Published in the ECHO Journal, November 2009

How Developer Protections in Governing Documents Work to Block Association Defect Claims

By now, most readers are probably aware of the basic protections that a developer adopts in the governing documents to protect itself from future litigation: arbitration provisions, mediation requirements, and the pre-litigation procedures of Title 7 and the Calderon process.¹ All are important, but by 2009, these provisions are now old hat. This article explores the more recent developments in CC&R drafting by developers and their counsel,² as well as what can be done to avoid the traps these newer provisions have set for an association that may have a construction defect claim.

Part 1

Don’t Make a Claim without a Member Vote, or How to Make Defect Litigation Much, Much Harder For Associations

First among the newer developer self-protection provisions is the requirement that a member vote be held before an association can “initiate a construction defect claim.” While this provision would certainly require a member vote before the association could bring a lawsuit, its intent is far broader. By using the language “construction defect claim,” the provision could be read to require a member vote before the association could give any notice to the builder that defects were present. This would include notice required by either California Civil Code Section 1375 or Title 7, which are prerequisites to a defect claim, and trigger certain time periods during which each side must provide information to the other and the builder can investigate and offer to repair alleged defects.

Practically, the effect of this provision is enormous. Statutes of limitations run quickly—indeed, under Title 7, some can run as quickly as one year after the association takes control from the developer. Serving the statutory notice to the builder stops the statute from running for a period of time. But if the association cannot even get the notice out until it holds a member vote and gets quorum, statutes may run before there are even enough votes to make a decision. The association stands to lose its rights because it must wait for member approval in order to “initiate a construction defect claim.” This could also be read broadly to apply to virtually any communication from the association to the developer regarding construction deficiencies, basically crippling the board of director’s ability to bring such issues to the developer’s attention.

And that is exactly what the provision is designed to do. Ask yourself: When Microsoft wants to make a claim against another company, does it hold a shareholder meeting to authorize a notice of that claim or the resulting lawsuit? No, and the reason is straightforward: delay could be potentially disastrous to the claim. Further, the board of directors of Microsoft has the responsibility to conduct the business of the company, including making necessary claims. That is not a responsibility that is delegated to the shareholders. But then, Microsoft’s governing documents were not written by the very people Microsoft might have to sue. New associations, however, are forced to work with governing documents written by developers–the same developers whom the association may have to sue to remedy defects or budget deficiencies. And it is in the interest of those developers to make it as hard as possible for an association to bring that case.

Part 2

Don’t Hire an Attorney on Contingency for Construction Defect Cases, or How to Make Defect Litigation Much, Much Harder For Associations

Similar provisions requiring member approval pop up in the context of fee arrangements with attorneys. Here’s one example from a recent set of CC&Rs:

“Litigation/Arbitration: The Board has authority to enter into a contingent fee contract with an attorney in a matter involving alleged design or construction defects in the Project, only as to the facilities or improvements the Association is responsible for maintaining as provided herein, and then only after getting the vote at a duly noticed and properly held membership meeting, of a majority of a quorum of the Members other than Declarant [developer].”

So, in order to hire a law firm to represent the association for a contingent fee for defect cases, or any other cases involving facilities the association must maintain, the association must get member approval. What if the case is about something else? Under this provision, the board could hire a contingency attorney all on its own. Only for “facilities” and “maintenance” cases, e.g., construction defect cases, does the board need to go to its members in order to hire an attorney on a contingency fee contract.

Why might an association want to hire an attorney on a contingency fee contract? To answer that, first a little background: A contingency fee agreement is one in which the client does not pay the attorney’s hourly rate as the attorney works the case. Instead, the client agrees that a portion of the recovery, if any, is paid to the attorney as that attorney’s fee for services. Thus, the client does not have to put up any money for attorney’s fees during the prosecution of the case. Similarly, the attorney takes the risk that if there is no recovery, he or she does not get paid.

For a new association looking at a potential construction defect action, a contingency fee agreement can have certain advantages. New associations are typically without sufficient money in the budget to pay an attorney’s hourly rate, especially for the hours required in pre-litigation discussions or in litigation itself. (In some cases, new associations don’t even have sufficient funds from the developer to meet maintenance obligations, much less to hire counsel.) The use of a special assessment is hardly palatable, and in an era of foreclosures and delinquencies, it may create more problems than it solves by piling further obligations on people who are already having trouble paying their mortgages. This leaves a contingency arrangement as, occasionally, the only realistic way in which an association can obtain competent, experienced counsel to represent its interests.

So why require a member vote before an association can enter into such an agreement for defect cases? It is yet another way to make litigating a defect case harder for an association. If the association is too poor or underfunded to pay an attorney’s hourly rate, but they can’t hire one on contingency because they cannot get a quorum of members together (a frequent problem, particularly in new associations), then guess what? They cannot hire a competent attorney to bring their defect case. That is exactly the goal of the developer in inserting this provision.

One more thing to remember: While the association is struggling to muster a quorum on a vote to hire an attorney on contingency, the various statutes of limitations on its defect claims are running. So not only must the association struggle to obtain counsel, but it risks missing the statute of limitations deadline while it tries to get the required vote. And if you observed that this is the same problem identified in the last section with regard to member votes to “initiate a defect claim,” you’re exactly right. The very design of these “member vote” provisions is to delay the association from bringing its claim and increase the chance that the association will miss the deadline imposed by the various statutes of limitation.

The Architect You Never Knew You Needed And Can’t Pay For, or How Inspection Requirements Can Trap an Association

Here’s another provision that has been popping up in developer-drafted CC&Rs for some time now:

The Association shall cause inspections of all infrastructure to be routinely made in conjunction with the Association’s manager. The Board shall engage professionals to conduct inspection of these components of the Project if the Board or the Association’s manager deem that such inspection by professionals, such as an architect, a civil engineer, structural engineer, landscape architect or other such professional is warranted. Inspections shall be made at least yearly and, for appropriate items or events, more often.

Let’s be blunt: The entire purpose of this provision is to provide the developer a defense to a construction defect claim. How? After all, that provision seems innocent enough. Why shouldn’t an association hire necessary professionals? But here’s how it works. Say the association discovers leaks two years after taking over control from the developer. In those intervening two years, there were no obvious problems; so the issue of hiring an architect or engineer didn’t come up. When the association later sues for defects, the developer points to this failure and argues that the defects could have been discovered earlier if the board had engaged the services of a professional. Thus, the developer argues, it is the association’s fault that the defects were not repaired, because the manager and/or board should have hired a professional. Just like that, the developer has an immediate defense with which to attack the association’s claim, and one that might work even if there were defects in the project at the time of turnover.

Of course, the problem facing many new associations is a financial one. Even if they wanted to hire an architect, engineer or other professional, they may simply lack the funds to do so. Combine that with ever-decreasing assessments as new homeowners more often default, and the reality is that hiring an expert is simply outside the realm of possibility for an association.

Now, a response may be that this provision has other purposes. Proper maintenance is, after all, the obligation of the association and delineating those requirements—along with the option of hiring professionals—gives specificity that benefits both the board and the membership. And the provision does leave discretion over the decision to the board and manager. All of this may be true. But if you have any doubt that the actual goal of this provision is to provide a defense to the developer, take a look at the clause which almost always follows:

For a period of ten (10) years after the date of the last Close of Escrow in the Project, the Board shall also furnish to Declarant [the developer]: (a) the report of each inspection performed for the Board, whenever such inspection is performed and for whatever portion of the Common Area that is inspected, within thirty (3) days after completion of the inspection; and (b) the most recent inspection report for any portion of the Project, within ten (10) days after the Association’s receipt of a written request therefore from Declarant.

This section obligates the association to send all inspection reports to the developer for 10 years. If the goal of the provision describing the inspections was to spell out the association’s obligations for its benefit and that of its members, why did the developer insert this provision to make sure it gets a copy of those reports? Why does the developer even care? And why is the obligation for 10 years as opposed to 5 or 3?

The answer to all these questions is the same: The provision is designed to protect the developer against defect litigation by the association. Why does the developer want the inspection reports? So it knows exactly what maintenance the association is (and is not) doing. Why does it want the reports for 10 years? Because the absolute final statute of limitations for defect claims for latent defects is 10 years. Read together, these provisions require not only that the association maintain the project, but that it provide records of that maintenance to the developer for as long as there is even the potential for the developer to be sued. The developer can even request all of the records itself and the association has ten days to provide them. This gives the developer all the maintenance records it needs to prepare a “lack of maintenance” defense to an association’s defect lawsuit. The purpose of this clause is obvious.

Managers need to be alert for these provisions as well. Board members are unlikely to know about these obligations unless a manager informs them. If a manager fails to do so, the consequences can be severe. An association may face a defense to their defect suit, and they may potentially lose their case. No board member, and no manager, wants to have a finger pointed at them for that problem.

The 90% Solution , or Why CC&Rs Can Be Harder To Amend Than the U.S. Constitution

If you’ve managed to get this far into the article, I know what you’re thinking. Yes, these provisions are detrimental, but can’t an association just amend them out? It can certainly try. But to succeed, it may need an impossibly overwhelming vote: 90% of members and first lenders. Here’s how that provision reads:

Amendments Regarding Initiation of Construction Defect Claims. Notwithstanding anything to the contrary contained in this Declaration, this section shall not be amended without the vote or approval by written ballot of at least (a) ninety percent (90%) of the voting power of Members of the Association other than the Declarant and (b) at least ninety percent (90%) of the First Lenders.

Now, ask yourself: In what other situation is a 90% member vote required for approval of an action? None. To bring litigation? Nope, the board can do that on its own in many circumstances, and even when a member vote is required, a majority of quorum will do the job. Under most CC&Rs, an association can shut itself down and sell off its property with less than a 90% majority. Think about that for a second: It takes a more owner votes to amend out the developer protections in these CC&Rs than it would take for the association to cease operations completely. Even the supermajority of states required to ratify an amendment to the U.S. Constitution—75 percent, your high school civics teacher would remind you—is less than this! And keep in mind that the vote is not just of members but also 90% of first lenders. Its two super-super-majorities rolled into one and it is unheard of anywhere else in association law. And most likely, it will be impossible to achieve.

By now, you do not need to be told why this language exists. All the provisions we mentioned earlier are designed to protect the developer from association defect litigation. This one is designed to prevent an association from amending the CC&Rs to remove those very protections.

What Can An Association Do?

So you’re in an association that is riddled with defects, or you are managing one, and the CC&Rs have one or all of the above provisions. What should you do?

1. Make the claim anyway if the statute of limitations deadline is looming.

   It’s risky, but sometimes it’s the only way to stop the statute of limitations from running. Hire an attorney on an hourly or fixed-fee basis to file the necessary statutory notice or just to get the complaint on file, so as to avoid the member vote for contingency arrangements. This will require some up-front cost, but it will not be substantial. Yes, the CC&Rs may require a member vote to initiate a claim in the first place, but a board is charged with acting in the best interests of the association and managing the business affairs of the association. So, if a statute of limitations might be running on a claim, a board has the duty to do what it can to preserve that claim and then get the required vote. If a board sits on its hands and waits for a member vote, only to watch the statute of limitations expire, will that “member vote” provision shield it from a breach of fiduciary claim for missing the statute? Maybe, but I wouldn’t want to defend them.

2. Of course, do what you can to obey the CC&Rs.

   If a statute of limitations is not about to expire, the board has an obligation to go through the procedures to the best of its ability, including putting the required provisions out to member vote. Review your CC&Rs and know exactly what your obligations are.

3. Whatever your decision, if you think you have a problem with a CC&R provision, get the advice of competent, experienced counsel.

   Obviously, if you follow #1, you’ll need to do this. But it is a good idea even if the issue has not reached a statutory red alert stage. Each set of CC&Rs is a unique animal, and while this article has discussed these provisions generally, they may be slightly different in your association’s governing documents. Paying a small up-front fee to have an attorney spent a couple of hours reviewing your association’s situation is money well spent, especially if helps avoid liability for the association on the back end for not acting properly in pursuing its defect claims.

Will a Court Bail You Out?

What if an association decides not to abide by these provisions that are obviously intended to benefit the developer at the expense of the membership and the best interests of the association?  Courts have invalidated similar self-serving provisions in governing documents provisions intended to protect developers. Mandatory binding arbitration provisions that require an association to waive its right to have its claims heard by a jury, for example, have been invalidated as being over-reaching and oppressive contractual provisions. And CC&Rs are part of the contract with the developer. As discussed above, CC&Rs written in the last few years contain many provisions that limit the association’s rights or that require surprisingly high levels of reporting or maintenance obligations. Some of these would probably survive a legal challenge while others, being too overreaching, would not. How to deal with these from a strategic point of view, taking into account the specific verbiage, the nature of the defects, the interests of the members and other factors requires a careful analysis by competent experienced counsel and the engagement of the board.

There is never an excuse for letting an important claim be lost to a statute of limitations while you ponder the enforceability of CC&R provisions written by a developer for its own protection. When that much is on the line, and if compliance with the developer-protection provisions would cost the association its claim, the decision to proceed without compliance will probably be understood by a court. Keep in mind that, in most cases, unless a developer has a continuing ownership interest in the project, it is the members, not the developer, who have the standing to object to a board’s failure to comply.³ Since it is for the member’s ultimate benefit that a claim would be made, it is likely that a court would ignore pleas to the contrary from the developer.

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¹ California Civil Code Section 1375 et seq.

² It also follows the recent article by Tyler Berding entitled “When Do Statutes of Limitation Begin to Run on Construction Claims?” (ECHO Journal, August 2009) In that article, Mr. Berding discusses a CCR provision, which we will not cover further here, purporting to waive the developer’s control over an association’s ability to bring Title 7 claims, and the effect that provision has on the statute of limitations.

³ The majority of cases hold that once a developer has no further ownership interest in the project, it cannot enforce the CC&Rs. See, e.g., Bramwell v. Kuhle (1960) 183 Cal.App.2d 767, 776; Kent v. Koch (1958) 166 Cal.App.2d 579, 586; La Mancha Dev. Corp. v. Sheegog (1978) 78 Cal. App. 3d 9, 14. But in one case. [B.C.E. Development, Inc. v. Smith (1989) 215 Cal.App.3d 1142]where the CC&Rs granted the developer a continuing right to approve architectural modifications and this power went unchallenged by the owners after completion of the subdivision, the court held that the developer’s successor-in-interest had standing to enforce the documents. Because the developer’s control had been permitted by the owners for so long (nearly 20 years had lapsed between the recordation of the CC&Rs and the litigation challenging the developer’s right to enforce them), the court held that the owners effectively ratified the developer’s actions.

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Matt Malone is an attorney in the litigation department at Berding│Weil in Alamo. He represents individual homeowners, commercial real estate owners and common interest developments in complex construction defect actions.