By Michael J. Gelfand, Esq. / Published March 2017
In a modern day David versus Goliath story, a monumental bankruptcy court decision highlights the importance of the duties of directors, especially the pitfalls of ignoring basic corporate functions; and in particular, that developer-appointed directors still owe a fiduciary duty to the members.
The stunning multi-million-dollar award and the denunciation of the directors’ conduct were contained in a recent bankruptcy court decision, Mukamal v. D.R. Horton Inc., United States Bankruptcy Court, Case No. 12-19056-BKC-AJC-A. The bankruptcy trustee for Majorca Isles Master Association Inc., a homeowners association comprised of low- to moderate-income residential homes, prevailed against D.R. Horton, the largest residential developer in the United States, receiving compensatory damages plus $12.5 million in punitive damages.
Far from a fairy tale, but seemingly starting a long time ago, in 2005, D.R. Horton began a project to consist of 681 condominium units and single-family homes in Miami Gardens. D.R. Horton appointed four of its employees as directors of the Master Association.
When the recession hit, D.R. Horton stopped building. Three hundred fifty-five of the units were completed; the rest were never built. Unit values plummeted to less than half of the $300,000 original purchase price range. Financial issues loomed large. The master association required a monthly $40,000 cash flow, but reported monthly income of only $20,000. There was not enough income to cover the condominium and homeowners association expenses.
Soon after the turnover of the associations to the members, and with insufficient funds to pay its bills, the master association sought protection in Chapter 11 bankruptcy. The Chapter 11 trustee then filed a lawsuit on behalf of the master association against D.R. Horton and the four developer-designated directors for breach of fiduciary duties and violation of Florida’s Deceptive and Unfair Trade Practices Act.
The bankruptcy court determined that D.R. Horton was obligated to deficit fund the master and condominium association expenses. D.R. Horton cut services and amenities that the owners were entitled to receive. “These actions by D.R. Horton can only be classified somewhere between not nice and evil,” the court said. While the sub-associations were controlled by the developer, the sub-associations failed to remit monies collected from unit owners to the master association, resulting in unpaid assessments of more than $400,000.
The court recited how D.R. Horton substituted home alarm monitoring for security personnel at a cost of one-third of the monthly assessments. That expense “had to be replaced by keeping the lights on, by paying the insurance, and by attending to possible life-threatening conditions at the property.” Finally, in September 2009, the master association forwarded the delinquent owner accounts to a law firm to initiate collections against the sub-associations for non-payment. D.R. Horton rejected counsel’s advice that the master association could pursue collections against the individual owners.
The court concluded that in anticipation of the turnover of a 355-unit community to its owners, D.R. Horton’s appointed board did nothing. Even though they owed the master association a duty to act reasonably and in its best interests, the board, acting as agents of D.R. Horton, fell short:
a) Did not advise the members of the master association of the extent of the deficit funding (the full nature of which had been concealed from the unit owners), or that the master association could not pay its bills without the deficit funding;
b) Did not advise the master association that the calculated and published budget was woefully inadequate, even if it was fully collected;
c) Did not write off or write down the uncollectable assessments;
d) Did not institute a meaningful collections program; and
e) Did not leave the master association with any meaningful reserves.
In other words, the board took no action to advise the members of the master association of the inadequate revenue, the lack of collectable assets, or the extent of the master association’s in ability to function.
The court determined that D.R. Horton violated Florida’s Deceptive and Unfair Trade Practices Act “based upon the clear and convincing evidence that D.R. Horton engaged in an unfair practice ‘that offends established public policy and one that is immoral, unethical, oppressive, and unscrupulous.’” In addition to individ-ual breaches of fiduciary duty, D.R. Horton and the four directors were found to have conspired to breach their fiduciary duties and for aiding and abetting each other. The court awarded the master association $12 million in punitive damages and stated that, “Hopefully, this amount will be sufficient to deter future unlawful, malicious conduct and otherwise fulfill the intent of punitive damages.”
What is the moral to the story? This decision reinforces the need for directors, including developer-appointed directors, to pay attention. While the court did not address the minimum level of director inquiry to staff or management, there is apparently a minimum duty to inquire as to the status of unit ledgers, roster, and in recessionary times, bad debt budgeting. Realistic budgeting is de rigueur.
Developer-appointed directors being loyal to everyone—their employer, the association, and association members—might have been theoretically possible in “the good old days” when pre-turnover operations were measured in weeks, and there were no financial difficulties. However, in this day and age when pre-turnover activities extend over multiple annual budgets and there are significant financial issues, a call for truly independent directors may be raised. This may reinforce the lesson learned by many a developer: the need for truly independent counsel for pre-turnover associations.
“Woe is me,” the refrain by Florida associations when a lender forecloses is repeatedly asserted. So what can be done to recover at least something from a foreclosing lender?
The starting point is to read the fine print. One word can make a difference, and as it is said in the real estate world, “location, location, location” is just as important for determining that one word’s impact.
So, what is that word? In the Homeowners Association Act, it is “initially,” and it comes into play when a lender files a foreclosure action. Recently, a Florida appellate court ruled that a lender must name the homeowners association as a defendant when the mortgage foreclosure complaint is initially filed in order for the lender to be protected by the “safe harbor” provision, Section 720.3085, Fla. Stat., which otherwise limits lender liability to an association.
The ruling was issued in Federal National Mortgage Association v. Mirabella at Mirasol Homeowners Association Inc., No. 4D15-4792 (Fla. 4th DCA, November 23, 2016). The court explained that the Federal National Mortgage Association (FNMA) obtained title to property through a mortgage foreclosure action. Because FNMA did not join the association as a defendant until four years after the foreclosure action was filed, the court asked this question for the first time, “Which word does the word ‘initially’ modify in the statute limiting liability of a first mortgage holder for certain homeowner association assessments?”
Agreeing with the trial court that the statute is not ambiguous, the appellate court found that the association was entitled to seek the entire amount of unpaid assessments because FNMA failed to “initially join” the association as a defendant in the mortgage foreclosure. Rejecting FNMA’s arguments, the court stated the following:
It is completely reasonable to conclude that the legislature, in modifying the common-law position, wanted a homeowners association to be able to be involved in the case from the start so that it could have the ability to move the case along and monitor its progress. . . .As a non-profit entity, it could have attempted to minimize its loss in assessments as it is generally in an association’s best interest to move the case to a quick resolution.
Nevertheless, Florida association celebrations must remain somewhat muted. The judgment did not address what happens if an association’s assessment authority contained in a declaration of covenants is more restricted than the statute. Also, as occurs from time to time, Florida’s Condominium Act is a bit different, not containing the word “initially,” which is in the Homeowners Association Act. The court called out as citation in support of its decision Michael J. Gelfand, “Condominium and Homeowners Association Liens,” in Florida Condominium and Community Association Law §16.92 (The Fla. Bar ed., 2d ed. 2011).
This decision may provide Florida homeowners associations a bit of solace as they play catch up to lenders. Associations should confirm if their covenants include the recent statutory language. If not, associations should consult with counsel regarding whether to update their assessment collection provisions.
Michael J. Gelfand, Esq.
Senior Partner of Gelfand & Arpe, P.A.
Michael J. Gelfand, the Senior Partner of Gelfand & Arpe, P.A., emphasizes a community association law practice, counseling associations and owners how to set legitimate goals and effectively achieve those goals. Gelfand is a Florida Bar Board-Certified Real Estate Lawyer, Certified Circuit and County Civil Court Mediator, Homeowners Association Mediator, an Arbitrator, and Parliamentarian. He is the Chair of the Real Property Division of the Florida Bar’s Real Property, Probate, & Trust Law Section, and a Fellow of the American College of Real Estate Lawyers. Contact him at email@example.com or (561) 655-6224.