Horror stories about physical defects in newly constructed condos abound, but Leni Morrison Cummins, partner at Cozen O'Connor, tells Habitat the story of a board taking over from sponsors and then discovering irregularities.
You hear a lot of horror stories about physical defects in newly constructed condos, but not so much about boards taking over from sponsors and then discovering irregularities about how the building has been run. Can you talk about your experiences with this problem?
Unfortunately, this is not unusual. I’ve dealt with several of these cases, including one at a luxury Manhattan condo. Three years into the life of the building, the sponsor had sold out all 250 residential units but maintained ownership of the four commercial ones. When the owners took control, the new management company created a budget that called for a 20 percent common charge increase.
Ouch is right. The board wanted advice on how it could cut expenses and explain the situation to unit-owners so they wouldn't have a revolt on their hands. I got hold of the last three financial statements prepared by the auditor for the sponsor-controlled board, which is standard operating procedure, and noticed that while the top-line expenses remained the same, the building was running at a deficit. That didn’t add up, since the condo had just been created, and the offering plan contained a budget that was in line with the common expenses.
Something was rotten in the state of Denmark.
So it seemed. I pulled the governing documents and compared them to the offering plan and the budget. In every declaration of bylaws, there is a section on allocation of expenses, which is essentially a roadmap to how expenses like repairs, maintenance and service contracts are allocated among the residential and commercial unit owners. As I mentioned, in this case the commercial units were still owned by the sponsor, which was controlling the board.
We can see where this is headed.
It turned out the sponsor-controlled board had skewed various expenses to the residential unit owners and away from the commercial ones, bringing the commercial common charges down substantially. Apparently, it thought there was a free lunch, but they were busted.
Did you threaten a lawsuit?
I did. The board members were employees of the sponsor, but they still had a fiduciary duty to all of the unit owners. Deviating from the governing documents and self-dealing to financially benefit their employer was a very clear-cut case of breach. We called an emergency board meeting, re-examined the budget and, sure enough, found a zero percent common charge increase for the commercial owners, but a 300 percent increase for the residential owners. We caught them red-handed.
What happened next?
The sponsor-controlled board agreed to pay back the $200,000 they had pushed off to residential owners annually for the last three years. The money went into condo’s reserve fund, and it’s there for capital expenditures, which benefits everyone.
So a happy ending. What’s the takeaway here for other boards?
When owners take over control of a board, as important as it is to have an engineer and architect do a forensic study of the physical building, it's just as important to take a hard look at the books. You never know what you may find.