by David F. Feingold, Esq.
When it comes to disclosures, I like to talk about "Disclosure Awareness." It is kind of like the seventh sense. If you are a manager or director, when a Civil Code §1368 "Request for Documents and Information" is received from a seller, the back of your neck should tingle, the hair on your arms should stand straight up, and your pupils should dilate. If you are prepared, this will be a welcomed feeling, because you will know exactly how to handle the situation.
This article will briefly summarize the disclosure issues relating to the purchase and sale of a unit or lot in a common interest development in California. It will also provide specific advice on setting up safeguards that will protect the managing agent, the board and the association from liability for non-disclosure claims.
The Disclosure Minefield
Dealing with disclosures in the purchase and sale of an interest in a common interest development is like walking through a minefield. In California, much of the legislative activity over the years in the disclosure area has been sponsored by the California Association of Realtors. Over a decade ago, there was a great hue and cry from buyers of homes in community associations who were routinely being caught by surprise by undisclosed defects in the common areas and under-funded reserve accounts, and, of course, the resulting special assessments. This also caused a hue and cry from the Realtors, who were being dragged into the resulting lawsuits.
The uproar from the Realtors resulted in legislative action. Except now, 13 years after the Davis-Stirling Act took effect, and after countless revisions, the disclosure system is often misunderstood. Associations, managers, sellers and Realtors are being hauled into court with everyone else to explain why the statutory disclosures were not made. Buyers claim that they did not know either (a) about the under-funded reserves, (b) about the anticipated special assessment and/or (c) that they were purchasing a property in a common interest development. You can protect yourself and your association by thinking of disclosure as a two-step process and following a specific disclosure plan.
THE TWO STEP DISCLOSURE PROCESS
The Two Steps
Associations must deal with a series of overlapping disclosures required by the Davis-Stirling Act and most governing documents. In its most simple form, the association's disclosure obligation at purchase and sale has two parts. First, a community association board of directors must study and then disclose to its members, on an annual basis, information about the association relating to, among other things, the budget, reserves, financials, collection practices, insurance information, and "anticipated" assessment increases. Second, when a member sells, the association must, upon request, provide that same information and other relevant documents to the selling member, who then, in turn, is obligated to provided it to the buyer.
The First Step
Every California community association is required to distribute to its members each year the information and documents described in Civil Code §1365. Perhaps the most important component of Civil Code §1365 is sub-section (a), which refers to the "Pro Forma Operating Budget." I call it the "Pro Forma Budget Package." You can avoid a great deal of non-compliance simply by 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, the association must 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 therefor."
This bears repeating. The board must make a statement as to whether it "anticipates" the need to levy a special assessment in the future. The American Heritage Dictionary of the English Language defines "anticipate" as "to realize beforehand; foresee; to look forward to." How will the directors be judged on the issue of whether they should have "realized" beforehand? They will be judged by the "reasonable director under similar circumstances" standard. Needless to say, opinions can differ on what is "reasonable," and what the board should have "realized."
Civil Code §1365 also requires that the association provide to its members the year-end financial statements, the collection policy and insurance information. In addition, although not directly related to purchase and sale disclosures, there are additional disclosures to members required by California law and the Davis-Stirling Act, including the Notice of Right to receive annual report (Corp. Code §8321), right to minutes [Civil Code §1363.05(e)], schedule of fines and penalties [Civil Code §1363(a)], summary of Alternative Dispute Resolution Rights [Civil Code §1354(i)], and the Notice of Construction Defect Resolution and Repair Plan and timeline (Civil Code §1375.1).
The best way to ensure compliance with the requirements of statutory disclosure to members is to rely on professional assistance, which typically can be provided by professional management, your reserve study provider, and, if necessary, your legal counsel. Year in and year out, make sure that your association is providing your members with all of the information required by the Davis-Stirling Act, particularly Civil Code §1365. If you have not complied with this statute, you have no hope of complying with the second step of the disclosure process. 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 which 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." Civil Code §1368 provides that the selling member must request from the association certain documents and information, including:
- a copy of the governing Documents;
- a statement regarding age restrictions, if any;
- a copy of the most recent documents distributed pursuant to Civil Code §1365;
- a statement regarding assessment levels and past due assessments;
- a preliminary list of defects (if any) provided to members per Civil Code §1375;
- a copy of the post-litigation defect correction summary (if any) provided for in Civil Code §1375.1;
- any change in assessments approved by the board but not yet due and payable.
The specified information and documents must be delivered by the association to the seller within 10 days of the mailing or delivery of an owner's request. The association may charge a fee which must not exceed the reasonable cost of providing the requested information. While Civil Code §1368 provides for a maximum $500 civil penalty for a willful violation, and attorneys fees to the prevailing party, the real exposure is in a lawsuit for non-disclosure, where a claimant's damages may include all "detriment proximately caused" by the non-disclosure. Typically, this includes amounts a new buyer may be assessed for their share of a future special assessment that arose from a problem known, but not disclosed, at the time of purchase.
Here is an example of such a scenario: the association receives information that its siding has failed prematurely and that its reserves are inadequate. While the board is evaluating this information, but before it has had an opportunity to complete its evaluation or propose a special assessment for a vote of the members, a sale occurs. The association provides to the selling member the 1368 disclosure, but either affirmatively states that there is no special assessment anticipated, or fails to mention that it is currently evaluating information which may in the future lead to a special assessment. A year later a special assessment of $20,000 is approved by the members, and the buyer then sues everyone involved and refuses to pay based on a non-disclosure theory. Even if the association had not communicated directly with the buyer at the time of purchase, the association may either be sued directly by the buyer on a "reasonable reliance" theory, or be brought into the case by a cross-complaint from the seller. In such an action, it is very difficult to defend the association if the provisions of Civil Code §1368 have been ignored.
Clearly, compliance with Civil Code §1368 is critical. In fact, it is so important that Civil Code §2079.3, which deals with a real estate agent's inspection duties, was amended in 1994 to provide that the agent's inspection duty is limited to the unit offered for sale (and not the common area) only if the seller or broker complies with Civil Code §1368. While there are certainly a number of brokers and agents who are experienced with common interest developments, don't rely on an agent to request the appropriate information.
Most of all, do not deal with each purchase and sale on an ad hoc basis. Develop an approach, have it approved by your legal counsel, and then make sure it is followed.
THE FOUR STEP SPECIFIC APPROACH TO DISCLOSURES
A Specific Approach
Any approach which ensures full and complete disclosure is a good one. If you have worked with your counsel and are comfortable with the process you have in place, stick with it. If you don't have an approach, or simply leave it up to management, you need to review your procedures.
I recommend an approach that makes it clear that it is the association, through its board, that is controlling disclosures, not the manager. It is also important to adopt an approach that is flexible enough to be updated as needed. The four components of such an approach include (1) a written resolution of the board, (2) the use of only an authorized form, (3) a flexible disclosure summary and/or compilation of relevant documents, and (4) adding disclosure as an agenda item.
1. Adopt a Written Resolution. The board adopts 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. A sample resolution is set forth in the box on page 11. Among other things, the resolution requires communication only with the seller or the listing agent, 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. the managing agent or director in charge of responding to these requests may also provide a copy of the resolution to pesky buyers and sellers----to "prove" that the manager's or director's authority is limited when it comes to disclosure.
2. Use Only an Authorized Form. Pursuant to the instructions in the Resolution, the managing agent or director handling these requests only communicates with the seller or the seller's agent, and regardless of the form of the request received, responds with the approved form. Be very cautious, as many forms you receive from Realtors ask the board to make specific representations that are improper. The approved form can be custom or pre-printed. I prefer a pre-printed form, such as Professional Publishers Form 147 Cal., revised January 1998, reproduced on page 9. This form adheres to the statutory requirements of Civil Code §1368, and Realtors in many California counties are used to using these forms. (You may order the forms directly from Professional Publishers by calling 1-800-288-2007.)
3. Develop a Disclosure Summary or Compilation of Documents. If your association is like many mature projects, you may be involved in evaluating the nature and scope of premature component failures, and the adequacy of your reserve accounts. This process may take a year, maybe two, maybe more. The data and information you receive 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 experts, and any other information that the board has that is relevant to the anticipated assessment increase. 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 of documents can then be attached and delivered to a seller with the response to the Civil Code §1368 Request for Documents and Information.
4. Agendize Disclosure. I also recommend that at each regular board meeting you 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. Don't be concerned about how large the package becomes. Many more trees will be killed if a non-disclosure suit is filed. Prospective purchasers and their consultants, after receiving the information from the seller, can then make their own evaluation.
Whether you are a member of the board of directors or a manager, it is in your best interest to take an active role in disclosing important information to the owners at large, and then to selling members. This is especially important in aging associations anticipating extraordinary repairs and special assessments. Don't worry about being the bearer of bad news. Even the most bleak situation can have a positive side if presented in the appropriate context. As the saying goes, "people hate bad news, but they hate surprises even more." Don't surprise anyone, and you will stay out of trouble.