Compliance with Reserve Study Requirements During
Construction Defect Litigation
by Paul P. Terry, Jr., ANGIUS & TERRY LLP
At least once every three years, all common interest developments (hereinafter referred to as "associations") must conduct a study of their reserve accounts. The requirement for such reserve studies (hereinafter referred to as "reserve studies") is found under Civil Code Section 1365.5(e), which is part of the Davis-Stirling Act. This law does not require that the reserve studies be prepared by an independent or outside consultant, most associations routinely retain outside consultants to prepare their reserve studies because of the detailed requirements of §1365.5. Unfortunately, when an association with pending construction defect litigation has a routine reserve study performed, the findings of this reserve study could detrimentally impact the association's construction defect lawsuit.
Generally, reserve studies are not as accurate or detailed as forensic investigations, and, thus, can harm an association's ability to recover its damages during litigation.
Because reserve studies are limited in nature and can be prepared by persons without even minimum qualifications, the evaluation of the association's major components in a reserve study is not and cannot be as thorough or extensive as the investigation and evaluation performed by the association's litigation consultants. As a consequence, it is not unusual for the reserve study commissioned during the pendency of the litigation to project much longer useful lives and much less expensive repair and maintenance costs than those estimated by the association's litigation consultants.
Despite the obvious differences in the scope and nature of the investigations performed for the reserve study, defense attorneys in the construction defect litigation have used reserve studies to challenge the findings of the association's litigation consultants and impeach their testimony on issues including the adequacy of the reserve funding and the costs of repairing and/or replacing the various components. For this reason, it is not in the best interests of an association to have a routine or standard reserve study performed during the pendency of the association's construction defect litigation.
A board of directors should not ignore its statutory duty to conduct a reserve study as this poses other risks to the association and the board of directors.
Ignoring the requirement for a reserve study can create problems for both the board and the association. Initially, it should be noted that the Davis-Stirling Act does not set forth a penalty for failure to comply with the reserve study requirements of Civil Code §1365.5. The violation of a statute, including Civil Code §1365.5, can be used as evidence of negligence by either the association and/or the board. See Evidence Code §669(a)(1). As an example, if an association does not conduct a reserve study and is unable to fund necessary repairs and property values decline, the lack of a reserve study could be used as evidence of the board's and/or the association's negligence if disgruntled homeowners decided to sue.
In addition, if the board consciously decides not to conduct a reserve study, this decision could affect the insurance coverage available to both the board and the association should a claim and/or litigation arise. Since most insurance policies exclude coverage for willful acts, the Association's insurance company, asserting that the board's decision was a wilful act, may deny coverage for such claims. Indeed, the association's insurance company could also use a board's decision not to commission a reserve study as a basis for either nonrenewal of the association's policy or for increasing the association's insurance premiums.
The lack of a reserve study could also compromise the association's ability to raise necessary assessments. Many associations rely on Civil Code §1366(b)'s authority to increase regular assessments and/or impose special assessments. Yet, if an association does not conduct a reserve study once every three years and distribute a summary of the reserve study to its members annually, the association cannot rely on Civil Code §1366(b)for the power to increase regular assessments or impose additional assessments. Civil Code §1366(a).
Further, board members who decide to conduct such studies without consulting their attorneys or other consultants could be found to have breached their fiduciary duty to the association and its members and, as such, face personal liability for a decision not to conduct a reserve study. The board's fiduciary duty includes both the duty of care and the duty to act in the best interests of the Association and all of its members. See Corp. Code §7231(a), Remillard Brick Co. v. Remillard-Dandini Co. (1952) 109 Cal.App.2d. 405, 241 P.2d 66 and Raven's Cove Townhomes, Inc. v. Knuppe Dev. Co. (1981) 114 Cal.App.3d 783, 171 C.R. 334. The board will also have difficulty defending its decision, since conducting a reserve study is not only required by statute but, arguably, in the association's best interest.
An association can comply with its reserve study obligations under the Civil Code without commissioning a formal reserve study until after the litigation concludes.
Is it possible for the board to satisfy the reserve study requirements without jeopardizing the association's construction defect litigation? The short answer is YES.
Civil Code §1365.5 does not impose any obligation to commission a separate reserve study during the pendency of the association's construction defect litigation. During the pendency of the litigation, the board's obligation to conduct a reserve study is satisfied by the investigation undertaken by the association's litigation consultants. Until the litigation resolves, commissioning any additional review of the association's reserves beyond that performed by the association's litigation consultants would be an unnecessary expense and a meaningless endeavor in light of the extensive investigation already undertaken for litigation purposes.
Civil Code §1365.5(e)(1)-(4) sets forth the requirements for reserve studies. In summary, these requirements are to:
1. Identify the major components with a remaining useful life of 30 years or less that the Association is responsible for maintaining;
2. Estimate the probable remaining useful life of the components identified under Item No. 1;
3. Estimate the cost of repair, replacement, restoration or maintenance for the components identified under Item No. 1; and
4. Estimate the annual contribution by association's members necessary to fund the association's reserve requirements as estimated in Item No. 3.
The association has already retained various experts and consultants for its construction defect litigation. The scope of the investigation conducted by these experts satisfies both the letter and the spirit of the first three reserve study requirements under Civil Code §1365.5(e) (i.e., Item Nos. 1-3 above). In investigating the project's "construction defects," these experts and consultants will necessarily identify and evaluate the components for which the association is responsible; estimate the remaining useful life of those components and the costs of their repair and/or replacement.
Further, Corp. Code §7231(b) expressly authorizes a board of directors to rely on information, opinions and/or advice of legal counsel and experts such as the association's litigation consultants. Therefore, relying on the findings and opinions of the association's litigation experts and the legal opinion that said investigation satisfies the requirements of Civil Code §1365.5 provides both the association and its board with another layer of protection against a breach of duty claim.
While the board could retain someone to estimate the necessary annual contribution to the association's reserves (i.e., Item No. 4 above) and, thereby, "complete" the association's reserve study, this would be a meaningless exercise while the association's construction defect litigation is pending. Until the litigation ends and the total recovery obtained by the association is determined, it will be impossible for anyone to estimate with any accuracy the funding needed from the association's members to adequately maintain the association's reserves.
Moreover, it is likely that at the conclusion of the construction defect litigation, the association will repair many of the components addressed in the association's reserve study. The repaired components will have substantially greater remaining useful lives following completion of the repairs. In fact, some repaired components may have remaining useful lives greater than 30 years and no longer be required to be included in the association's reserve study.
Since "[t]he law neither does nor requires idle acts" (Civil Code §3532), the board can wait until the association's pending construction defect litigation has been resolved before the board completes the association's reserve study.
At the conclusion of the construction defect litigation, the board should commission a new reserve study to evaluate the association's reserves in light of the funds recovered from the litigation and the repairs anticipated by the association. The board can adjust the reserve study as part of its required annual review when the litigation related repairs have been completed and the actual cost of repair (as opposed to the projected cost of repair) has been finally determined.
During the pendency of the litigation, the association's annual disclosures regarding reserves, as required by Civil Code §1365(a)(2), should be based on the association's last, complete reserve study, with a notation that the information may no longer be accurate in light of the association's pending construction defect litigation. Obviously, the association should not disclose the opinions and conclusions of the construction experts during the litigation in order to avoid the risk of disclosure of privileged information to other parties in the litigation.
Civil Code §1365.5(e) also requires that the board review the association's reserve study annually. In most cases, the board's periodic meetings with association's counsel and litigation experts and consultants for status updates on the litigation will satisfy the annual review requirement of Civil Code §1365.5(e).
By discussing the commissioning of the reserve study with the association's legal counsel and following the course outlined above, associations and their boards should be able to comply with the Davis-Stirling Act's reserve study requirements without any adverse affect on their pending construction defect litigation.
