Many homeowners associations are unincorporated. The directors of these unincorporated associations must evaluate whether incorporation is actually to the advantage of their homeowners association. The purpose of this article is to outline the very real benefits of incorporation and to discuss some of the practical aspects of incorporating an unincorporated homeowner association. Incorporation is advantageous for a host of reasons, including clarity of operating rules, limited liability of members, centralized management, and contractual power. The cost of incorporation and inconveniences of corporate operation are greatly outweighed by the numerous benefits of incorporation. Associations contemplating incorporation should obtain advice and counsel from their attorney and their accountant.
Many homeowners associations are unincorporated. The directors of these unincorporated associations must evaluate whether incorporation is actually to the advantage of their homeowners association. The purpose of this article is to outline the very real benefits of incorporation and to discuss some of the practical aspects of incorporating an unincorporated homeowner association. Incorporation is advantageous for a host of reasons, including clarity of operating rules, limited liability of members, centralized management, and contractual power. The cost of incorporation and inconveniences of corporate operation are greatly outweighed by the numerous benefits of incorporation. Associations contemplating incorporation should obtain advice and counsel from their attorney and their accountant.
4 Advantages to Incorporating a Community Association
The Davis-Stirling Act recognizes that homeowner associations may be incorporated or unincorporated. Civil Code §4080 defines “association” as a nonprofit corporation or unincorporated association created for the purpose of managing a common interest development.
Civil Code §4805 provides in part:
Unless the governing documents provide otherwise, and regardless of whether the association is incorporated or unincorporated, the association may exercise the powers granted to a nonprofit mutual benefit corporation, as enumerated in Section 7140 of the Corporations Code, except that an unincorporated association may not adopt or use a corporate seal or issue membership certificates in accordance with Section 7313 of the Corporations Code. The association, whether incorporated or unincorporated, may exercise the powers granted to an association in this act.
Although the Davis-Stirling Act allows the homeowners association to be unincorporated, there are significant advantages to incorporating the association.
1. Clarity of Operating Rules
An unincorporated association is recognized in California law as a legal entity. For example, it can sue and be sued. Incorporated homeowners associations likewise are recognized as legal “persons” with the power to take legal action, such as entering into contracts and bringing lawsuits. Here the similarity ends. Unincorporated associations have vague and undefined operating rules. Only the bylaws of the association establish the procedures for governance.
In contrast, a homeowners associations incorporated under the California nonprofit mutual benefit law is subject to detailed statutes that specify how it operates and also delineate the rights and obligations of members. For example, members of an incorporated association have the right to call a special meeting of the members based upon a petition of five percent or more of the members presented to the association president. The meeting must be called within 35-90 days after receipt of the written request. [See California Corporations Code §7510(e), 7511(c)]. The right of a member of an unincorporated association to call a special meeting of the members is unclear, absent a specific provision in the association’s bylaws.
2. Centralized Management and Director Protection
Unincorporated associations may encounter difficulties in entering into contracts because the authority of an individual to act on behalf of the unincorporated association must derive from the association’s governing instruments. The contract may need to be executed by all members of the association. Officers and directors of incorporated homeowners associations, acting within the scope of their apparent authority, may obligate the association with respect to necessary contracts. This obviously makes business more practical and predictable.
The Corporations Code empowers the board of directors to manage and operate the affairs of a corporation. [See Corporations Code §7210]. The Code further authorizes the membership to vote, in person or by proxy, for the directors who will run the corporation by vote. [See Corporations Code §7220 and §7613]. Members of an unincorporated association may or may not be able to use proxies in director elections. The power of the directors of an unincorporated association, deriving as it does solely from the bylaws or other governing instruments, may be ambiguous or overly restrictive.
It is noteworthy that the California Corporations Code authorizes the board of directors of a corporation to indemnify an officer or director for expenses incurred in his defense in litigation. [See California Corporations Code §7237]. Indemnification of a director of an unincorporated association may require the consent of the entire association membership.
3. Tort Liabilities
Corporations Code §18620 addresses the tort liability exposure of members, officers and directors of unincorporated associations. It provides:
- A member, director, officer, or agent of a nonprofit association shall be liable for injury, damage, or harm caused by an act or omission of the association or an act or omission of a director, officer, or agent of the association, if any of the following conditions is satisfied:
- The member, director, officer, or agent expressly assumes liability for injury, damage, or harm caused by particular conduct and that conduct causes the injury, damage, or harm.
- The member, director, officer, or agent engages in tortious conduct that causes the injury, damage, or harm.
- The member, director, officer, or agent is otherwise liable under any other statute.
- This section provides a nonexclusive list of existing grounds for liability, and does not foreclose any common law grounds for liability.
This statute appears to protect officers, directors and owners in an unincorporated association who do not cause injury or damage through their conduct or do not engage in wrongful activity causing injury. However, subsection (b) of the law states that the statute does not preclude common law grounds for liability. Therefore, there is a risk, in an unincorporated association, that officers, directors and members may be liable for wrongful conduct of another member of the association under common law grounds of liability, such as agency.
Civil Code §5805 gives condominium owners in both incorporated and unincorporated associations limited immunity from liability for torts arising from the owner’s status as a tenant in common owner of the common area. However this statute does not extend immunity to owners of homes in unincorporated associations from joint enterprise liability.
4. Contract Liabilities
Three sections of the Corporations Code address the liability of members, directors and agents of the association with respect to contractual obligations of the unincorporated association. They are, Corporations Code §18605, §18610 and §18615, which provide:
18605. A member, director, or agent of a nonprofit association is not liable for a debt, obligation, or liability of the association solely by reason of being a member, director, officer, or agent.
18610. A member of a nonprofit association is not liable for a contractual obligation of the association unless one of the following conditions is satisfied:
- The member expressly assumes personal responsibility for the obligation in a signed writing that specifically identifies the obligation assumed.
- The member expressly authorizes or ratifies the specific contract, as evidenced by a writing. This subdivision does not apply if the member authorizes or ratifies a contract solely in the member’s capacity as a director, officer, or agent of the association.
- With notice of the contract, the member receives a benefit under the contract. Liability under this subdivision is limited to the value of the benefit received.
- The member executes the contract without disclosing that the member is acting on behalf of the association.
- The member executes the contract without authority to execute the contract.
18615. A director, officer, or agent of a nonprofit association is not liable for a contractual obligation of the association unless one of the following conditions is satisfied:
- The director, officer, or agent expressly assumes responsibility for the obligation in a signed writing that specifically identifies the obligation assumed.
- The director, officer, or agent executes the contract without disclosing that the director, officer, or agent is acting on behalf of the association.
- The director, officer, or agent executes the contract without authority to execute the contract.
These statutes do not immunize members of an unincorporated homeowners association from liability for the contracts of the association. For example, if the association fails to pay a contractor, such as a roofer, the members of the unincorporated association can be sued directly, to the extent of the value of the labor and materials furnished by the contractor to that member.
Therefore, the members of an incorporated homeowners association enjoy an advantage over the members of unincorporated homeowners associations in that they cannot be directly sued by creditors of the corporation. The creditors of an unincorporated homeowners association can sue individual members, to the extent of the benefit incurred on the member, if such members knew about the contract and received a benefit under it.
However, if an association, incorporated or unincorporated, becomes liable for breach of contract, the judgment creditor may obtain a court order compelling a special assessment to be levied against the members under Civil Code §5610. [ James F. O’Toole Co., Inc. v. Los Angeles Kingsbury Court Owners Assn., 126 Cal.App. 4th 547 (2005)].
Disadvantages of Incorporation
Although incorporated associations have the benefits of an established body of corporate law governing the rights and liabilities of the association and its members, limited liability of members from contract and tort obligations, centralized management, and clearer authority to hold title to real property and enter into contracts, there are, nevertheless, disadvantages to incorporation. For example, the unincorporated association may allow the members more control over management of the association by its directors. The unincorporated association may also be simpler and less expensive to manage and maintain. The expenses of the incorporation process also are a consideration.
However, except in the smallest of associations, there probably are no particular advantages to unincorporated status because the budget, accounting and financial disclosure requirements are identical for incorporated and unincorporated associations under the Davis-Stirling Act. And, the advantages of incorporation greatly outweigh the expenses of establishing and operating the corporation.
The Incorporation Process
An unincorporated association contemplating incorporation should reserve its desired corporate name with the Secretary of State. The directors of the unincorporated association should submit to the members for approval articles of incorporation, bylaws and amended CC&Rs that will make changes necessary and appropriate to an incorporated entity. The secret ballot process in §5100 of the Civil Code applies to this vote. The respective amendment clauses in the articles of association, bylaws (if any) and CC&Rs must be followed.
Upon approval of the governing instruments by the members, the directors may execute the articles of incorporation and a statement of incorporators acknowledging the approval of incorporation by the members. The articles of incorporation are then filed with the Secretary of State. The CC&Rs (and, if desired, bylaws) may then be recorded in the appropriate county.
To complete the incorporation process, the board of directors will hold a first meeting of directors of the association and conduct certain formalities, such as the selection of a fiscal year and designation of a corporate bank account and signatories. A deed should be executed by the directors to transfer title to any real property owned by the association (common area) to the incorporated entity. Insurance policies must be amended to change the name of the insured.
Jeffrey A. Barnett is an association attorney with legal offices in San Jose. He is a past member of ECHO’s Board of Directors and a current member the Legal Resource Panel, the Legislative Committee and several regional resource panels.