Sunday, July 17, 2011

Bankruptcy Won't Work

A member raises his hand at a meeting and asks the question: if the association is too broke to pay its bills, why not simply declare bankruptcy? Hold the creditors at bay until the economy picks up? No one on the board has a good answer because it almost never happens. Here are the practical and legal reasons why...

Creditors with big claims against a community association are rare. A potential large creditor might be a bank making, say, a construction loan. If the association didn’t repay the loan, the lender would have the right to have a receiver appointed with authority to impose and collect assessments from the owners, to lien units and to file suit against individual owners who don’t pay their share. This is unlikely to happen, however, since the lender would have qualified the association and evaluated its ability to repay the loan through assessments before agreeing to extend credit in the first place. 

Another creditor might be someone who wins a large judgment against the association. If the insurance carried by the association remained in force, it is likely that the claim would be covered and settled by the carrier before a judgment would be entered. If not, this could be a substantial unplanned-for expense, but one that would survive any bankruptcy filing because of the ability to reach the assets of individual owners, as discussed below. 

Vendors who provide regular services to a community association are typically paid monthly or are on limited annual or monthly contracts. Any of these vendors can and will cancel further service if the association falls too far behind. So, unless there has been a big expense, like major re-construction, the amount of any vendor’s outstanding invoice is not going to be high. And it is unlikely that any association would commence a major reconstruction project without having the funding for it in place. So, the likely number of third party creditors with big claims against a community association is pretty low.

Actually, an association’s largest “creditor” is often itself. The failure, year after year, to complete reserve transfers creates unfunded liability that makes it impossible for the association to effect repairs when the time comes. Consistent with this creditor-as-self theory, the members who haven’t paid enough in assessments in the past now have only each other to look to for funds to pay to do the work now. Filing bankruptcy wouldn’t relieve the association of the duty to make (and look to the members to pay for) repairs.
But community association bankruptcies don’t occur for a big legal reason―the individual owners are essentially liable for the association’s debts. Most community associations are corporations, but there is a major difference between a community association and the typical business corporation. With a typical corporation the investors’ (shareholders’) liability is limited to the amount of their individual investment.  Community associations have lien rights in an owner’s separate interest that secures his or her share of assessments. The corporate structure of the association protects an individual owner from being solely responsible for the association’s total obligations, but not for the share assessed to the owner and against the owner’s property.

That has the effect of passing through the association’s obligations to the owners.  State law buttresses this obligation with the requirement that every association assess its members sufficient sums to pay its ongoing obligations. California Civil Code Section 1366(a) contains the following language: “Except as provided in this section, the association shall levy regular and special assessments sufficient to perform its obligations under the governing documents and this title.” As has been made clear by California case law, such as James F. O'Toole Company vs. Los Angeles Kingsbury Court, a court may use the authority to levy emergency assessments and the owners’ obligation to pay those assessments as grounds to find individual owners liable for a debt of the corporation. Thus individual owners are not insulated from the debts of the corporation. 

For these reasons, bankruptcy will not normally be considered a viable remedy for a community association. There would have to be no individual owner equity available in the community, and each individual owner would have to file his or her own individual bankruptcy petition for that to be effective as against the association’s creditors. If a community association gets to the point of considering bankruptcy, a different strategy is likely to emerge. When it can no longer pay its utility bills, insurance premiums, or management, then questions of basic habitability arise. At that point the owners may need to consider a “partition” or sale of the entire property, the appointment of a receiver, or even a government takeover, all strategies with inherent flaws and none of which are likely to preserve owner equity. 

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