SAVING FOR A RAINY DAY – RESERVE OR ELSE . . .
There has been much confusion concerning Associations’ legal duty to set aside funds for future repairs and/or for the replacement of major components. Hopefully, this Article will provide some clarity relative to this issue. By law, Associations with common areas are required to prepare a Reserve Study at least once every three (3) years. An exception to this requirement exists where the replacement value of all major components is less than one half of an Association’s gross budget. Generally, this exception only applies to Association’s with extremely limited common area elements. The study is intended to:
- Identify these major common area components which the Association is required to maintain or replace within thirty (30) years;
- Provide an estimate of the remaining useful life of these components;
- Provide an estimate of the costs of maintaining and/or replacing these components over the next thirty (30) years; and
- Suggest a funding plan which will enable the Association to accumulate sufficient funds to perform such maintenance and repair.
Board Members should not attempt to prepare the reserve study themselves. Instead, this function should be delegated to qualified and experienced reserve study specialists, a number of whom are members of this CAI Chapter. By establishing a funding plan, the Reserve Study essentially provides a road map for the long term financial health of an Association. Boards are required to review the study annually and to determine whether any adjustments to the study plan are required.
In order to ensure the transparency of the Board’s operations, the Davis-Stirling Act mandates that Associations distribute a summary of the reserves with the pro forma operating budget. In addition, Civil Code §1365.2.5 mandates use of a statutory form for the Reserve Assessment and Funding Disclosure. This form must:
- Identify current assessments per unit;
- Disclose any additional assessments that are to be imposed;
- State whether current reserve balances are sufficient to meet the funding goals;
- Disclose a plan to meet requirements of the current funding goals;
- Identify the major components included in the Reserve Study but which may not be included in the reserve funding program; and
- Disclose the current balance of the Reserve Funds on deposit.
Associations must establish reserve accounts which are separate from their operating funds. Two (2) Directors must sign any check which transfers funds from the reserve account. Community managers may not be signers. Except for temporary transfers, reserve funds may not be utilized for any purpose other than the repair, replacement and maintenance of the Association’s major components. While funds can be “borrowed,” Boards must first notify the membership of their intent to transfer such funds at a noticed meeting. In addition, Boards must disclose the reason for the transfer and the means that the debt will be repaid, including whether or not a special assessment is contemplated. If a transfer is authorized, the Board must prepare written findings and include the same in its meeting minutes. Generally, borrowed funds must be returned to the Reserve Account within one (1) year except that repayment may be delayed if it is reasonably necessary to do so.
While the law requires the preparation of a Reserve Study, it does not expressly require funding of this account. However, as fiduciaries, Boards of Directors are required to act in the best interest of the Association and its members, in accordance with the Business Judgment Rule. The failure to reasonably fund the reserves may therefore result in liability for mismanagement and breach of duty. Also, Boards must exercise prudent fiscal management in maintaining the integrity of the reserve account. In other words, there is a duty to preserve these sums against losses. Consequently, the reserves should only be placed in secure investment vehicles such as insured, laddered, Certificates of Deposits and Treasury Bills. While Boards should strive to maintain reasonable returns, they should not do so by placing the reserve funds in risky investments.
Southern California living is certainly not without risk. Earthquakes, floods, pests and wildfires can all contribute to need for unplanned repairs/replacement of major components. When combined with deterioration due to age and the all too common failure to properly maintain common components, is without question that Association’s should strive to adequately fund their reserve accounts. Fully funded reserves can also enhance property values, or, at a minimum, make a community more attractive to potential buyers. Accordingly, my words of advice are fund, fund and fund.
Matthew L. Grode, Esq. is an equity partner with the law firm of Gibbs, Giden, Locher, Turner & Senet LLP in Los Angeles, California. Mr. Grode’s practice is dedicated to the representation of common interest communities, real estate and construction matters. Mr. Grode can be reached at (310) 552-3400 or by email at email@example.com.
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