Managers and Civil Code Section 1368: How to Make it Safely Through the Disclosure Minefield
April 1, 2000
An article reprinted from the spring 2000 CACM Law Journal. It discusses an Association and its manager's legal responsibilities under Civil Code Section 1368 to provide documents and information to a selling member, who in turn provides the same to prospective purchasers.
Managers and Civil Code §1368:
How To Make It Safely Through The Disclosure Minefield
by David F. Feingold, Esq.
Dealing with disclosures in the purchase and sale of a home in a common interest development can be like walking through a
minefield. California Civil Code '§1368 requires that an owner of an interest in a common interest development provide ("as soon as practicable") a prospective purchaser with specified documents and information about the Association. The Association, of course, must provide those documents and information to the selling owner. In order to understand the statute, it helps to know a little about its history.
Civil Code §1368 was originally enacted as an amendment to Civil Code §1360, and passed as an urgency measure and signed into law by Governor Duekmejian in September of 1983. Sponsored by the California Association of Realtors® (CAR), the basis of the bill was the recently decided Raven's Cove opinion, which held that directors were fiduciaries and, among other things, obligated to maintain proper reserves. In support of the bill, CAR maintained that most Associations had "ignored the responsibility to maintain adequate monetary reserves." The intent of the bill was to "establish uniform budgeting disclosure procedures for all homeowners associations. "
The bill, as originally drafted, was opposed by the Department of Real Estate (DRE). Then DRE Commissioner James Edmonds, Jr. wrote, prophetically, that:
The bill would require every common interest subdivision association, whether it be a condominium, stock cooperative, community apartment project, or planned development, whatever may be its size and whatever may be the extent of its common facilities to make identical reports at specific times. Today, a common interest subdivision can tailor its financial reporting requirements to suit the project.
If this bill becomes law, every homeowners' association will bear a like and onerous burden of reporting. Civil Code §1360 has since been folded into the Davis-Stirling Act as Civil Code §§'1365 and 1368. Today, sixteen years later, some insist that the complex system of disclosures has replaced one problem with another. While reserve funds are no doubt more plentiful than they were in 1983, too often we see Associations, managers, sellers, and realtors, especially when small, older associations are involved, being hauled into court to explain why the statutory disclosures were not made. This article will illustrate that by thinking of disclosure as a two-step process, and implementing a specific disclosure plan, the managing agent and the Association can be protected from liability for non-disclosure claims while providing full information to all concerned parties.
THE TWO STEPS
While it is the Association's obligation to provide the selling owner with the necessary information upon the sale of a unit or lot, as a practical matter, it is the manager who receives and responds to these requests. To handle this task effectively, you need a clear understanding of the disclosure framework.
The Association's disclosure obligation at purchase and sale has two parts. First, an 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. It is the seller's obligation to provide 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." We call it the "Pro Forma Budget Package." You can avoid a great deal of non-compliance by simply 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, Civil Code §1365(a)(3) requires the Association to 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. Opinions can certainly differ on what should have been "anticipated". For most older Associations, the statement should be something along the lines of "maybe, it depends."
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).
Who do Associations look to for guidance in complying with the requirements of annual member disclosures? Management, of course. The obligation to provide this service is not only more than likely in the management contract, it is also required in the exercise of a manager=s standard of care. If the Association has not complied with Civil Code §1365, there is little hope of complying with the second step of the disclosure process. Also, remember that 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:
(1) a copy of the Governing Documents;
(2) a statement regarding age restrictions, if any;
(3) a copy of the most recent documents distributed pursuant to Civil Code §1365;
(4) a statement regarding assessment levels and past due assessments;
(5) a preliminary list of defects (if any) provided to members per Civil Code §1375;
(6) a copy of the post-litigation defect correction summary (if any) provided for in Civil Code §1375.1; and
(7) 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 selling owner within 10 days of the mailing or delivery of the 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 attorney's 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 nondisclosure. Typically, this includes amounts a new buyer may be assessed for their share of a future special assessment, which arose from a problem known, but not disclosed, at the time of purchase. We have recently seen settlements and judgments in the tens of thousands of dollars in this area.
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 the broker complies with Civil Code §1368.
A community Association simply should not address each purchase and sale on an ad hoc basis. The key is to implement a process, have it approved by the Board and the Association's legal counsel, and then make sure it is followed.
Any approach which ensures full and complete disclosure is a good one. If you have worked with the Board and Association counsel and are comfortable with the process you have in place, stick with it.
We recommend an approach that makes it clear that it is the Association, through its Board, that is controlling disclosures, not the manager. A manager who handles 1368 disclosures without routinely consulting with the Board risks being accused of exceeding the scope of his or her authority. Such a claim would not likely come from the Association's general counsel. In the event of a nondisclosure claim, rather than dealing with the Association's attorney, the manager may suddenly be faced with an insurance defense counsel (under a D&O policy) who simply wants to pass liability to another target. And having completed the 1368 disclosure, the manager has a bulls eye painted prominently on his or her backside. But fear not. Put in place a specific approach and you will be well protected.
The four components of the approach we like 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. 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 buyers and sellers, to "prove" that the manager's or director's authority is limited when it comes to disclosures. It should be noted here that limiting the lines of communication does not mean managers should adopt a "circle the wagons" approach to disclosures. Full information can and should always be provided to the seller. Values in the community are not enhanced by secrecy. Managers should be kind and respectful to all real estate agents, especially those that need some education on the process.
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 real estate agents ask the Board to make specific representations that are improper. The approved form can be custom or pre-printed. I prefer a preprinted form, such as Professional Publishers Form 147 Cal., revised as of January 1998. This form adheres to the statutory requirements of Civil Code §1368, and real estate agents in many California counties are accustomed to using these forms. (You may order the forms directly from Professional Publishers by calling 1-800-288-2006. They are about $8 for a pack of twenty-five tear apart forms.)
3. Develop a Disclosure. Summary or Compilation of Documents. If the Association is like many mature projects, management and the Board may be involved in evaluating the nature and scope of premature component failures, and the adequacy of the reserve accounts. This process may take a year, maybe two, maybe more. The data and information received 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 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. We also recommend that at each regular Board meeting, the Board 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 nondisclosure suit is filed. Agendizing disclosure is a convenient way to make sure it is the Board, and not the management, who is in charge of disclosures.
The Board must 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. Managers of common interest developments are in a unique position to facilitate disclosures, protect the Association and themselves in the process, and enhance the value and desirability of the community.
David F. Feingold, Esq., is a partner with the San Rafael law firm of Ragghianti Freitas LLP and serves community associations in the Bay Area as general and litigation counsel.
Document Download: mgrscc1368disclosures.pdf