Published in the ECHO Journal, October 2012
We are all far too familiar with the implosion of the subprime housing bubble in late 2008 and the resulting free fall in California home values, and in condominium values in particular. For the past four years volunteer directors and community managers have been struggling with an epidemic of delinquencies, banks refusing to foreclose nonperforming loans, and the difficulty faced in raising assessments. Essential services have often been a higher priority than common area repairs. In the midst of these significant problems it is no wonder that directors have struggled with fulfilling the most essential duty of all – the duty, spelled out in one way or the other, at the beginning of virtually every set of CC&Rs. It is the duty to “enhance and maintain the value” of the property.
While the market is far from recovered, there are encouraging signs as the total number of sales rise and average sales prices increase. How can your community ride the wave of a positive turn in market conditions in light of these issues, and especially the need to make full disclosures?
One way is to change the way you think about disclosures. It does not cost anything to change your point of view. Too often the mandatory and rigorous association disclosure obligations are seen as a burden, and a negative factor affecting values. But what if they were viewed from a positive perspective? Sure there are major repairs to be made and reserves are low, but what about all the positive energy that has gone into identifying exactly what the issues are, selecting priorities, determining what can be deferred, obtaining competitive bids, and garnering the support of a tight community in tackling the issues rather than ignoring them? Disclosures that ensure compliance with the law while putting bad news in context, and which highlight the positive aspects of the community, are in many ways the most important thing a Board can do in these difficult times.
Luckily, there are some simple guidelines to follow. This article will first provide an overview of the two-step process for association disclosures. Second, it will present a four step process that can be used to create positive disclosures.
CID Disclosures: A Two Step Process
California Civil Code §1368 requires that the seller of an interest in a common interest development provide to a potential buyer specified documents and information about the association. The association, of course, must provide those documents and information to the selling owner, so they can be passed along to the potential buyer. In order to understand the statute, it helps to know a little about its history.
Civil Code §1368 was originally enacted in 1983 as an amendment to another bill, which addressed the fact that buyers of condominiums were often in the dark about what they had bought. Sponsored by the California Association of Realtors® (CAR), the basis of the bill was the Raven’s Cove opinion, which held that directors were fiduciaries and, among other things, obligated to maintain proper reserves. In support of the bill, CAR maintained that most associations had “ignored the responsibility to maintain adequate monetary reserves.” The intent of the bill was to “establish uniform budgeting disclosure procedures for all homeowners associations.” Almost thirty years and countless amendments to the Davis Stirling Act later, associations in California are now bound by a plethora of notice, reporting, record keeping, and disclosure obligations that must be rigorously followed.
The First Step
The first step is to pay close attention to the annual and periodic reports and summaries required to be provided to members. These required disclosures are simply making sure that the members know how the association is doing, physically and fiscally.
Among all these required disclosures, the most important in terms of non-disclosure claims to be mindful of is Civil Code §1365 (a), which refers to the “Pro Forma Operating Budget.” It should be called the “Pro Forma Budget Package.” You can avoid a great deal of non-compliance by simply adopting this phrase; it is a package, not a sheet of paper. In addition to the budget, the Pro Forma Budget Package must contain specific information about the Association’s Common Area components and reserve funds. Along with a summary based on the most recent reserve study, and a percent-funded calculation disclosure summary, Civil Code §1365(a)(3) requires the Association to provide “ a statement as to whether the Board of Directors of the Association has determined or anticipates that the levy of one or more special assessments will be required to repair, replace or restore any major component to provide adequate reserves therefore.…”
This bears repeating. The Board must make a statement as to whether it “anticipates” the need to levy a special assessment in the future. Opinions can certainly differ on what should have been “anticipated,” and this opens the door for potential claims. For older Associations, the statement should almost always be something along the lines of “ it depends.”
If the Association has not complied with Civil Code §1365, there is little hope of complying with the second step of the disclosure process. Also, remember that a related benefit of compliance with Civil Code §1365 is that the Board may raise assessments, if necessary, up to the limits set by Civil Code §1366 without member approval. This right is lost if the Board does not provide the members with a Pro Forma Budget Package that complies with Civil Code §1365(a).
The Second Step
How does this important information about the Association then find its way to the prospective buyer? This occurs through the second step, which is known as the Civil Code §1368 disclosure, or the “Request for Documents and Information.” The specified information and documents must be delivered to the selling owner within 10 days of the mailing or delivery of the owner’s request.
As of January 1, 2012, the legislature did us all a favor by requiring that the cost to obtain copies of these numerous documents be disclosed in advance. This necessitated the development of a mandatory “billing disclosure” form, which can be found in Civil Code Section 1368.2 The form lists all of the required Civil Code Section 1368 disclosure documents. Disclosures of course may be, and often are, delivered electronically, and there are many options for associations and managers for vendors who offer this service.
Given the importance of disclosures, an association should not address each purchase and sale on an ad hoc basis, especially if it wants to create legally compliant and positive disclosures. The four step process below presents a suggested process to handle disclosures methodically and positively.
The Four Step Process
Any approach which ensures full and complete disclosure, and sees disclosures as a positive opportunity, is a good one. If you have such a process in place, stick with it.
In general, it should be the Board of Directors, not the community manager, ultimately deciding what is in the 1368 disclosure package. A community manager who handles 1368 disclosures, without routinely consulting with the Board, risks being accused of exceeding the scope of his or her authority, or missing something important. By taking control of disclosures the Board can both ensure legal compliance and have a role in the creation of a positive disclosure.
The four step approach we like includes:
- Adoption of a written resolution of the Board
- The use of only an authorized form
- A flexible disclosure summary and/or compilation of relevant and updated documents
- Adding disclosure as an agenda item
Adopt a Written Resolution
The first step is for the Board to adopt a written resolution which sets forth how and in what form the Board or its managing agent will respond to a seller’s Civil Code §1368 Request for Documents and Information. Among other things, the resolution might address who is authorized to communicate with whom. The law only requires that the manager or board communicate with the seller or listing agent, and not the buyer or buyer’s agent. This approach is set forth in Civil Code §1368 and was upheld in Kovich v. Paseo Del Mar HOA (1996) 41 Cal.App.4th 864. However, should this be loosened up? When would it be ok for the manager and/or directors to communicate directly with prospective purchasers? The prospective buyer may soon be your neighbor and fellow board member; shouldn’t they be made to feel welcome? Should a potential buyer or their agent sign a disclaimer and waiver before having conversations with directors or managers? Values in the community are not enhanced by secrecy, yet there are risks involved in exceeding the statutory minimums. The key is to consider how these communications will be handled and create a policy to handle them.
Use Only an Authorized Form
Pursuant to the instructions in the Resolution, the managing agent or directors handling these requests should communicate with the seller or the seller’s agent, and potential buyers if authorized, and most importantly respond to requests with an approved form. Be very cautious, as forms received from real estate agents may ask the Board to make specific representations that go too far, and are beyond the Section 1368 requirements. The approved form can be custom or a commonly accepted pre-printed form. Check with counsel if you have any questions about the form used.
Develop a Disclosure Summary or Compilation of Documents
If the Association is like many mature projects, management and the Board may be involved in evaluating the nature and scope of premature component failures, and the adequacy of the reserve accounts. This process may take a year, maybe two, maybe more. The data and information received may change rapidly. In these circumstances, where the Board “anticipates” that an increase in assessments may be necessary in the future, we recommend developing either a compilation of relevant documents or a disclosure summary. The compilation could include copies of relevant owner updates, perhaps preliminary reports from consultants and any other relevant information. The benefit of a compilation of documents is that it can be quickly and easily added to as new information is received. A summary which is updated as necessary may also serve this purpose. That summary or compilation can then be added to the electronic disclosures, or provided in hard copy, with the response to the Civil Code §1368 Request for Documents and Information.
Agendize Disclosure
We also recommend that at each regular Board meeting, the Board add to the regular agenda, under “Old Business,” the line item “Disclosure.” At each meeting consider whether there is any new information that should be added to the package, or the summary. Also consider whether any update can be provided to continue to provide a “positive disclosure” that will enhance, not detract from, value and desirability of the community.
Summary
The Board must take an active role in disclosing important information to the owners at large, and then to selling members. This is especially important as communities emerge from the subprime market debacle. Shifting your point of view so that you think of disclosure obligations as a positive opportunity to be seized, rather than a negative burden to be ignored or minimized, is one of the least expensive and most important tools you can use to maintain and enhance property values.
David F. Feingold and Matthew A. Haulk are members of the San Rafael law firm of Ragghianti Freitas LLP, and practice community association law in the San Francisco Bay Area.