The Truth Behind Borrowing from Reserves
Complaints are all too common in California about boards that borrow from or use reserve funds for expenditures other than repair or maintenance of components for which the funds are collected. There is no doubt that it is difficult making ends meet for most community associations. The expenses are rising, the members expect the dollars to stretch into appreciable services, and boards are, in many cases, facing a double-edged sword. They want to keep the assessments down if they can, but they are confronted with rising costs in many areas. Among those rising costs are insurance, utilities, administration and services. Compliance with ever increasing legislative requirements is also an ongoing concern.
At the same time, the laws are toughening up on reserve planning, borrowing and spending.
Borrowing from homeowner association reserve accounts is comparable in seriousness to borrowing from your children’s education investment accounts or from your own retirement investment accounts. If you have specific monies set aside for these things in IRAs or other investment accounts, you know there are very stringent controls against taking money out—more stringent controls than on an association’s reserve accounts. On the bottom line, you just should not withdraw from these types of accounts unless:
- It’s absolutely necessary;
- You follow the legal requirements;
- You have a plan to repay borrowed funds.
If you continue to borrow without regard to these factors, it will likely catch up with you and your family. If a board of directors continually relies on the reserves as a backup bank, it will likely catch up with the members.
If a board is facing doubled or tripled insurance premiums, which has all too commonly occurred in recent years without sufficient warning to allow for prudent budgeting, the money has to come from somewhere. Some boards deal with this by utilizing a remedy involving an emergency assessment. Others look to the reserves. Others still respond by offering a vote to the owners asking for approval of an assessment for the cost. Because of delays and special voting requirements that went into effect several years ago, balloting owners for approval of assessments has become quite a bit more difficult, time consuming and costly; boards may try to avoid this remedy for those matters they think they can define as an emergency.
The budget is a flexible tool, the board’s best “guestimate” of what expenses will be for the coming year. It is based on past experience and estimates of future expenses. Contingency accounts are common. Sometimes there is enough flex in this “guestimate” to allow for unexpected increases. However, “robbing-Peter-to-pay-Paul” is a syndrome that cannot continue from year to year. If a board exercises this practice, the board members can get into trouble both as owners (who have to pick up the monetary slack along with all the other owners) and as board members (who could have personal liability as fiduciaries). Intentional raiding of reserves could expose board members to serious losses. Negligence is accidental and carelessness may be forgivable, but continuing these practices after noting the resulting problems can cause a board member to cross over into the realm of punitive remedies (meaning a judgment against you that punishes that conduct, and rewards a victim beyond actual losses), or to be without a paid defense, if intentional conduct like ignoring laws and prudent choices is proved.
Legal Restrictions on Reserve Borrowing
The issue of reserve spending is a hot topic and it’s time to focus on that. For starters, it is important to know that there are legal restrictions in California on borrowing. Civil Code §5510(b) says that the board of directors shall not expend reserve funds for any other purpose than the repair, restoration, replacement and maintenance of major components which are the obligation of the association, or related litigation.
Civil Code §5520 goes on to state that the board may authorize the temporary transfer of moneys from a reserve fund to the association’s general operating fund to meet short-term cash-flow requirements or other expenses, if the board has provided notice of the intent to consider the transfer in a notice of meeting, which is specified in Civil Code §4900-§4955. The notice shall include the reasons the transfer is needed, some of the options for repayment, and whether a special assessment may be considered. If the board authorizes the transfer, the board shall issue a written finding, recorded in the board’s minutes, explaining the reasons that the transfer is needed, and describing when and how the moneys will be repaid to the reserve fund. The transferred funds shall be restored to the reserve fund within one year of the date of the initial transfer, except that the board may, after giving the same notice required for considering a transfer, and, upon making a finding supported by documentation that a temporary delay would be in the best interests of the common interest development, temporarily delay the restoration. The board shall exercise prudent fiscal management in maintaining the integrity of the reserve account, and shall, if necessary, levy a special assessment to recover the full amount of the expended funds within the time limits required by this section. This special assessment is subject to the limitation imposed by Civil Code §5605, §5615, and §5650. The board may, at its discretion, extend the date the payment on the special assessment is due. Any extension shall not prevent the board from pursuing any legal remedy to enforce the collection of an unpaid special assessment.
Perserving the Reserve
The intent of these sections of the Civil Code is to establish legal limits on use of reserve monies and prevent borrowing unless the board provides notice to the owners of the intent to borrow and discusses and takes action at an open meeting. Associations may borrow from the reserves to meet unanticipated operating shortfalls. (If the shortfall was anticipated, it should have been resolved in the budget process.) If reserve monies are used other than for the express statutory purposes (repair, restoration, etc., of major components that are the responsibility of the association to maintain), then these sections require accountability by the stated notices, discussion of the matter an open board meeting, the requirement of written findings to be reflected in the minutes and “documentation.” The statute does not define “documentation” needed to delay restoration of funds beyond the one-year period. However I can say that a court will want to see documentation if there is a challenge; and it better be there and better explain in understandable terms what happened.
Extent of the Law
Questions about this statute arise as to what constitutes a legitimate borrowing, including disagreements over the words “short-term cash-flow requirement,” and to what extent funds may be used for additional, new, or added capital improvements (necessary or unnecessary) that are not in the reserve study.
Professionals sometimes disagree on the exact intent embodied in the “one-year” payback time, which changed in 1995 from a previous “three-year” payback deadline. Questions arise as to the effect of borrowing from reserves on the “disclosures” required by Civil Code §5300, §5310, and §5205. Associations contemplating borrowing from reserves should consult knowledgeable professionals. This is an area where legal claims may arise. Board members have a higher duty than the average member who bugs the board with questions or serves on a finance committee. A fiduciary is a person that is in a position of trust with regard to responsibility for the assets of others. This person is subject to liability if that trust is breached or the person lets the assets diminish under his or her control.
Civil Code §5520 goes on to add that when the decision is made to use reserve funds or to temporarily transfer moneys from the reserve fund to pay for litigation, the association shall notify the members in the next available mailing to all members (pursuant to Corporations Code §5016 which includes newsletters, etc.) of the transfer of funds and of the availability of an accounting, which must also be prepared. This accounting must be done on at least a quarterly basis (unless the governing documents required a more stringent standard) and it must be made available for inspection by the members at the association office.
Many bards fall short on the “pre-borrowing” requirement of notice to owners and in the preparation of an accounting. This may be because they are unaware of the law. If boards knew of the requirement, they would probably follow it. Most boards do not try to break the law; they are simply ignorant of it. Often they find out after the fact that they have missed a step, and then the owner who pointed out the error sometimes want the borrowing rolled back. Fixing such a situation is not the easiest thing in the world. If an expenditure was legitimate, and the board borrowed from the reserves to pay a necessary expense, and an owner points out an error, one alternate option is to seek a special assessment due and payable immediately from all owners. However that is not a very desirable alternative and the owners may prefer that the board just move on with the business at hand.
Finding the money to operate an association in today’s world is not easy. Boards are caught between owners who want to keep assessments low and owners who want sufficient money in the association accounts when it comes time for big expenses that the board does not have to borrow and impose assessments. Costs are ever rising for associations, just as they are for everyone else. In many cases, association owners still enjoy amenities they could not enjoy if they had to pay for them as individuals in a single family home. But a dollar isn’t stretching like it used to. And of course, there are those cases where boards use money in the bank to fund a project that was not approved by owners, that was not in the budget, and that was not even discussed in open meetings before it was paid for or contracted out, precluding owners from having any knowledge or opportunity to object.
Good planning is of the utmost importance.
Beth A. Grimm is a Pleasant Hill-based attorney representing HOAs and homeowners in common interest developments. She is the current co-chair of the ECHO East Bay Resource Panel. Visit www.californiacondoguru.com for more information on reserves and other common issues facing HOAs and for articles, classes, publications and other available resources.