Category: Governance

The Question of the Correct HOA Reserve Funding Level

Some think reserves should be 100% funded. However, a 100% funding level for reserves can be difficult to achieve without imposing a special assessment on the members, and can be a real burden on the association.

I am often asked about appropriate funding levels for reserves. The funding level of reserves can have an impact on the desirability of a property, impact property values, and the ability of buyers to obtain mortgages on property within an association (Fannie Mae recently revised its lending guidelines to require HOA’s set aside 10% of their budget to funding reserves in order for properties to be eligible for loans).

Some think reserves should be 100% funded.  However, a 100% funding level for reserves can be difficult to achieve without imposing a special assessment on the members, and can be a real burden on the association.

In requiring an HOA to periodically prepare a pro forma operating budget, Section 1365(a)(4) of the California Civil Code calls for identification of the methods of funding used to defray future repair, replacement, or additions to major components. However, a specific funding goal is not indicated in the law.  The truth is the right level of reserve funding depends on the HOA’s individual circumstances, and there is no “industry standard” as to the level of funding for reserves.  Often, the funding goal will depend on the methodology the board uses in developing a funding strategy.

Reserve funds are monies collected for the repair and replacement of major components of the property maintained by the HOA. They differ from operating funds which are collected to fund annually recurring expenses such as insurance, management and legal fees, common area utilities, janitorial services, and common area landscaping. An Association’s obligation regarding reserves and reserve accounts is typically found in the Civil Code. However, some Association’s governing documents also contain requirements which the Association must follow in maintaining and even funding reserve accounts. An example of such a requirement might appear in the CC&Rs and/or bylaws as follows:

Reserves, The Regular Assessments shall include reasonable amounts as determined by the Board collected as reserves for the future periodic maintenance, repair or replacement of all or a portion of the Common Area, or any other purpose as determined by the Board. All amounts collected as reserves, whether pursuant to this Section or otherwise, shall be deposited by the Board in a separate bank account to be held in trust for the purposes for which they are collected and are to be segregated from and not commingled with any other funds of the Community Association. Such reserves shall be deemed a contribution to the capital account of the Community Association by the Members

Types of Accounts. Assessments collected by the Community Association shall be deposited into at least two (2) separate accounts with a responsible financial institution, which accounts shall be clearly designated as (i) the Current Operation Account and (ii) the reserve account. The Board shall deposit those portions of the Assessments collected for current maintenance and operation into the Current Operation Account and shall deposit those portions of the Assessments collected as reserves for replacement and deferred maintenance of major components which the Community Association is obligated to maintain into the reserve account. The Community Association may expend funds from the reserve account only for the purposes set forth in Section 1365.5 of the California Civil Code

Because reserve funds are collected for specific purposes, they can only be used for certain types of expenses. The Civil Code states that reserve funds can only be used for the “repair, restoration, replacement, or maintenance of major components which the Association maintains” or to “pursue litigation involving the repair, restoration, replacement, or maintenance of major components which the Association maintains.” In addition, reserve funds can also be used to meet short-term cash flow needs. However, since borrowing from reserves means the monies may not be available for the purposes they were originally collected, before an Association can take money out of reserves to fund operating expenses, certain formalities must be met.

First, the Board must provide notice of a meeting to the members advising them of the intent to consider a transfer out of reserves. The notice must state (1) why the transfer is needed, (2) possible options for repayment, and (3) whether a special assessment may be considered to repay the amount transferred out of reserves. Lastly, the Board must discuss and approve the transfer during the open session of the properly noticed meeting. These requirements are designed not only to give members notice of the potential transfer out of reserves, but to offer them the opportunity to hear the discussion explaining why such a transfer may be necessary, as well as an opportunity to address the Board and state any concerns they may have over such a transfer.

Once the Board has made the decision to transfer funds out of a reserve account, the next consideration is with regard to repaying the funds. The Civil Code is specific with regard to repayment of reserve funds and requires that funds borrowed from reserves to meet short-term cash flow needs be repaid within one year of the initial transfer. While the time to repay the loan from reserves can be extended briefly, if the Association is not going to meet the one-year repayment requirement the Board must give the same notice of meeting to the members as it did before the initial transfer out of reserves was approved, and discuss the option of delaying the repayment during open session. The Board is also required to make a finding, supported by documentation, that a temporary delay in repaying the amount borrowed from reserves would be in the best interest of the Association. Such documentation should include some form of cash flow projection which shows the impact of the proposed repayment plan and the impact on the Association’s ability to meet its operating expenses over the time period which the Board is considering extending the repayment period. In addition, the Board must consider whether a special assessment would allow it to recover the full amount of the funds which must be repaid into reserves.

In light of the stringent requirements on borrowing from reserve accounts, and the requirement that an Association actually have reserve accounts, one would expect that the legislature would have imposed some minimum requirement on the funding levels for reserves. However, there is no statutory requirement to fund reserves to a certain level. All that is required is that the Board adopt a reserve funding plan in the open session of a meeting. The plan should indicate how the Association plans to fund the contribution necessary to defray the costs to repair, restore, replace or maintain the major components with a remaining useful life of less than thirty years. While there are no statutory requirements for minimum funding levels, the Association’s governing documents must also be reviewed to determine any requirements contained in the documents themselves.

Given the lack of any specific minimum reserve funding level requirement, the Board’s funding plan could conceivably consist of a special assessment being passed when the funds are needed. However, while such a plan would satisfy the statutory requirements, one could question whether such a plan would satisfy the Board’s fiduciary obligations to exercise prudent fiscal management in connection with the Association’s affairs. In light of the difficulties many Associations face in collecting regular monthly assessments, even if it complies with statutory requirements, failure to fund reserve accounts could expose the Board to claims of breach of fiduciary duties. Therefore, without a minimum funding level mandated by statute, a question arises as to how a Board determines the correct funding level for their Association.

The benefit of the lack of a statutory minimum reserve funding level is that the Board has flexibility in exercising its judgment when it comes to determining the funding level for an Association’s reserve account. The right level of reserve funding depends on the HOA’s individual circumstances, and there is no “industry standard” for funding reserves. Often, the funding goal will depend on the methodology the Board uses in their funding strategy.

There are several possible strategies a Board can consider in determining the funding level. These include:

  • Fully Funded Model – setting a reserve funding goal which keeps the reserves at or near 100% funded
  • Threshold Funded Model – setting a reserve funding goal which keeps the reserve balance above some predetermined threshold. This is generally more than “Baseline Funding” and less than “Full Funding”
  • Baseline Funded Model – “Minimum Funded Model” – setting a reserve funding goal which keeps the reserve cash balance at the end of each year in the overall reserve funding projection at or above $0

Each of these models depends on an analysis of cash flows into and out of the reserve fund over thirty years. Once the funding model is determined, assessment calculations should then be made sufficient to reach the Board’s funding goals.

The stringent requirements on borrowing from reserve funds, as well as the Board members’ fiduciary obligations, require that the Board exercise prudent fiscal management in maintaining the integrity of the reserve accounts. Any Board contemplating borrowing from reserve accounts should seriously consider levying a special assessment to recover the amount needed to fund the reserves and also consider increasing dues to meet operating expenses. In addition, if not already part of the budget, the Board should consider budgeting for “bad debt” to ease the impact of late assessments on the overall financial health of the Association. Failure to do so puts the Association’s assets at risk and exposes the directors to claims for breach of fiduciary duties.

Reserve funds are monies collected for the repair and replacement of major components of the property maintained by the HOA. They differ from operating funds which are collected to fund annually recurring expenses such as insurance, management and legal fees, common area utilities, janitorial services, and common area landscaping. An Association’s obligation regarding reserves and reserve accounts is typically found in the Civil Code. However, some Association’s governing documents also contain requirements which the Association must follow in maintaining and even funding reserve accounts. An example of such a requirement might appear in the CC&Rs and/or bylaws as follows:

Reserves, The Regular Assessments shall include reasonable amounts as determined by the Board collected as reserves for the future periodic maintenance, repair or replacement of all or a portion of the Common Area, or any other purpose as determined by the Board. All amounts collected as reserves, whether pursuant to this Section or otherwise, shall be deposited by the Board in a separate bank account to be held in trust for the purposes for which they are collected and are to be segregated from and not commingled with any other funds of the Community Association. Such reserves shall be deemed a contribution to the capital account of the Community Association by the Members

. . .

Types of Accounts. Assessments collected by the Community Association shall be deposited into at least two (2) separate accounts with a responsible financial institution, which accounts shall be clearly designated as (i) the Current Operation Account and (ii) the reserve account. The Board shall deposit those portions of the Assessments collected for current maintenance and operation into the Current Operation Account and shall deposit those portions of the Assessments collected as reserves for replacement and deferred maintenance of major components which the Community Association is obligated to maintain into the reserve account. The Community Association may expend funds from the reserve account only for the purposes set forth in Section 1365.5 of the California Civil Code

Because reserve funds are collected for specific purposes, they can only be used for certain types of expenses. The Civil Code states that reserve funds can only be used for the “repair, restoration, replacement, or maintenance of major components which the Association maintains” or to “pursue litigation involving the repair, restoration, replacement, or maintenance of major components which the Association maintains.” In addition, reserve funds can also be used to meet short-term cash flow needs. However, since borrowing from reserves means the monies may not be available for the purposes they were originally collected, before an Association can take money out of reserves to fund operating expenses, certain formalities must be met.

First, the Board must provide notice of a meeting to the members advising them of the intent to consider a transfer out of reserves. The notice must state (1) why the transfer is needed, (2) possible options for repayment, and (3) whether a special assessment may be considered to repay the amount transferred out of reserves. Lastly, the Board must discuss and approve the transfer during the open session of the properly noticed meeting. These requirements are designed not only to give members notice of the potential transfer out of reserves, but to offer them the opportunity to hear the discussion explaining why such a transfer may be necessary, as well as an opportunity to address the Board and state any concerns they may have over such a transfer.

Once the Board has made the decision to transfer funds out of a reserve account, the next consideration is with regard to repaying the funds. The Civil Code is specific with regard to repayment of reserve funds and requires that funds borrowed from reserves to meet short-term cash flow needs be repaid within one year of the initial transfer. While the time to repay the loan from reserves can be extended briefly, if the Association is not going to meet the one-year repayment requirement the Board must give the same notice of meeting to the members as it did before the initial transfer out of reserves was approved, and discuss the option of delaying the repayment during open session. The Board is also required to make a finding, supported by documentation, that a temporary delay in repaying the amount borrowed from reserves would be in the best interest of the Association. Such documentation should include some form of cash flow projection which shows the impact of the proposed repayment plan and the impact on the Association’s ability to meet its operating expenses over the time period which the Board is considering extending the repayment period. In addition, the Board must consider whether a special assessment would allow it to recover the full amount of the funds which must be repaid into reserves.

In light of the stringent requirements on borrowing from reserve accounts, and the requirement that an Association actually have reserve accounts, one would expect that the legislature would have imposed some minimum requirement on the funding levels for reserves. However, there is no statutory requirement to fund reserves to a certain level. All that is required is that the Board adopt a reserve funding plan in the open session of a meeting. The plan should indicate how the Association plans to fund the contribution necessary to defray the costs to repair, restore, replace or maintain the major components with a remaining useful life of less than thirty years. While there are no statutory requirements for minimum funding levels, the Association’s governing documents must also be reviewed to determine any requirements contained in the documents themselves.

Given the lack of any specific minimum reserve funding level requirement, the Board’s funding plan could conceivably consist of a special assessment being passed when the funds are needed. However, while such a plan would satisfy the statutory requirements, one could question whether such a plan would satisfy the Board’s fiduciary obligations to exercise prudent fiscal management in connection with the Association’s affairs. In light of the difficulties many Associations face in collecting regular monthly assessments, even if it complies with statutory requirements, failure to fund reserve accounts could expose the Board to claims of breach of fiduciary duties. Therefore, without a minimum funding level mandated by statute, a question arises as to how a Board determines the correct funding level for their Association.

The benefit of the lack of a statutory minimum reserve funding level is that the Board has flexibility in exercising its judgment when it comes to determining the funding level for an Association’s reserve account. The right level of reserve funding depends on the HOA’s individual circumstances, and there is no “industry standard” for funding reserves. Often, the funding goal will depend on the methodology the Board uses in their funding strategy.

There are several possible strategies a Board can consider in determining the funding level. These include:

· Fully Funded Model – setting a reserve funding goal which keeps the reserves at or near 100% funded

· Threshold Funded Model – setting a reserve funding goal which keeps the reserve balance above some predetermined threshold. This is generally more than “Baseline Funding” and less than “Full Funding”

· Baseline Funded Model – “Minimum Funded Model” – setting a reserve funding goal which keeps the reserve cash balance at the end of each year in the overall reserve funding projection at or above $0

Each of these models depends on an analysis of cash flows into and out of the reserve fund over thirty years. Once the funding model is determined, assessment calculations should then be made sufficient to reach the Board’s funding goals.

The stringent requirements on borrowing from reserve funds, as well as the Board members’ fiduciary obligations, require that the Board exercise prudent fiscal management in maintaining the integrity of the reserve accounts. Any Board contemplating borrowing from reserve accounts should seriously consider levying a special assessment to recover the amount needed to fund the reserves and also consider increasing dues to meet operating expenses. In addition, if not already part of the budget, the Board should consider budgeting for “bad debt” to ease the impact of late assessments on the overall financial health of the Association. Failure to do so puts the Association’s assets at risk and exposes the directors to claims for breach of fiduciary duties.

What is a Capital Improvement?

Many HOAs have language in their governing documents that act as a spending cap on capital improvement projects without member approval (often at 5% of the annual budget). However, often the term “capital improvement” is not defined, and boards are left to wonder whether or not a particular expense is a “capital improvement”.

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Many HOAs have language in their governing documents that act as a spending cap on capital improvement projects without member approval (often at 5% of the annual budget). However, the term “capital improvement” is often not defined. This often leads to confusion as to whether an expense requires member approval. “Capital improvement” is an accounting term. Unfortunately, there is no industry adopted definition of what constitutes a “capital improvement” in the HOA context.

A “capital improvement” is often defined as the addition of a permanent structural improvement or the restoration of some aspect of a property that will either enhance the property’s overall value or increase its useful life. This definition of “capital improvement” provides little guidance to a Board as to whether an expense is a “capital improvement” which might require member approval. For example, new roofs on a building both enhance the property’s overall value and increase its useful life. Therefore, they could be considered a “capital improvement”. Treating new roofs as a “capital improvement” may require member approval prior to incurring the expense. Such a requirement would conflict with the Board’s authority to maintain the common area facilities. Therefore, a better definition for common interest developments is needed for purposes of CC&R restrictions.

Some in the industry suggest Associations consider adopting the following definition for capital improvement:

A capital improvement is any (i) substantial discretionary addition to the common areas, (ii) voluntary significant upgrade to common area materials, or (iii) discretionary material alterations to the appearance of the development.

While adopting such a definition would go a long way towards resolving the confusion caused by the use of an accounting term in the HOA context, even this definition is subject to confusion in its application. A Board would still have to determine if an expense is for a “substantial” discretionary addition or if it is for an “insubstantial” discretionary addition, or if the expense is for a “significant” upgrade to common area or if it is an “insignificant” upgrade.

Even with these potential pitfalls, to best deal with the uncertainty created by a capital improvement restriction Boards should consider defining “capital improvement” whenever they amend or restate their CC&Rs. If amendment is not a viable option, at minimum, Associations should adopt the definition and follow the procedure for a rule change to give notice to the members that it is considering the adoption of a given definition of “capital improvement”. Neither option will guarantee that an expense will not be challenged. However, a Board’s decision will stand a greater chance of surviving scrutiny, whether it is by a member or a court, when the membership is given advance notice and a chance to vote or at least provide their input to the Board prior to the adoption of any such definition.

Several courts in and out of California have ruled on various challenges to HOA expenses and determined whether expenses qualified as capital improvements. The results have been mixed, and are often factually specific. Therefore, it is impossible to provide a bright line test for Boards to follow when attempting to determine if an expense is a “capital expenditure” and subject to a cap on spending. Exceptions to the capital expenditure limitation have been found in cases of expenses required by governmental mandate and expenses which are necessary to protect Association assets. In such cases, the expenditures may be seen as within the Board’s authority to maintain and repair the common area property. However, any such expense must be examined in light of the individual factual circumstances. Any Board faced with a spending cap should consult with their legal experts to determine whether a vote of the members is required before undertaking an expense which could be viewed as a capital improvement.

Some considerations for a Board attempting to determine if an item is a Capital Expense subject to a spending cap are:

1) Do the Governing Documents place a spending cap on Capital Improvements? – If not, no vote is necessary.

2) Do the Governing Documents define “Capital Improvement?” – If so, determine if the expense falls within definition.

3) Is the expense less than the spending cap? – If so, no vote is necessary.

4) If the expense is above spending cap, is it for a new facility? – If so, it may be a capital improvement and member vote may be required.

5)     Is the expense for repair or replacement of an existing item with like quality, or is it an upgrade?

a) If the expense is for a like quality repair or replacement, it most likely falls within the Board’s authority to maintain, repair and replace, and a member vote may not be necessary.

b) If the expense is for an upgrade or improvement to an existing item, determine if there are any possible exceptions to requirement for a member vote.

i) Is the expense necessary due to governmental requirement (ex: replacing wood shingles with fire retardant material)? – If so, members cannot veto, and a vote may not be necessary.

ii) Is the expense necessary to protect Association assets (ex.: underpinning of building foundation to prevent settlement)? – If so the expense is most likely within the Board’s authority to maintain, repair and replace, and a vote may not be necessary.

iii) Is the expense for a new technology or building material that did not exist at the time of construction that will last longer and not need to be maintained or replaced as frequently? – If so, it may fall within the Board’s discretion and business judgment, and a vote may not be necessary.

c)    If the expense is for an upgrade to an existing facility, and no exceptions apply, it will most likely be considered a capital improvement and approval of the members may be required.

New Articles at HOALeader.com

I recently contributed to several articles for hoaleader.com, a national web-based publication for homeowners association and condominium management professionals:

I recently contributed to several articles for hoaleader.com, a national web-based publication for homeowners association and condominium management professionals:

Having an Election? Know Who is Entitled to Vote.

In any HOA election there are two record dates that need to be idenitified. The Record Date for determining the members entitled to notice, and the Record Date for determining members entitled to vote.

A question came up on the discussion forum of hoaleader.com, and my friends over there asked me to respond. A homeowner was concerned that his Association had improperly set the record date for an upcoming director election. The question was:

Can anyone confirm that in California, regarding a CID director election via an absentee ballot, that the Davis-Stirling Act requires the board to set a “record date for good standing” which is between 60 days in advance of the election and the mailing date of absentee ballots? I am concerned that our board has declared that ballots are to be mailed to association members in good standing on May 31, 2010, but they have declared a “record date for good standing” for June 15, 2010, two weeks after mailing, an obvious conflict which I believe is a D-S violation. This may deprive some members of their vote, even after receiving ballots, and open a door to election fraud. Am I correct in my legal understanding and concern? We have an election on July 3, 2010, and time is short to correct this error.

In any HOA election there are two record dates that need to be identified:  The Record Date for determining the members entitled to notice, and the Record Date for determining members entitled to vote. The Davis-Stirling act does not have any requirements for determination of a record date. The record date is determined by the Association’s bylaws and by California Corporations Code section 7611. If the bylaws are silent, the Board may set a record date consistent with section 7611.

Section 7611(a) provides the time frame for the Record Date to receive notice of a meeting of members, which “shall not be more than 90 nor less than 10 days before the date of the meeting.” In the absence of a record date defined in the bylaws or by the Board, members at the close of business on the business day preceding the day on which notice is given are entitled to receive notice of a members meeting.  For the purpose of determining a record date for members entitled to vote at a meeting of members, the record date shall not be more than 60 days before the day of the meeting. If no record date is fixed by either the bylaws or the Board, members on the day of the meeting who are otherwise eligible to vote are entitled to vote.

In responding to the question above, we do not know if the Association’s bylaws contain any instructions for establishing the relevant “record dates” for the upcoming election. However, it appears that May 31 was selected as the record date for notice of the meeting, and June 15 was selected as the record date for determination of voter eligibility. Assuming the bylaws are silent on the issue, the dates selected by the Board comply with the requirements of section 7611 for a July 3rd election date. In addition, by mailing out ballots on May 31st, the Association complies with the Davis-Stirling Act, which requires that written ballots be mailed out at least 30 days prior to the election (Civil Code section 1363.03).

While the owner raising the question is concerned that some owners may lose their right to vote after receiving their ballots, it is just as likely that owners who are not in good standing will have the opportunity to rectify the situation between the time they receive their ballots and the later date being used to determine voter eligibility. In addition, in order to deem an owner not to be in good standing, the Association will have had to call the owner in for a hearing. Given the time frame identified, it is likely that any owner who loses their right to vote between the time the ballots are mailed and the record date for voter eligibility will have been in violation of the CC&Rs prior to the ballots having been mailed.

2009 California HOA Legislative Update

With the end of year upon us, I thought it would be a good time to post a summary some of the laws enacted in California during 2009 that impact our local homeowners associations. This is not a complete list of all new legislation, but rather brief summaries of the statutes I believe will have the biggest impact on California HOAs. The full impact of 2009 California legislation on an HOA will require a more detailed analysis. Any HOA that has questions on the impact of a new law should consult with their corporate counsel.

Just a BillWith the end of year upon us, I thought it would be a good time to post a summary some of the laws enacted in California during 2009 that impact our local homeowners associations. This is not a complete list of all new legislation, but rather brief summaries of the statutes I believe will have the biggest impact on California HOAs. The full impact of 2009 California legislation on an HOA will require a more detailed analysis. Any HOA that has questions on the impact of a new law should consult with their corporate counsel.

1. AB 313 (Fletcher) Assessments

This statute will allow those HOAs whose declarations allow assessments to be based on the assessed value of the individual separate interests to continue to assess in this fashion, but will prohibit other existing and newly formed HOAs to do so.

2. AB 899 (Torres) Disclosures

This statute imposes three new requirements on HOAs. The first requirement is that the title of the Assessment and Reserve Funding form disclosure must now include the ending date of the fiscal year for which it was prepared, and the form must disclose the rate of return and inflation rate assumptions used by HOA in its reserve planning.

The second requirement this statute places on HOAs relates to agreements by members to receive delivery of documents via email, facsimile or other electronic means.  Such agreements must now comply with consumer consent and disclosure requirements of California Corporations Code section 20, and the Federal E-Sign Statute, 15 U.S.C. section 7001(c)(1).

Lastly, this statute adds a new section to the Davis-Stirling Act, Civil Code, section 1363.005, which requires every Association to distribute, upon request by a member, a document disclosure index identifying the disclosures provided by the HOA, along with a reference to the Civil Code section requiring that disclosure.

3. AB 1061 (Lieu) Water-Efficient Landscapes

This statute is one I have written about before here on HOA Brief. This statute amends section 1353.8 of the Davis-Stirling Act, and restricts an HOA’s architectural standards and other governing documents from prohibiting or providing conditions that hinder or prohibit use of low-water usage plants. In addition, this statute requires compliance with local water ordinances.

4. AB 1233 (Silva)

AB 1233 amends the Non-Profit section of the California Corporations code relating to nonprofit mutual benefit corporations (most HOAs in California are non-profit mutual benefit corporations). Subject to certain limitations, AB 1233 authorizes the articles or bylaws to require the presence of one or more specified directors in order to constitute a quorum to transact business. In addition, this statute prohibits a committee exercising the authority of the board from including as members persons who are not directors of the corporation. However, the statute does not prevent a committee which is not exercising the authority of the board from including a non-board member on the committee.

In my opinion, this statute is also the most troubling for HOAs. This statute also alters the protections afforded directors where the HOA had appropriate insurance in place. Prior to the passage of this statute, existing law prohibited a cause of action for monetary damages from arising against any director or officer of a nonprofit corporation, who served without compensation, on account of any specified negligent act or omission if the HOA had a general liability insurance policy in a specified amount in force both at the time of the injury and at the time the claim was made. With the enactment of this bill those causes of action now are only prohibited if the HOA maintains a liability insurance policy that is applicable to the claim. That means that if a claim is not covered, the directors may face liability, despite the fact that there is a general liability policy in place. I fear this will have a negative impact on the ability of HOAs to get people to volunteer and serve as directors. This is already difficult enough. There are many communities where people refuse to serve, and there are perpetual openings on the board. Now people who already hesitate to serve will have another reason to refuse to do so.