Vol. 77, No. 3, March 2004

Advising Developers in Operating Community Associations

by Lisa M. Pardon

ondominium and homeowner associations, also known as community associations, have gained in popularity in Wisconsin and in the country. Nationwide, approximately 6,000 to 8,000 new community associations are developed each year.¹ This flurry of building activity increases the potential for disputes and litigation. Construction problems and financing shortfalls have always plagued real estate projects, but with condominiums and similar types of projects, developers have additional liability exposure in their relationships with owners associations.

In addition to constructing buildings, to complete a project, a developer also must form an owners association to manage and operate the property.² Generally, these associations are formed as nonstock corporations. Initially, the developer appoints the board of directors.³ Eventually, as units are sold, owners are elected to the board, replacing the developer-appointed directors.⁴ An interim period, known as the period of developer control, commences with the developer's formation of the organization and ends with the election of owners to all board positions.⁵ Developers of community associations can find themselves in complex relationships with the projects they develop that can easily turn contentious. Proper legal counseling can help developers avoid dissension and legal problems with these associations and facilitate a smooth transition to an owner-controlled project.

Until the owners take control, the developer is responsible for and controls all aspects of the project's operations through the appointed directors.⁶ Responsibilities include property maintenance, covenant enforcement, and financial management.⁷ Difficulties can arise because, during this period of developer control, the developer also is still developing and marketing the project. The developer thus is charged with the dual aims of promoting sales of its project and governing the project on behalf of the present and future owners. Of course, the developer's ultimate goal is to enjoy a return on its investment, but if this profit is realized at the expense of depriving the owners of a fully functioning, financially sound, and well-maintained project, then the developer can find itself in a lawsuit.

Standard of Care for Developers

Courts in many states differ as to whether developers owe a fiduciary duty to the owners association. Some states have held that developers owe a fiduciary duty to the owners association in operating the project.⁸ The Restatement Third, Property (Servitudes) section 6.20 suggests that the developer's duty depends on the particular role it is playing. In the role of a purveyor of real property, the developer has no fiduciary duty to potential purchasers, because the developer-purchaser relationship is an arm's length transaction. However, when in control of the unit owners association, the developer has a fiduciary duty of care in operating and managing the project. The basis of this fiduciary duty is found in corporate law, in which a developer has been likened to a promoter of a corporation.⁹ As a promoter, the developer must not do anything that hinders the viability of the organization it has created.¹⁰ For example, several courts have held that developers have breached their fiduciary duties when they have turned over to the owners control of a project that is in a state of disrepair with underfunded accounts.¹¹

Not all jurisdictions impose a fiduciary duty upon developers. The Ohio Supreme Court held in Belvedere Condominium Unit Owners' Ass'n v. R.E. Roark Cos. that developers were not fiduciaries.¹² The court reasoned that in light of the developer's dual role, the court could not impose such high standards of care because a fiduciary must subordinate its own interests for the benefit of another. The court recognized that the developer had a legitimate right to protect its own interest in promoting its project. Additionally, the majority reasoned that the Ohio Legislature accommodated for this inherent conflict by providing consumer protections in that state's condominium statutes, such as the ability of the owners association to cancel contracts entered into by the developer and the phasing out of the developer's control. However, one dissenting justice argued that the majority's decision permits the developer to engage in self-dealing with impunity while operating the owners association and doubted that that was the Legislature's intention.¹³

Wisconsin's Condominium Ownership Act (Wis. Stat. ch. 703) contains provisions similar to those in Ohio for canceling contracts and leases entered into by the developer and for phasing out the developer's control.¹⁴ Although owners associations in Wisconsin have brought several suits against developers for breach of fiduciary duty, there are no published opinions that hold that a developer owes a fiduciary duty to an owners association. An argument could be made that a developer should be held accountable for the negligent operation of the association during the period of developer control, because the developer has the exclusive right to appoint and remove directors from the owners association's board during this time.

Standard of Care for Developer-appointed Directors

Regardless of whether the developer stands as a fiduciary to the owners association, the developer's appointed directors do have a common law fiduciary duty to the association as directors of a corporation.¹⁵ The developer-appointed directors have a duty of good faith and fair dealing to the association and may be individually liable for breaching that duty.¹⁶ Individual directors also may breach their fiduciary duties for failing to enforce the association's covenants against the developer or for failing to disclose developer misconduct.¹⁷ Because of these conflicting loyalties, attorneys for developers should advise their clients to obtain directors and officers liability

coverage for their board appointees. This is particularly important when principals of the developer corporation place themselves on the association's board of directors - as is often the practice - thereby removing themselves from the protection of the development entity's corporate shield. In addition, to avoid future claims of conflict of interest, the developer's attorney should not act as a director of the owners association.

Developers can avoid many potential problems with owners associations if they are advised and prepared to assume a quasi-fiduciary role in operating the owners association for the owners' ultimate benefit. When establishing the owners association, attorneys representing developers should advise them of their various obligations for operations under Wis. Stat. chapter 703 (if it is a condominium) and under Wis. Stat. chapter 181 (if it is a corporation). Chapters 703 and 181 both require organizations to maintain adequate books and records in accordance with standard bookkeeping procedures.¹⁸ Thus, the developer-appointed board must maintain separate records for the owners association and not commingle any association funds with development funds. The developer-appointed board also should establish bank accounts, budgets, and records separate from those of the developer's own organization. The directors should hold board meetings, give appropriate notice to owners of these meetings, and record all actions of the board in the minutes. Of course, developers and their board appointees must abide by the project's governing documents, namely, the declarations, bylaws, and articles of incorporation. Developers may be unaware that these covenants apply to them as unit owners.¹⁹

The Importance of Sound Fiscal Management

In creating a viable organization, the developer should establish a sound fiscal basis for the association and set realistic maintenance fees that meet the association's operational needs. Developers often are accused of fiscal mismanagement or self-serving fiscal policies. Much of this can be avoided if the developer is advised to differentiate its development and marketing expenses from the association's maintenance and operational expenses. The association's governing documents should reveal what expenditures can be charged to owners as "common expenses"²⁰ and how these common expenses will be assessed against the owners. Authorized common expenses generally are limited to maintenance, repair, insurance, taxes, and professional services. Developers must apply maintenance fees to the common expenses and cannot use the owners' funds to complete construction of the project or for remedial work for defects covered by the developer's warranties.

Developers often are accused of "low-balling" maintenance fees, undercharging owners, and subsidizing operations to keep assessments at an artificially low level to attract sales. In Wisconsin, developers, real estate brokers, and condominium purchasers alike have all come to expect that maintenance fees should hover around $100 per month regardless of the actual costs of operating and maintaining a condominium project. Often, the maintenance fees are inadequate to cover the actual costs of operations. Unit assessments are supposed to be based on that unit's proportionate share of the annual expenses of the owners association.²¹ Under Wis. Stat. section 703.33, developers must disclose the condominium association's annual budget to unit purchasers. There is a temptation to manipulate this budget to achieve the low maintenance fees. The danger in doing this is that it exposes the developer to claims of fraud and misrepresentation if the developer fails to disclose the actual costs of operating the condominium.²² A developer's misrepresentations of the association's financial state will surface eventually when the owners take over control of the association's operation and have possession of the association's accounts and records. These misrepresentations, besides being illegal, can create an atmosphere of animosity and distrust, which can lead to other disputes with the owners. Moreover, the developer probably still will have unsold units after turning over control to the owners, and if the owners association is having financial difficulties, then this can affect future unit sales.

Although not yet required in Wisconsin, condominiums in most states are required to set aside fund reserves for the future maintenance, repair, and replacement of the project's common elements, such as roofs, siding, and painting. Even though Wisconsin does not require reserves, an adequate reserve fund is essential to the financial health of a community association. It is a good practice to earmark part of the owners' assessments for future repairs and maintenance and to spread the cost of major projects over time to avoid having to burden owners with large, unforeseen special assessments. Although there is no statutory obligation to fund a reserve account, there are several cases in other jurisdictions that hold that developers are in breach of their fiduciary duty to owners associations if they fail to turn over the property in good condition and fail to provide enough funds in the association's accounts to remedy the ill condition.²³

Maintenance Fees for the Developer's Own Units

Pardon

Lisa M. Pardon, U.W. 1999, is an attorney in the Madison office of Brennan, Steil & Basting S.C., practicing in condominium and homeowners association law. She serves on the board of directors for the Wisconsin chapter of the Community Association Institute.

Developers also are unit owners and, like other owners, must comply with the community association's governing documents unless expressly exempted.²⁴ This includes paying maintenance fees.²⁵ Developers may relieve themselves of this obligation if the unsold units have not been constructed.²⁶ However, this action may force associations to operate at a deficit, because the unit owners are responsible only for a set percentage of the common expenses. If the number of sold units is less than 100 percent and the developer exempts its own units, then less than 100 percent of the common expenses can be collected. When drafting the governing documents, the developer's attorney may wish to consider how the project's operations will be funded if the developer's units are exempt from assessments.

Courts have been asked to decide whether a developer can offset its assessment obligations with expenditures made on the association's behalf.²⁷ In states other than Wisconsin, this practice has been permitted as long as the expenditures were documented and could be permissibly charged as a common expense under the association's governing documents.²⁸ The better practice is for the developer to make timely maintenance fee payments and to have expenditures paid from the owners association funds. Otherwise, the developer runs the risk of incurring late charges on maintenance fee delinquencies and having a lien being placed on its unsold units.²⁹ Conversely, the developer needs to be careful if it overpays its assessment obligations to the association with the expectation of being repaid. Under Wis. Stat. section 703.10(2)(f), the procedure for borrowing money must be in the association's bylaws. The developer may face difficulties in getting reimbursed if it did not follow the procedures set out in the bylaws. Borrowing procedures should be considered at the project's drafting stage if the developer intends to lend the association its initial startup costs.

Regardless of whether Wisconsin courts find that developers owe a fiduciary duty to owners associations, developers can avoid many potential conflicts with owners if, from the moments of it inception, the owners association is regarded as a separate entity from the development entity. The developer also should be advised that the sound operation of the owners association during the period of developer control is essential to the project's overall success and to reducing claims by owners. Good operation of the owners association contributes to the project's reputation as a desirable place to live, which ultimately benefits the developer in selling the remaining unsold units.

Lisa M. Pardon, U.W. 1999, is an attorney in the Madison office of Brennan, Steil & Basting S.C., practicing in condominium and homeowners association law. She serves on the board of directors for the Wisconsin chapter of the Community Association Institute.

Endnotes

¹http://www.caionline.org/about/facts.cfm.

²Wis. Stat. § 703.15(2)(a).

³Wis. Stat. § 703.15(2)(c)1.

⁴Wis. Stat. § 703.15(2)(d).

⁵Wis. Stat. § 703.15(2)(c).

⁶Wis. Stat. § 703.15.

⁷Id.

⁸See Hampton Ridge Homeowners Ass'n v. Marrett Property Ltd., 265 Ga. 655, 460 S.E.2d 790 (1995); Raven's Cove Townhomes Inc. v. Knuppe Dev. Co., 114 Cal. App. 3d 783, 171 Cal. Rptr. 334 (1981); Maercker Point Villas Condo. Ass'n v. Szymski, 275 Ill. App. 3d 418, 655 N.E.2d 1192, 1194 (1995).

⁹See Duncan v. Brookview House Inc., 262 S.C. 449, 205 S.E.2d 707 (1974); Rafalowski v. Old Country Road Inc., 719 A.2d 84, 45 Conn. Supp. 341 (1997).

¹⁰See Maercker Point Villas, 275 Ill. App. 3d 418.

¹¹See id.; see also Concerned Dunes West Residents Inc. v. Georgia-Pacific Corp., 349 S.C. 251, 257, 562 S.E.2d 633, 637 (2002).

¹²67 Ohio St. 3d 274, 617 N.E.2d 1075 (1993).

¹³Id. at 292, 617 N.E.2d at 1089.

¹⁴Wis. Stat. §§ 703.35, .15(2).

¹⁵See, e.g., Rose v. Schantz, 56 Wis. 2d 222, 201 N.W.2d 593 (1972).

¹⁶Raven's Cove, 114 Cal. App. 3d 783.

¹⁷Pebble Cove Homeowners' Ass'n v. Shoratlantic Dev. Co., 191 A.D.2d 544, 595 N.Y.S.2d 92 (1993).

¹⁸Wis. Stat. §§ 703.20, 181.1601.

¹⁹LeFebvre v. Osterndorf, 87 Wis. 2d 525, 275 N.W.2d 154 (1979).

²⁰Wis. Stat. § 703.02(3).

²¹Wis. Stat. § 703.16(2).

²²Cleve v. Shepard/Legan/Aldrian Ltd., 350 N.W.2d 741 (Wis. Ct. App. 1984) (unpublished).

²³Concerned Dunes, 349 S.C. 251; Goddard v. Fairways Dev. Gen. Partners, 310 S.C. 408, 426 S.E.2d 828 (Ct. App. 1993).

²⁴LeFebvre, 87 Wis. 2d 525.

²⁵Aluminum Indus. Corp. v. Camelot Trails Condo. Corp., 194 Wis. 2d 574, 535 N.W.2d 74 (Ct. App. 1995).

²⁶Id.

²⁷See LaFreniere v. Fitzgerald, 669 S.W.2d 117 (Tex. 1984); Battery Homeowners Ass'n v. Lincoln Fin. Resources Inc., 309 S.C. 247, 422 S.E.2d 93 (1992).

²⁸Id.

²⁹Wis. Stat. § 703.1

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