The question of how a community association will pay for a lawsuit must be decided by the board when the need for litigation arises. Depending on whether the HOA is the defendant or pursuant in a lawsuit will often determine what financial sources the association can draw from.
The question of how a community association will pay for litigation must be decided by the board when the need for litigation arises. Depending on whether the HOA is the defendant or pursuant in a lawsuit will often determine what financial sources the association can draw from.
How to Pay as a Defendant
When an HOA is served as a defendant in a lawsuit, there is of course no choice but to be involved in a lawsuit, as the corporation must be defended to avoid a default judgment. It is likely that there is insurance coverage to pay for the defense of the association, as well as the defense of the board, in most circumstances. The lawsuit papers should be sent (“tendered”) to the insurance carrier as soon as possible, so that the insurance company can either hire an attorney to defend the interests of the homeowners association or agree to reimburse the HOA’s counsel. It is the date of tender which typically triggers the insurance company’s obligation to reimburse, so it is best to tender the defense first, or have your counsel do so, before incurring costs and expenses connected with the defense, even when you are dealing with a large deductible.
How to Pay as a Pursuant
When the board has voted to bring a lawsuit against another party, the lawsuit will not be funded by insurance, so the board needs to determine how to pay for the lawsuit. If it is filing a lawsuit against a developer for construction defects, for example, there are attorneys who will take the case on a contingent fee basis, which means that the attorney’s fees paid will be contingent on winning or settling the case, and the amount of fees will be a percentage of the amount recovered for the association. In contingent fee cases, there are still costs to be considered, which may have to be paid for up front, such as filing fees, consultant and expert costs, and deposition expenses.
If the association is bringing a lawsuit that is not a contingent fee suit, the attorney’s fees can be paid from the legal budget for the HOA, using monies in the operating account. Because litigation is expensive, and sometimes not anticipated when the budget is prepared, there may be insufficient funds available in the operating account. In those cases, funds may be borrowed from the reserve fund account, but only temporarily.
Under California Civil Code Sections 5515 and 5520, the board, after proper notice, may authorize a temporary transfer of moneys from a reserve fund to the association’s general operating fund to meet short-term cashflow requirements. The money must be repaid to the reserve account within one year of the date of the initial transfer, unless the board meets again on the subject, makes new written findings, and gives notice that a temporary delay in the repayment is in the best interests of the homeowners association. Section 5515 pertains to any type of litigation, as it authorizes temporary transfers for any short-term cashflow needs. The board must always exercise prudent fiscal management in maintaining the integrity of the reserve account.
Pursuant to Section 5520, when reserve funds are borrowed to pay for a lawsuit that involves major association components for which the reserves were established, the board may decide to simply use reserve funds or to temporarily transfer from the reserve funds to pay for this type of legal fees. The board must give proper notice of its expenditure of reserve funds in either event. The board must also give notice of the availability of an accounting of the funds. Unless the governing documents of the homeowners association impose more stringent standards, the association must do an accounting of the litigation expense on at least a quarterly basis when it is using or borrowing reserve funds under Section 5520.
Any time that the moneys are being borrowed from reserves, the board must issue a written finding in its minutes explaining why the transfer is needed, and what the plan is for repayment. Under Section 5515 (e), if the board is unable to repay the reserve account within the time limits of one year or the temporarily extended time period, it should levy a special assessment to recover the full amount of the expended funds.
Sharon Glenn Pratt is the managing partner of Pratt & Associates in San Jose, California. She is a specialist in common interest development law and litigation and has been practicing in the San Jose area for 25 years.