A condominium association’s board of directors, which is responsible for administering the affairs of the association, is initially appointed by the developer until a certain number of units is sold. When the owners of the individual units (called “co-owners”) take control of the board, they may conduct financial and physical audits, and those audits may lead them to assert claims against the developer. The developer needs to take preventative steps to protect itself by structuring its legal and business affairs to reduce the likelihood of claims and the ease and cost of defending them. This includes providing for alternative dispute resolution, obtaining necessary insurance to cover (and defend against) claims of physical defects, and arranging for the assistance of expert witnesses in defending both physical and financial claims.
Developer’s control of board and conflicts of interest
The presence of developer designees on the board can create an inherent conflict in that the developer, on the one hand, is attempting to sell units in the condominium and, at the same time, is managing the affairs of the association. Because it controls the board, the developer can determine the amount of monthly assessments for maintenance that will be levied. The developer’s interest in selling units may create an incentive to “lowball” these assessments in order to increase sales, but developers should be aware of the consequences. If there are insufficient funds available at the time of turnover of control for the association to meet its expected needs, including a reserve fund for major repair and replacement, then the developer will be responsible for replenishing the reserve up to ten percent (10%) of the budget of the association on a noncumulative basis.
Financial and physical audit
When the co-owners take over control of the association, they may well undertake various audits. These may include a financial audit, to determine whether the developer has properly managed the financial affairs of the association, and a physical audit to determine the nature and extent of any defects and deficiencies in the common elements for which the developer will be responsible. In connection with the physical audit, many condominiums will hire architects and/or engineers to investigate the common elements to determine if there are construction defects and deficiencies.
The developer should attempt to limit its exposure by way of forming a corporation or limited liability company, and it may utilize other techniques in the condominium documentation to insulate itself from liability, including inserting provisions in the articles of incorporation to take advantage of the Nonprofit Corporation Act limiting director and officer liability. However, developers often appoint themselves as directors of the association. While it is now more difficult to succeed in an action against even paid directors due to the recent changes to the Michigan Nonprofit Corporation Act, it is still possible that a breach of fiduciary duty, conflict of interest, breach of duty of loyalty and other theories of liability may apply to personal conduct when that person is essentially wearing “two hats,” which may be inconsistent with one another.
It is important, therefore, that in organizing the condominium regime, the developer take into consideration not only the physical quality of the units being constructed, but also take the time and care to retain counsel who can prepare condominium documents which will be fair to the purchaser but, at the same time, will reasonably insulate the developer from potential liability. There are provisions that can be placed in the condominium documents which will help to limit the exposure of the developer. The developer, however, must be familiar with its own documents to ensure that it takes care of complying with them during the course of its control of the association.
Alternative dispute resolution
The developer should attempt to provide for an alternative dispute resolution process for any disputes that may arise with the association (to the extent permitted by law), as well as with individual purchasers regarding their units (i.e. non-common elements matters). Generally speaking, developers will fare better before an arbitration panel than a jury, although developer’s counsel should not underestimate the difficulty which associations may experience in raising the funds necessary to pursue a major construction defect lawsuit against the developer.
The developer should also attempt to obtain broad based insurance coverage, including products liability coverage to the extent possible, in developing a condominium project. The developer should also maintain directors and officers liability insurance to insure the directors and officers who are appointed by the developer while it is in control of the association.
The developer should also, through its counsel, notify its insurance carrier in order to engage the carrier’s counsel to defend the lawsuit and thereby avoid the potential costs of defending the case, even if the carrier is taking the case under a reservation of rights, which frequently occurs. This may have a significant effect on the association’s willingness to actively pursue the matter when it realizes that the developer is, in a sense, getting a “free ride” in regard to the defense costs of the litigation and/or arbitration proceeding.
If a lawsuit arises, the developer’s counsel should be totally familiar with the condominium documents as well as the Condominium Act, which now contains its own statute of limitations regarding claims brought on behalf of the association. The statute requires suit to be brought within two years of accrual of the action or three years from the transitional control date, whichever is later. In addition to the other defenses which would normally be raised by a developer, the developer should also be cognizant of the fact that there may be preconditions in the condominium documents which must be satisfied before the association has standing to bring the lawsuit. The developer may be able to bring a preliminary motion to dismiss the lawsuit if these preconditions have not been met, assuming, of course, that these preconditions are deemed to be reasonable.
It cannot be over-emphasized that the quality of the condominium documents will have a significant impact on the potential issues for the developer. It is often the case that poorly drafted condominium documents can create challenges for the developer even if the physical structures constructed by the developer are not causing a problem. Certainly, the purchase agreement and the limited warranties, if there are any given by the developer, should be carefully drafted by the developer’s counsel, who should have expertise in condominium law, keeping in mind the consequences if these documents do not contain the proper disclaimers as well as the requirements that may be mandated by state and federal law as well as the Condominium Act.
Finally, if a construction defect case is filed, it will frequently include a claim that the association was “financially shortchanged” by the developer, both in the manner in which the developer managed the association and, perhaps, in the way in which the developer spent association funds. The developer’s counsel will, therefore, need to engage the services of competent experts both in the engineering and architectural fields at the outset as well as experienced accountants and/or managing agents who have had experience in representing condominium associations. These people can assist the developer and its attorney in the ferreting out the legitimate claims of the association from those that may be overstated. Also, communication with the association and active responsiveness by the developer to the association’s concerns are paramount in order to avoid exacerbating already existing problems or creating new ones.
In summary, it would appear that there will be more litigation in the condominium association arena just from the sheer number of condominium associations that are being developed and the sloppiness on the part of many developers in having documents prepared by people who have not had sufficient experience in determining the potential problems and shortfalls of condominium development. With a team of experts in place who have had experience in condominium operation and management, the developer can avoid legal problems before they arise. Just as in any other situation, preventative law maintenance is much cheaper than trying to extricate oneself from a lawsuit that could have been avoided through proper planning and communication with the purchasers.