D&O: Revisited

#1 Board/Director Rule:  Never serve on a Board of Directors for a community that does not have proper Directors & Officers (D&O) insurance coverage in place.  Without such coverage, money may not be available to defend you in the event that you are personally sued by an angry homeowner - leaving you potentially exposed to covering such costs out of your own pocket!  Of the different types of insurance communities need to carry, D&O is the least standardized. For instance, did you know there are three areas of coverage? 

• Side A coverage protects Directors from claims of wrongful acts when the Association refuses or is unable to provide indemnification
• Side B is for claims by the Association for money paid to indemnify a Board member 
• Side C is for claims by the Association against the Association itself.

Confusing? In addition, constant court challenges continue to add new wrinkles to how D&O is processed.  See how technicalities impacted three recent court decisions:

 

Internal lawsuit coverage

Normally, insurance cannot be used when parties within the same corporation are suing each other (ex: the Association suing an individual Board member, or Board members suing each other).  However, in Georgia this assumption has been weakened.  At the trial level, the D&O insurance carrier (St. Paul Mercury) obtained a judgment against the FDIC and former bank officers, barring coverage under the usual insured v. insured exclusion.  However, the Georgia appeals court reversed the ruling, saying that such exclusions are ambiguous under state statutes, and outside evidence might be necessary to determine intent.  

Timing of Contract

In a Rhode Island case (Transched Systems v. Federal Ins.), the insured client negotiated to sell its software products. Following delivery, the purchaser realized that the seller had breached the asset purchase agreement, and that the senior officers misrepresented the software.  Since the seller was no longer in business, the purchaser attempted to collect a judgment from the seller’s D&O insurance company, but was denied based on the breach of contract and other exclusions.  The court reversed this, saying that contract exclusion did not apply since the misrepresentations took place before the contract was formed.

Substandard Coverage

Over in Kentucky, (State Auto v Highland Terrace Counsel of Co-owners), Highland Terrace was sued by an owner trying to block a $700,000 special assessment.  The Association's D&O claim was denied by the carrier.   The court upheld the denial, since the underlying suit did not allege claims against the individual members of Highland Terrace for which the insurance could have had an indemnity obligation.  The State Auto D&O form did not provide entity coverage to Highland Terrace.

The above situations illustrate why it is critical that you use a professional insurance broker who regularly operates in the HOA industry – preferably someone who is active with the local Community Associations Institute (CAI) chapter.

While there will always be kinks in obtaining the best coverage possible, here are some ‘best practices’ you can implement to reduce risk exposure, according to insurance attorneys:

• Create term limits
• Locate and train Board volunteers with diverse sets of skills and backgrounds
• Evaluate the quality and effectiveness of Board meetings, including the use of agendas, the preparation and distribution of materials, and the timing and length of meetings
• Keep apprised of governance trends and legislation
• Develop and adhere to a code of ethics
• Develop and implement committees to oversee and monitor areas of potential liability, such as  director nomination, financial audits, and regulatory compliance
• Prohibit related-party transactions or require independent review of such transactions
• Maintain open and active homeowner relations

Financial Sense

Occasionally new clients or Board members express confusion about how community financials are reported.  For those of us working in the for-profit business world, using anything other than accrual-based accounting seems backward.

What is accrual accounting?   It is planning for the transfer of funds before they actually occur.  So, you report expected income a month or more in advance of when you actually receive money, and also post expenses for items that will come due at a future date.
However, for homeowner associations, there are downsides to this method:

• It may require that the financial books be kept open longer into the month so that bills can be received and properly accrued 
• It requires a higher level of accounting/bookkeeping knowledge to properly prepare financial statements 
• It can be more difficult for the layman user (most volunteer Board members) to understand
• Fraud/theft may take longer to detect

On the other hand, there is cash-based accounting, which is what most of us use for our personal banking.  Only at the time cash actually goes in or comes out of the bank are transactions recorded.  Delayed deposits or check payments result in an inaccurate picture of the financial status. A Board of Directors using this method may incorrectly assume that there is less or more cash, income and expenses than there actually is.

For small associations with very few transactions, the cash method of accounting may be appropriate. However, for most communities, most Georgia accountants feel that a modified cash method of accounting should be used.  The modified cash method is a hybrid between cash and accrual. There is no formal standard as to what items are modified, but common practice is to record income on the accrual method and expenses on the cash method. So you will only see accounts receivable on the balance sheet, not accounts payable.

This method of accounting is a valid option because most expenses are ‘standard’:  The majority of them occur on a monthly basis and are fairly static. Examples include utilities, management contract, pool and landscaping.   There really is no point in creating opportunities for error and confusion by accruing a future expense that rarely varies month-to-month!

When it comes to long-lasting (capital) assets like furniture, vehicles, tools & equipment, the depreciation question comes up.  Depreciation is a way of slowly reducing the value of these items, to spread an expense out over a period of years.  While it is possible to report this depreciation on the financials under any method of accounting, it is not typically done in not-for-profit associations.  The items in question are usually not integral to your core operations, and the main benefit of recognizing depreciation is during the tax season, which your CPA automatically handles for you. 

Another term you may hear mentioned when reviewing a Balance Sheet is the word ‘liability’.  This is just another way of saying ‘future expenses’.  Cash method financial statements generally do not list liabilities. While you may choose to list long-term liabilities (such as a bank loan) on a modified cash method statement, the balances often only update at year end, since the expenses are not accrued monthly or quarterly.

While the full accrual method is respected and has a valid place in for-profit corporations, for community associations CPAs recommend a K.I.S.S. (Keep it simple, stupid) approach by using modified cash to assist in understanding the financial health of your community. As always, please consult with your community's CPA about the benefits of all approaches prior to making any changes. 

Full Disclosure

New homeowner association clients occasionally ask, “Why do we need to provide the management company the bank statements for Board-controlled accounts, such as CDs or money markets?”  Since the management company doesn’t draw on these monies, the confusion is understandable.

Although not directly handling these funds, the management company is required to provide a full picture on the financial health of the community.  Incomplete disclosures impact several areas:

• Insurance.  The fidelity/crime coverage must be adjusted based on actual dollar amounts held.  Besides not receiving back all funds in the event of a loss, lenders may also refuse to provide home loans if the Association is under-insured in this area.
• Tax Returns.  These could be delayed or require re-filing if the CPA does not have full, timely access to bank statements of all assets.
• Homeowners & Lender Inspection Rights.  Georgia Statutes and the Association’s Bylaws require that financials be made available for review, often within five days of a request.  Providing inaccurate balance sheets (by not listing all funds) exposes the Association to potential litigation which may not be covered by the Directors & Officers (D&O) insurance carrier.
• Speaking of D&O:  Withholding account information may be considered a violation of fiduciary duty, which can be used as an excuse to deny coverage for any D&O claim, not just one directly related to financial disclosures.  It gets expensive litigating with the insurance company afterward, trying to reverse a denial of coverage.

To ensure information is getting forwarded to your management company in a timely fashion, be sure to notify all of your lenders to automatically mail copies of bank statements to the manager.  You want to reduce human error and avoid any appearance of impropriety:  Failing to fully disclose only raises red flags.

Condo Loans

HUD hands down stricter condominium lending regulations every year!  In September 2015, HUD stated that loan approval would not be granted for communities where the Declaration of Covenants gives the Association approval authority over leasing units.  During the question and answer session, it was added that the Association cannot have the power to evict tenants. 

Although not every single loan is directly tied to FHA/HUD, 90% of all loans are impacted.  Other lenders need to be able to sell their loans on the secondary market, which can’t be done unless they conform to FHA/HUD demands.  So unless you want cash-only home sales (i.e. slum lord investor owners) dominating your community, you should look to amending your leasing language.

Even for communities with pre-approval HUD/FHA status (which must be done every two years), we are seeing each new home loan being scrutinized for community restrictions.  It’s best to proactively address this situation, before an angry mob of homeowners shows up at a meeting, unable to sell their homes.  Hopefully, your governing documents give the Board of Directors authority to automatically amend to comply with federal regulations, without the need for a community vote!

HUD also clarified that the Association can:

• Restrict total number/percentage of units that can be rented 
• Maintain a hardship exception 
• Require the landlord to provide a copy of the lease 
• Require that the lease be on a specific form
• Set minimum and maximum lease periods 
• Require that the lease conforms to the Declaration 
• Require the landlord to check the Registered Sex Offenders list
• Require rent to be assigned to Association if the unit owner is delinquent
• Provide corporate leasing restrictions

The Association cannot: 

• Ban all leasing, except in age-restricted and affordable housing communities 
• Require the owner to live in the unit for X amount of years before being allowed to lease 
• Restrict leasing by delinquent owners 
• Require tenant interviews with the Board 
• Require credit references 
• Require criminal background checks (except for the Registered Sex Offenders list) 
• Be granted automatic power of attorney 
• Have the power to void leases
• Allow short-term leasing

As always, consult with the Association’s attorney before acting upon the above information.