also requested all minutes and status reports. Again, no privilege to block production. When Sally first reviewed the interrogatories, she knew she really had a problem. The board had been discussing the roof problem for years, as reflected in the minutes. Sally’s status reports included letter from owners about the leaks and problems closing sliding glass doors. The minutes did not include or reference this information.

Then there was the big ‘omission’; the board met, not just once but a couple of times, and did not approve or publish the minutes. Yes, Sally took the minutes, but the board refused to approve them. There was no applicable exception to the Open Meeting Act, but the board instructed Sally not to disseminate draft minutes. These were the first discussions of the problem, more than three years ago when the board first discussed the problems in detail and agreed to hire the engineer and then, of course, the engineer’s report. The board simply didn’t want to tell the members. Sally really doesn’t know what Ralph will say about this. She has a sinking feeling that the company will be dragged through the mud on this issue. After all, she could have alerted Steve, the association’s attorney, who would explain the risk facing the board. Now it is too late; no way to rewrite history. She really should have brought this to the attention of her operations manager.

The status reports and letter to members pose another hurdle for Sally and her company. When Sally reviewed them in preparation for delivery to Brown, she recognized the glaring inconsistencies between the two sets of documents. The correspondence to members and residents could be viewed as a ‘whitewash.’ Residents were told that the problem would be addressed, that the problem was minor, that management would have a contractor look at the problem, and finally that the association would repair the interior damage ‘later’, after the installation of a new roof.

The status reports told a different story: repair invoices from three roofing companies stating that the roof was in such poor condition that there was no effective repair solution; the two companies that tried to repair a sliding glass door warning of substantial structural problems; and, of course, Sally’s dire warnings that the directors couldn’t bury their heads in the sand (how she finally pushed the board to hire the engineer). Sally cited Corporate Code Section 7231—the part that says “A director shall perform the duties of a director . . . in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.” The question Sally anticipates that Ralph will ask her is “Did you really believe the answers you published to the members , the ‘everything is fine, no real problems’ part? Sally gets a very sick feeling in her stomach that trying to protect the board may have been a very bad idea. Maybe she can justify her acts by stating that she works for the board and not the association (true).

Then there were the budgets. Of course Sally prepared the budgets; it is part of her management duties that is specified in the contract. She coordinated the reserve study, supplying the preparer with the necessary information. Of course the board didn’t want to spend the money to have the reserve study preparer visit the property; so they continued to use the old numbers. No one checked. Sally later told the board that it was not management’s obligation to make this visual comparison under the contract. What bothers Sally now is the realization that she should have pushed the board to investigate and perhaps refuse to disseminate what she should have known to be misleading information.

But wait, thinks Sally, maybe things aren’t so dire. Even though the association’s D & O insurance won’t cover Jones’ $60,000 total assessment, maybe they will cover legal fees for the board and management. After all, the association’s governing documents provide that the board has the authority to hire management to assist in carrying out the board’s duties. Jack, the association’s insurance broker, is quick to respond. “If the board, their agent, or an individual director breaches their fiduciary obligation to the association, D & O may not provide coverage.” [3]Jack continues the analysis of D & O coverage as it applies to both the directors and manager (luckily, the association’s policy does cover Sally’s company); the directors fall under the ‘safe harbor’ provision of Civil Code Section 1365.7 and Corporate Code Section 7231, provided, Jack emphasized, that they follow the business judgment rule—that ‘good faith’ thing.

Just what is ‘good faith,’ Sally wonders as she recognizes the first sign of a huge migraine. Sally jumps up from her desk as Ralph walks by and asks Ralph to visit for a minute. Cautiously she asks Ralph to explain ‘good faith.’ Ralph, already more than just a little concerned, says that although abstract and not well defined in law, good faith is generally considered to be an honest belief unclouded by ulterior motive and “… freedom from knowledge of circumstances which ought to put the holder upon inquiry.” [4](4)

Thanking Ralph, Sally reaches for two more aspirins. Wow. No way can she paint this picture to reflect good faith. The board met without noticing members or publishing an agenda in order to discuss the repair complaints and then refused to publish the minutes. Sally didn’t do any better because she didn’t object to practices she knew to be wrong, published a ‘fairy tale’ budget, and basically lied to members who complained about water intrusion.

Jack also talked about fiduciary duty and utmost loyalty. Philosophically, as Sally pulls together her papers for the meeting, she realizes that her duty is to the board and the board’s duty is to the association. The board’s duty is to tell the hard truth in order to preserve the property, the only corporate asset. Directors are caretakers for current and future owners; they should not act like politicians seeking only to preserve their own status. The manager’s primary job is to advise the board. Sally thinks of the CACM Code of Ethics requiring loyalty, fidelity and integrity. Yes, she supported the board. No, she did not uphold the letter or spirit of Davis-Stirling. And no, instead of telling the client to do the right thing, she elevated the monthly management fee (and her pay) above what she knew to be right. As she walked to her manager’s office, she realized she sacrificed her integrity for a paycheck and the approval of these directors.

And who really benefitted, she mused? The directors are almost personae non gratae, members feel completely betrayed and much poorer ($30,000 each plus a 23% increase in assessments), and then there is the question of the current lawsuit quite likely to be joined by the three other owner who bought during this period. That swells the total to $240,000 plus legal fees. Seems pretty clear that the court will recognize that buyers have the right to rely on the disclosures produced by the association (yes, Sally thinks, that’s me). $240,000 plus probably another $100,000 for Brown.

There is a membership meeting to discuss the legal fees. The consensus seems to be that the members should not bear this cost because they had nothing to do with the way the board or management conducted business. The cost of defense, worries Sally, could easily be another $150,000. Wow, that is almost $250,000 in legal fees. It doesn’t seem like any of the directors has that kind of big money. Maybe she should ask Ralph if this is ‘joint and several’ liability (based on the company’s breach of it fiduciary duty, or gross negligence) where the company might be the deep pockets and pay any judgment imposed by the court. No, thinks Sally, maybe now is not the time to ask that question.

Oh, maybe you thought I meant that the board was caught?

Stay tuned for the next installment—could the board really be stuck with the attorney fees?