Legal Responsibilities of HOA Boards Regarding Reserves

Robert Nordlund 00:07

Well. Thank you, Paige and to everyone joining us today. Thank you very much for coming, for taking time out of your day to join us in other webinars we’ve prepared. We address the idea of what is a reserve study, the portions of it, how to use it, some of the calculations behind it. But today, we’re going to branch into why the legal responsibilities of boards, and for that, we’ve got a special guest with us today, Adrian Adams, and we’re going to walk through this whole idea with this kind of an agenda today, talking about the battle, the challenge that you have in front of a the rules of engagement, how to slay the dragon, how to come out on top. And we’ll wrap it up with a few closing remarks at the end. But I want to make it clear that this is a battle that you’re in. You are a bit of an underdog as the board or manager, you’re fighting some outside destructive forces, and we want to equip you to know what you’re up against and what your strategies are to move forward. Now, you need to know at first what at stake or what they if you lose. Is disruptive special assessments, possibly very expensive one. In addition to being disruptive, the high cost of loans, if you choose to not go down the special assessment route, higher project costs. And what I mean by that is when you let something deteriorate because you don’t have enough money, or you just choose to go slow and the deterioration causes additional damage. Think about a roof project that if you wait too long, it causes underlying structural concerns and damage that you then have to fix, and then also, if it’s leaking, you have leak related water repairs to do inside top floor units. And so things get expensive if you delay and loss of DNO coverage, that’s a possibility if you are not complying with the governing documents, and there’s Association liability. What if you aren’t doing your job to protect the association? And that may be actually individual board and reliability. Adrian will address that when we get to his section. But we are counting on you to fight this battle, and you need to be actively engaged, otherwise there’s some potential exposure for you personally. And then, of course, there’s lagging property values, and that’s the home that you live in, it may not rise with other homes in the surrounding areas, so there may be a financial pain. Now, if you are winning, that means you’re going to emerge with no special assessments, because you have adequate reserves. That’s a defined term. Nowadays, you have budget stability. Your homeowners know what to expect from year to year to year. You have minimized expenses again, because the projects happen at the scope that they were bid at a paint project is just a paint project that doesn’t have any carpentry or welding that you’ve got to do to the underlying materials. You have minimized liability exposure because you’re doing what the governing documents and state law ask you to do you’re serving the association you know walk in that straight line, and that results in having maximized home values. It’s good for your pocketbook. The things that we’re going to tell you today are smart. They’re good financial investments. If you have some of the consequences I mentioned in the last slide, those can get very expensive. So for those of you thinking about, gee, we can’t afford it, I want to encourage you to think you can’t not afford it, and having maximized home values means maximized owner enjoyment. The place looks good. It’s a pleasure to live there. Things work. It looks sharp. You are happy to invite friends to come over to your place. A lot of good things begin to happen. Okay, who is the enemy? The enemy is mother nature and Father Time. Very clearly, incredibly huge adversaries. You have no power over them. They are, in this illustration that we’re going through today this analogy, they’re the dragon, and you have to appreciate that the deterioration they cause is expensive. It’s predictable and ongoing, and deterioration is not a respecter of state lines. Deterioration is not a respecter of tight budgets. It’s not a respecter of what your governing documents say they’re going to do. Mother Nature and Father Time are going to do what they do. So you need to be ready that they are a very powerful, you can almost say, overwhelming force, but we’re going to help you put up a good defense today. Now there are other obstacles in. Path. A few other challenges. Short term thinking is one of them, and that’s because you have basically in this entire industry. This entire industry is built on untrained volunteer board members with short term agendas and short terms in office. That’s just the nature of this industry that we live in. And there’s another obstacle short term thinking, and that’s pursuing the wrong objective thinking that you want to pursue low monthly assessments. And it’s very clear that that’s nowhere in your governing documents. That’s nowhere in state law, your governing documents in state law. And I want to say government forces like Fannie Mae and Freddie Mac are actually forcing you in the opposite direction, taking good care of the property, that’s your responsibility, so getting off track. Aiming in the wrong direction is going to be bad for you. That’s an obstacle. You need to refocus and re aim. Another obstacle is momentum, where you are going one direction. You’ve been doing, perhaps years of reserve underfunding, years of no assessment increases, and that’s going to be hard to turn around. May be hard to turn that ship around in just one year. It may take a while to turn that ship around and get some positive momentum going at your association, and that’s usually accompanied by the thought that, well, we’ve always done it this way, or the board last year did it, and you know, worked for them. But you have to be very careful that you’re not just following momentum. Another factor in the momentum is the words that you choose. For years, we’ve been calling them reserve contributions, and that makes them sound optional. What they really are are reserve obligations, reserve transfers or reserve needs. And you need to start to begin to appreciate that these are bills as real as any other bill at the association. You can almost imagine a roof sending a deterioration bill each month. The asphalt, sending a deterioration bill each month. That’s what your reserve funding is on a monthly basis, the monthly deterioration bill. So be careful about calling them contribution. Another obstacle is when things are all good. You may have the owners on your side. They’re happy, but when you say, hey, it’s time for a change. We need to raise assessments. It’s very easy for them to think that you are the enemy, not the big dragon of cost of deterioration, inflation, tariffs, supply chain issues, things like that. So that’s a problem that you address with communication and transparency, but that is one of those follow along obstacles that you will hit that can result in board recalls, contentious elections, contentious budget times. But that’s a real factor in this world that we live in, and I do want to make it clear, also that we’re here four years and one day after the tragic collapse of Champlain towers south. This is not just a theoretical battle. This is real. Properties are deteriorating, and Champlain towers South deteriorated over 40 years of its existence, and it collapsed. And you’re looking at this picture on the screen and you say, Oh, gee, that’s a tragic, ugly picture. Look at all that shredded building. But I want to make sure you’re focusing on this pile right here. What you aren’t seeing is 98 people who died in the collapse. This is not only a budget issue, this is a safety issue, and before the end of today’s program, we’re going to make it very clear it’s a legal issue and it’s also a communication issue. So these are the tools that you’re going to be using to work with this problem, to fight this battle. So now I’m going to turn the pages to a new chapter here in our presentation, we’re going to talk about the rules of engagement, and these are basically how we’re going to address this challenge. What tools do we have? What are the rules that we need to follow? And for this portion of the program, I’m very pleased to have my friend and long term colleague in the community, association, industry, and a experienced expert in the legal profession, Adrian Adams, so Adrian, let me hand it over to you at this time.

Adrian Adams 09:29

Hey, thank you, Robert. Let’s go. There you go. Rules of Engagement, the factors, fiduciaries, and I saw that you have a lot of board members attending this which is good, and managers as well. The for boards directors, once they’re on the board, as soon as they’re elected, they become a fiduciary, which means they’re held to a higher standard. And one of the things that Homer associations are created to do is to manage common area. I mean, that’s exactly why they’re created. Yeah. And then you have an elected board of directors that oversees those common areas, which means that they have to make sure that they’re safe and that they’re well maintained. And that’s where reserve studies come into play, because you’ve got components that have a longer life, and at some point will need to be replaced, and boards of directors have to anticipate that and prepare for it, and that’s where reserve studies come in, setting up a separate reserve account and putting away monies on a regular basis so that the money is there when you need it earlier. You had slide about directors aiming at the wrong target or missing the target entirely. The there was association I was called in as an expert after they got sued. And what the board had been doing was that they had a number of people living in the their condo association that were on fixed incomes. And so what they did was they decided we’re not going to raise assessment so so that we don’t drive them out. And they went trying to think 15 years no assessment increases. And they they stopped contributing to reserves and deferred maintenance built up. And what happened was that then the roofs got to a point that one winter when there were heavy rains, water just poured in into units all over the complex, that resulted in lawsuits being filed, insurance taking under reservation rights damage due To the failure to properly maintain the roofs, and at the end of the day, the Association had to impose large special assessments to pay for all the damage, and then also to pay for new roofs. And what happened was that all of those people that they were protecting on fixed income, they were defaulting on their mortgages, or they’re being forced to move out because they couldn’t pay the special assessments, and they’re selling their units at now below market because of all the special assessments and deferred maintenance. So you know, it’s important that boards know what their responsibilities are and meet them, and if you’ll go to the next slide, and if they they do that, they’re going to be protected by the business judgment rule. And the business judgment rule says that a director can make a mistake in judgment and end up in a lawsuit, but not be personally liable if they follow these three steps, these three lakes of that stool, the decisions they make must be in good faith, in the best interest of the association and after reasonable inquiry. Okay, so what this board in this particular association were doing is that they were their hearts were in the right place, that they wanted to protect the older individuals have fixed income, but they certainly weren’t acting in the best interest of the association. And at the end of the day, they were not acting in the best interest of those individuals, those older fixed income people, because they were forced out of their units. So if the if boards, follow these steps, making decisions good faith, best interest, reasonable inquiry, they’re not going to be personally liable, even though they make a mistake and end up in a lawsuit. So if you’ll go to the next one, going back to Champlain towers, which you mentioned, everybody got sued in that board members, everyone and ended up was the settlement was up over a billion dollars, just about, yeah, and thank goodness it was settled rather than go to trial, because, you know, there could have been what deemed criminal negligence involved, and directors would have been seriously a risk. So this is why it’s important that board members take care of the financial aspects of the association, because those finances are what they need in order to take care of the common areas, which is the whole point of an association being set up. So as long as they do that, then they’re, first of all, they’re not going to end up in lawsuits, because they’re going to be funded enough that they can take care of what they’re supposed to be taking care of. Okay, let’s go to while we’re let’s go back up for just a second on the governing documents. One of the things that boards should do is to take a look at their governing documents. One of the elements that came up in that first lawsuit was the issue in their ccnrs, it said board the association must maintain their common areas in a first class condition. That became a real problematic issue for the association in that lawsuit, and the court specifically questioned me when I was on the stand as an ex. Burden. What does that mean? Because it puts it at variance with the whole concept of what a reserve study is supposed to do. In a with reserve studies, you’re allowing a component to go towards the end of its life, and then you have the money to replace it. Well, if you’re supposed to maintain in a first class condition. What does that mean? Does that mean it’s never going to reach, reach the end of its life? And so we we amend documents whenever we see that in a set of 16 hours, we amend them and take that out and put in different language. Okay, let’s go to the next slide. Okay. So the in addition to governing documents, you have state laws, and then you also have a federal agency involved. That’s Fannie Mae. So different state laws may have different requirements as to what boards must do when it comes to, first of all, just a reserve study. And Robert, you know how many, because you’re nationwide with your company, how many states have requirements that there be reserve studies? Well,

Robert Nordlund 16:10

about 25 states that have some requirements with respect to reserves. It may be a reserve disclosure. It may be a reserve study every X number of years, it may be a reserve funding requirement. So it’s different in different states, but roughly about 25 states,

Adrian Adams 16:28

yeah, and in California, there’s a requirement that a reserve study be done, be updated annually, and then an on site every three years. But there is no specific requirement that it be funded. But there are indirect requirements as part of their fiduciary duties and responsibilities to take care of the common areas. They need to have funded reserves, because without it, they can’t take care of the common areas. So it’s important, you know, to be looking at what, first of all, what your state requires, secondly, what your governing documents require. And then you’ve got other factors, such as Fannie Mae stepping in because the Champlain towers collapse, and they change their lending requirements questionnaires so that they want to know as an association, are you taking care of the common areas? Do you have anything that you’ve neglected? Because if you, if you do, if you have, we’re not alone in there. So they’ll blacklist the association. So it’s really important that boards set up reserve funds properly, fund those and then take care of the common areas, those components with those reserve funds. Okay? Let’s go to the next one. Okay, reserve costs outside your control. So as this slide points out, budget assessments or special assessments. If you’ve got underfunded reserves, you’re looking at special assessments. They’re inevitable, and special assessments can be very costly. And as you this next slide shows, the owners pay either way, they’re either going to pay incrementally, going into reserves that will then earn interest, or they’re going to be facing special assessments and bank loans where they’re going to be paying interest, and it’s much more expensive to go that route than to Simply set aside reserves and fund it properly. Okay? The next one, let

Robert Nordlund 18:24

me close out this first chapter of the rules of engagement. Adrian, when we were talking earlier, you talked about there’s actually two people that are the owners might be fighting, sometimes the board or the knight is not fighting, and in that case, they’re doing damage to the association when they are not doing what they need to do. So sometimes there’s the dragon out there, and sometimes it’s a non functioning board. So yes, again, we want to be very clear that the board has a job. They wear a different hat, and like you said, when they become a board member, they have a new role, and that role is the fiduciary of the association. They’re caring for the association, and that’s an obligation. So that’s a different role. So we just want to make sure we’re pressing that that point very clear. Okay, that’s a non

Adrian Adams 19:16

functioning board that’s not reserving becomes the dragon, becomes the problem, and a future board that steps in and tries to fix it, you know, they get blamed because they’re the one doing the special assessments, when actually they’re trying to do the right thing, exactly.

Robert Nordlund 19:30

And that’s that momentum factor, right? Yeah. So what we’re trying to do here is make sure you’re, you’re hearing and seeing the complexities of what we’re working with here. Okay, how to slay the dragon? Let’s now about a few points to help you get the upper hand. Now, Mother Nature and Father Time are formidable opponents, but what can you do? Let me turn you back over to Adrian for a couple moments.

Adrian Adams 19:59

Yeah. Another. Other lawsuit that I was involved in was brought in as an expert. The board the association was badly underfunded and had deferred maintenance. And their reserves, they just again. I don’t even remember what the reserve in their case. I think it was at 12% is where they were funded. New Board came in, decided that they need to take care of this problem, and they started funding the reserves and taking care of maintenance problems three years into their funding plan, as they’re building up their reserves and taking care of maintenance, their cast iron drain lines throughout the complex, the throughout the community, they started failing, and they all started failing about the same time. Pretty remarkable, and it was due to a manufacturing defect in the cast iron causing it to crack. And so what they had to do was to impose an emergency special assessment on the membership. Well, an owner who had bought in the year before, and also happened to be an attorney, sued the association and sued them for, you know, breach of fiduciary duties, negligence, all those kinds of things that you would normally throw into a lawsuit, and breach of their ccnrs. They brought me in as an expert, and I looked at what they were doing, and the board had been acting properly. They were they were bringing the reserves up. They were funding them. And had that not been for that defect in the cast iron, which was totally unexpected, they were on. They were on course there wouldn’t have been a special assessment, and they would have been able to take care of all their maintenance issues with their components. Once I showed that to the court, the court found in the association’s favor and found against plaintiff, so the plaintiff lost in that case. So this is where, if a board, even if you’re underfunded, you start doing the right thing, you’re going to be protected. And even if a lawsuit gets filed, you could show that you as this board, were doing the right thing, even though prior boards might not have and

Robert Nordlund 22:11

that’s just an illustration of the business judgment rule that you were talking about a moment ago. Exactly. Excellent.

Adrian Adams 22:18

Okay, the next one the state laws, yeah. Going back to this issue, you know, you’ve got 25 states that don’t have anything, 25 that do various kinds as boards. You need to find out what your obligations are under the law, because the law is going to trump your governing documents. So even if your governing documents don’t say anything about reserves and the law does? You gotta follow the law and then look at to see what your documents say, because it may have additional requirements related to your finances and maintenance obligations. So this is important for boards, and this where you’re going to one have a reserve analyst come in and help you set up a plan, a funding plan, and legal counsel to take a look at your documents to see what your obligations are, and also to tell you what laws apply to your situation. So once you’re as a board, you’re doing that, you’re helping to slay that dragon in that you’re you’re doing what you’re obligated to do, which then you’re protected under the business judgment rule. Okay, the next There we go, acting like a fiduciary. Again, as soon as you’re elected to the board, you become a fiduciary, which means you’re supposed to act, you’re required to act in the best interest of the community. So the that board I mentioned early earlier, they were not doing that. They were acting in the best interest of a few, and even then, it turned out to not be in their best interest because they were losing their units. So you have an obligation as a board to be looking at what you’re obligated to do, and that is to do what, to maintain the common areas. And you can’t do that if you don’t have the money to do the maintenance, and especially on big ticket items that have a longer life when they come due. You need to have that money in place in order to replace those roofs, to re pipe the buildings, to do whatever the big project is going to be, upgrade the elevators. It’s important as a fiduciary, that you act in the best interest of the community by setting aside those funds, Okay, the next one, okay, and the budget to pay your bills, spending. So this is important. From time to time, I run into a treasurer or even a board that believes it’s their duty to sit on the reserves and never spend them well, actually spending them is one of their duties. They’re required. You need to spend them if you’re going to do your job right. So you put the money aside so that when it’s time to re roof you’ve got the money to do it. And as a second bullet point. They’re wanting real estate is expensive. That’s true. And in fact, I’m sure, Robert, you know that those that are on either coast, on the water, their components will fail sooner than those that are inland, absolutely. So it’s important to know exactly, and this is where the reserve analysts come in, because they’ll be able to look at and know, you know, identify all the components, know what the remaining lifespan is and what it’s going to cost to replace them, and how to set aside money to reach that goal. So the money is there when it’s time to replace the components. Okay, the next one,

Robert Nordlund 25:39

right? And wondering what is that? How much is that? And the answer is, it’s usually the cost to keep things balanced, to have enough cash going into reserves so that you’re prepared at the right time, is typically about a quarter of your total budget, and the range is typically 15 to 40% but a real easy figure of merit for the purpose of this conversation today, 25% and if you are skimping on that, if you’re if you check your budget after the program today, and you see that you’re only setting aside 10% towards reserves, I think You’re going to find out like that, that lady that was looking at, I think, the cupcake and the apple that Adrian you showed earlier, the costs are going to be there. A roof is going to need to be replaced. The only question is, how you’re going to pay for it. So you’re never really saving homeowners any money by not funding reserves. So keep this in mind, typically, you’re going to be about a quarter of your total budget. Yeah, let’s

Adrian Adams 26:45

go back to for a second to that slide. If they don’t set aside the reserves, they’re still going to be spending that money. They’ll be spending it on legal fees and insurance because they could lose insurance coverage or have its spike significantly, especially when lawsuits started getting filed, as it was happening with this one association, they had numerous lawsuits filed against them because of all the what the damage coming in through those roofs. So it’s either you pay something that you know what the numbers are and you can budget for it, or you wait to get sued and lose insurance and then pay significantly more monies at the end of the day.

Robert Nordlund 27:25

Yeah, that’s a very good point. I think the association that go down that path think, oh boy, would have been so much cheaper just to fund reserves the way we should have those kinds of things. Very good point. Thanks. Adrian. Other ways rules you can put at your disposal is update your reserve study regularly. National best practice is a with site visit based reserve study every third year that gives you current information so you know where the dragon is, how close it’s approaching, how big it is, and you can fund as recommended in light of the reserve fund balance, interest and inflation changing costs. You’re going to get that fresh information from that updated reserve study, and then, as Adrian said just a moment ago, spending money is your job. It’s your job to take care of the place and do timely repairs and replacements before they get overly expensive. So plan, get that updated plan, and then follow the plan. And then we want to make sure that you understand there’s financial challenges here, there’s legal challenges here, but 1/3 of the solution is in your hands. Expect the solution is as much communication as it is financial, you want to keep the homeowners on your side, aligning them, understanding that the enemy is the high cost. It’s the dragon of inflation, the dragon of deterioration. It’s those kinds of things. So it’s incumbent upon you to be a great communicator and help your association understanding what you as the board are trying to do to take good care of the property. You’re just doing your job. But we’ll go that program to a conclusion, and I just want to say a couple things here, and let’s understand that in the big picture, what we’re working with here is the Community Association industry. It’s multi million dollar, not for profit, entities run by an untrained, volunteer board of directors, most of them with very short term seats on the board, a year or two, maybe three. Sometimes they re up and do it for a while. But when you have these very significant real estate entities run by untrained volunteers. What could possibly go wrong? And from my point of view, I see so many associations running themselves out of money and just not spending, not collecting and ignoring the fact that mother nature and Father Time are. Are day by day, ravaging their association. Adrian, what do you see?

Adrian Adams 30:05

Yeah, let’s go to the next slide, because the liability issue, what was happening is in the industry, first of all, litigation is on the rise. We’re seeing more lawsuits being filed, and people that are, you know, and it’s usually water damage. We see a lot in condominiums, and that is because of pipes, drain lines, windows, roofs, water comes in. It just finds its way in if the association hasn’t been maintaining the property properly. Lawsuits get filed. When lawsuits get filed, insurance companies look for an excuse to drop coverage, because the industry has been hit really hard with wildfires on the West Coast, hurricanes on the East Coast, and tornadoes in the middle and so if they can find a reason to drop coverage or to significantly increase premiums and raise deductibles, they will do it. So the what you want as a board to avoid is getting sued the and also if the association, if the matures, is taking under reservation of rights, and it doesn’t settle, and there’s a judgment, this insurance won’t necessarily be paying the judgment right? So it’s really important for boards, they want to avoid liability, to take their responsibility seriously on maintaining the common areas, and that means maintaining a good reserve,

Robert Nordlund 31:30

yeah, and taking good care of the place so you don’t make your insurance company nervous, and they say, Thanks, but no thanks, and then you’re left to try to find a new Insurance company that’s going to cost a whole lot more

Adrian Adams 31:43

well, just prioritizing the needs, and that is the maintenance, because their number one obligation is to maintain the common areas, not to maintain low monthly assessments. I mean, if you can do both, that’s great, but it’s better for the membership to have regular, small increases keeping up with inflation, because it’s easier for them to absorb than to go 1520, years with no increase and then suddenly massive special assessments and huge dues increases. And we’ve had clients that have done both where they’ve had to do 20% increase in the budget for a couple of years in a row, plus special assessments in order to try and get enough cash in order to take care of all of the deferred maintenance and projects that are critical that had to be done. So prioritizing the needs means number one is maintaining the common areas, and that means funding it, which means reserves and proper assessments. Okay, communications, absolutely, letting people know what you’re doing, why you’re doing it. Gain, being transparent, showing them the information. You’ll have some that will fight you no matter what, but if you stay on course, you do what needs to be done, you can avoid lawsuits.

Robert Nordlund 33:07

Let me leverage from that. Stay on court. Many of you who are here in today’s program are in associations that are in an underfunded situation or a challenging situation. Well, most likely it took years or decades to get there, and it may take time for you to turn the momentum and turn the corner and start getting things going in the right direction. If we want to let you know that if you have expectation for immediate pain, you probably got to let that go, we’re going to encourage you to move forward. It’s worth the journey, so get wise counsel. Lead your association. Well, we want you to be one of the victorious Knight that have looked after your association, fighting the dragon, keeping the dragon at bay, keep the dragon away from your association, and leading to a peaceful and productive association where people enjoy being part as the members of that negotiation. Well, I want to make sure we take a moment here to thank Adrian for joining us today and as our special guest, you can see some of the resources we spoke about at Adams. Sterling.com that’s Adams ad AMS sterling.com and the matching website dava Sterling, where they have a lot of research, that’s a great stuff, especially if you’re in California. Down the bottom right, you can see newsletters and awards if you sign up for his newsletter, even if you’re outside California and is so much wise counsel, common sense advice. Again, remember Adrian’s primarily serving a California audience, so he may have some California references, but great stuff. I enjoy reading that every time put the smile on my face and I feel like I’ve got an edge over the association. It’s a don’t and for negotiation, reserves, we’re at reservestudy.com As you heard, we’ve done a lot of reserve studies all across the country, all 50 states, since 1986 and plenty of resources on our website, although resources are also on YouTube, we have a strong YouTube channel where, if you search for reserve studies, most likely they’re ours. I got short intent and longer format content, where full webinars, like we’re doing here today, and then we also have a written recourse, a book called Understanding reserves, just released the second edition just a couple of months ago, and you’ll find all the reserve concepts we spoke about today in that book, it’s easy for someone to read. It’s not a technical document. You can order it on amazon.com I’ve got a copy here on my desk, and we’ll hand it out for someone who asks a great question during our Q and A session that’ll be in just a couple months. And finally, a free resource. We have a weekly podcast for board members. It’s called HOA insights, common sense for common areas, 30 minutes once a week, new episodes drop every Monday, and find the episodes on the website Hoa insights.org, wherever podcasts are found or also on our YouTube channel. So great information there to encourage and equip board members to reinforce the sound, financial and fiscally responsible principles that we’ve been talking about today. We have guest experts. Sometimes it’s minutes, sometimes it’s reading your financials. And we also celebrate bored heroes on the podcast. So it’s just a fun place to be part of the national community and to get refreshed with some encouraging information on a weekly basis. That’s HOA insights, common sense for common areas. And with that, I’ll turn the microphone over to Paige, who will coordinate our Q and A time together? You.