The Disclosure Trap

Published in the ECHO Journal, December 2008

The mood of the members is somber as the board meeting gets started. Four months ago the board finally decided to investigate complaints of leaks around the sliding glass doors and loose balcony railings. The engineers report calls for removal of the stucco, replacement of windows and balconies. Management reported a preliminary estimate of $3,000,000. The reserve balance is $240,000. The board is in shock, and tempers are short.

Sally, the manager for the last five years, starts her report. Mr. Smith, the board president, interrupts wanting to know who is responsible. Without waiting for an answer, he asks Sally why she didn’t discover this problem, concluding with “After all, you are the professional.” Sally takes a deep breath, expecting this reaction. Trying to remain calm, she recalls an article she’d read in the ECHO Journal and reminds the president that her management contract did not obligate her to conduct the level of professional investigation to discover the conditions now facing the association.1

After the five-minute eruption, Mr. Smith regains both his composure and control of the meeting. “OK, what can we do? Will our insurance cover this?” Without waiting for an answer, he continues by noting that the defective conditions didn’t just occur; “Can we sue the past boards?” he asks.

Quietly Sally responds: “Insurance is a not a bank account; the policy will not fund reserves or pay for ordinary wear and tear. It is for catastrophic or unforeseen events, such as storm damage to property. Also, the liability policy won’t cover the claim because no suit has been filed by the association and because the damage is to property owned or maintained by the association. The board could authorize the association to sue past directors but their defense would probably not be covered by the directors and officers insurance, which has exclusions for property damage and requires the insurer be put on notice of claims when first made. And, if the lawsuit wasn’t covered by insurance, the prior directors would, if they acted in good faith, be entitled to indemnifications from the association; so it would be like the association suing itself.2 Unfortunately, this is our problem.”

The meeting adjourns amid some turmoil and the abiding resignation that the board will have to raise the $3,000,000 either by special assessment, loan or a combination of the two. Sally has been assigned the task or researching the loan option.

During the following week Sally talks to representatives of banks that lend to associations. She learns that a usual underwriting requirement is that an association have a strong accounts receivable; this will be a problem for the association. Of its 50 members, two are in foreclosure and four others are seriously in arrears. Sally learns that a loan might be available for half of the needed $3,000,000 assuming at least half of the delinquencies are cured and the members approve the special assessment necessary to repay the loan. It may be tricky, but Sally thinks she can craft a solution to funding the construction. The big question is whether the members will authorize the special assessment.

OK, we are fast-forwarding six months. Sally and the board cobbled together a deal with a bank for $1,500,000 and convinced the members to approve an initial 23 percent increase in regular assessments and special assessments totaling the other $1,500,000. The special assessment was due two months ago, and the increase in regular assessments will start in three months.

The board meeting begins and the directors are again in a somber mood. Sally’s management report includes a letter from Mr. Brown, the attorney for Mr. Jones. The attorney’s letter states that Mr. Jones would not pay his special assessment or that part of the increase regular in his assessment occasioned by the bank loan/construction problem. Sally begins with the very difficult task of explaining Mr. Jones’ position and what this means to the board. “Mr. Jones contends that the board breached its duty. Mr. Jones purchased his unit 14 months ago. In all the documents presented for his review, including the budget summary, there was no mention of the need for the amount of money required to fix our project. The letter cites Civil Code section 1365(a)(3)(A), which provides that the board will disclose any repairs that are unfunded or for which there is no plan to do the work. The letter states that the purpose of section 1365(a)(3) was to protect buyers and owners alike and requires complete documentation of the financial liability of the members.”

Sally pauses and looks around. Finally one board member asks the question. “But we are all in this together. One person cannot just opt out. If one person doesn’t have to pay, then no one will pay.” Sally slowly begins to recount her conversation with the association legal counsel as she distributes his letter. “Basically, section 1365(a)(3) created both a new standards and a new problem. The concept of the law (effective January 2007) is to require the association to disclose to buyers and members both known liability as reflected in the pro forma budget and major components the board decided to defer or not repair or replace. The buyer may consider all aspects of the investment prior to purchase. Because the association failed to investigate the condition of the buildings and the assessments result from that failure, Mr. Jones argues that he is indemnified from the consequence of the board’s failure (the assessments). He may have a point. Our lawyer estimates $2500 to do the research and render an opinion. The research required would be to review all prior disclosures, confer with the association’s reserve study preparer, review minutes of prior board and membership meetings and look into other documents.” Sally continues by reporting that there are four other members who purchased units since the law took effect and who might also make the same argument.

What a story! This is a real cliff hanger. Will Sally and the board make it out alive after the members find out about this? We can worry about that later. Let’s first look at this problem.

In a previous article (see footnote 1) we argued that the association, and thus the board, has the primary responsibility to investigate the condition of the building even if they contract away that duty. And even if the board contracts with management or an outside service, the association still has the disclosure responsibility. However, if the board relied on professionals to conduct studies and prepare reports and those professionals fail to identify defects, then those parties will bear some, if not most, of the liability. Sally’s board did not contract for these professional services, not even through the management contract. The association has the full liability.

And now Mr. Jones’ argument. Pretty wild, right? He is saying that because the disclosure was deficient, he is not responsible for payment to correct the undisclosed liability. That liability is his share of the cost of replacing the balconies, sliding glass doors and stucco (plus, of course, any damaged framing or other components). Mr. Jones’ portion of that liability is estimated at $60,000, and there are three other members with ostensibly the same right. That means that the other 46 members must pay this $240,000. That works out to $5200 each for these 46 owners. Doesn’t sound fair, right?

Well, let’s look again at Civil Code section 1365(a)(3), enacted to protect the buying public and help members get information about their investment. With the budget, the board will also produce the Assessment and Reserve Funding Disclosure Summary, a disclosure required by the Civil Code. This document reasonably requires a detailed disclosure of the association’s financial liabilities and the funding plan for the next five years. It was the intent of this section that purchasers and homeowners would be able to evaluate the financial condition of the association easily and quickly.

In 2006 the Legislature added the section that requires statements of four conditions, the most important for our consideration being subsection (A): “Whether 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 repairs or replacement.” The other three ask whether the board anticipates a special assessment (B), the method of funding reserves and a loan disclosure. Quite clearly Mr. Jones has focused on this section. No one told him of the deferred maintenance. It is apparent that the association did not reserve for replacing the balconies, sliding glass doors or siding—there were no such reserve line items and thus no plan to fund for these replacements.

Looks like Mr. Jones has a point. He also doesn’t have a lot of options. Unlike rental property, Mr. Jones has no legal basis to withhold his assessment. He could ask for Alternative Dispute Resolution, but the board could not forgive payment of his assessment. The association’s attorney noted that under Park Place Homeowner’s Association v. Naber (1994) 29 Cal. App. 4th 427 assessments are independent of any counterclaims: there is no right of offset. A member may seek damages through ADR or a court action, but the board cannot waive any assessment. For that the member must file a separate action.

So back to the board meeting. With what is painfully becoming second nature, Sally takes a deep breath and outlines the problem in greater detail. Since Mr. Jones has not paid the special assessment (due two months ago) and has only put forward his argument, the association has no choice but to follow the Delinquent Assessment Collection Policy. Management already issued the pre-lien letter. Lawyer Brown, the attorney for Mr. Jones, recognized in his letter that the board cannot forgive a member’s obligation to pay an assessment; the purpose of the letter is give the board the opportunity of finding a solution. He will file the lawsuit when the lien is filed next month.

A tense month passes. Lawler Brown filed and served the lawsuit on Mr. Jones’ behalf, seeking relief from the debt. The board has again gathered in executive session with the attorney and insurance broker (wow, they are spending a lot of time and paying management and others big bucks for their extra time). Over the months, the mood has gone from somber to gloomy. One board member quit, and two others plan to announce their resignation tonight. No one else wants to serve. Sally’s concern is that when the lawsuit is announced the other members will either seek to join Mr. Jones or file their own lawsuit. This could be a huge catastrophe for the association and for the board. No wonder board members want to quit. Sally announces her plan: file the claim with the association’s D&O carrier. She briefly talked to the insurance broker who thought there might be an outside chance of coverage but noted that CID carriers normally do not cover assessments.

Steve, the association’s attorney, recapped the association’s position. There was simply no way the board could forgive the assessment nor the filing of a collection action. Now that Mr. Jones filed a lawsuit, the board has no option other than defend. ADR is an option open to Mr. Jones; the board cannot demand ADR.

Jack, the association insurance broker, outlined the insurance options. There are essentially three scenarios: board verses board, which we already considered (no coverage if the current board sues a previous board), owner verses board, and board verses owner. In the event that an owner sues the board or the association, there is almost always coverage based on a duty to defend. This ‘duty to defend’ means that the insurance company will hire an attorney to defend the board or association but may reserve the insurance company’s right to reimbursement if the board or association clearly breached their duty to the owner. The present situation, Jack continued, will be more likely construed as board-initiated, the third scenario, under which the company will probably ultimately deny coverage. After all, the board initiated the collection action.3

Steve discussed the nature of Mr. Jones’ claim and the underlying law, concluding that, more than likely, the insurance company will deny coverage because the board and the association breached its disclosure obligation. Once that breach occurred, there is no recovery. The only defense may be to try to prove that these buyers should have known of the condition as mitigation. “Based on what Jack said, it is doubtful that the insurance company will tender a defense, and if they do, it is likely they will find that the board breached it duty and no coverage is owed. Additionally, if the insurance company initially provides coverage they will choose the attorney.”

The board directed Steve and Jack to meet with the insurance company and their underwriter, which they did. At the end of the meeting, all were clear that the insurance company would eventually deny coverage.

Wow, what a story. The insurance company concluded that the board failed to exercise reasonable care and thus breached their duty to the association. We are not going to get into whether the directors have personal liability (outside the safe harbors of Civil Code section 1365.7 and Corp. Code section 7231), but this is an interesting discussion. Needless to say, by their failure to inspect (or have others inspect) the property they agreed to care take, these well-intended board members have not only disgraced themselves but also put themselves and the association in harm’s way.

This is a terrible story. Is it possible, you ask? Check the references, think about the situation, ask your attorney and then decide. It would be far better to recognize that this story is avoidable: hire a professional to inspect your property thoroughly at least once a year. Be clear on just whose money you are saving. In the lawsuit, each board member could be responsible not only for their legal defense but also the underfunded assessments. If you are a board member, are you willing to underwrite this liability just so that the members can underfund the association? Maybe not.


1 “The Duty to Inspect,” by David West, ECHO Journal, June 2008.

2 Under a recent case, Ritter v. Churchill, cited as C.D.O.S. 11192 (2008), the California Court of Appeals muddies the extent of indemnity to which a director is entitled (directors were responsible for their own legal fees).

3 Ibid


David West is the managing shareholder in West Management Company, Inc., an ECHO member. He has been in the CID industry for 22 years and real estate for 33 years. He holds a law degree from JFK University and is also a shareholder in West Construction and Maintenance Company, Inc.