Collection Hammer is Broken (Can it be Fixed?)

By Donald W. Haney, CPA MBA,MS (Tax)
 
www.haneyinc.com

California Homeowners Associations (CIDs) are suffering bad debt losses due to lack of equity in the units and superior lien holders’ foreclosure actions:

The perfect storm has hit California CIDs and it has affected their ability to collect delinquent assessments. The storm’s components are:

Lenders are making 100% of Fair Market Value (FMV) residential loans to owners; FMVs are declining; Many of these loans are made to “sub-prime” borrowers and contain complex variable interest rate features with significant payment escalators; Some owners and investors with equity in their residential real estate have borrowed that equity to pay consumer debt or to make sure that they are not leaving any equity on the table; The usual factors (job loss, divorce, death, bankruptcy, etc.) affecting owner occupants’ and investors ability to pay their CID assessments continue to occur at a slight increase from their usual rate; and The FMV decline and lack of remaining equity have combined to encourage residential real estate owners and investors to abandon their investment which leaves the CID and other lenders holding the bag.

The critical assumption underlying the assessment collection process for California CIDs is that there is equity in the unit. With equity in the unit the lien and foreclosure collection model will eventually collect all unpaid assessments and associations will not incur any assessment losses. The system expects the lenders to be the “equity protectors.” As stated above, the market and the lenders have collaborated to invalidate this critical assumption. Moreover, the first mortgage holders’ liens are superior to the association’s lien in California. If there is no equity in the unit, even if perfectly executed the existing lien and foreclosure hammer no longer works for CIDs in many cases and they are suffering bad debt losses. These losses must be covered by the other owners or come from reserves which in most cases are critically under funded– not a good thing in either case. For some associations these losses are significant and place severe burdens upon the owners who are current with their assessment obligations. We have to find a new tool kit to collect unpaid assessments.

The options for a new assessment collection model:
The current assessment collection system in essence positions the CID as a secured creditor. A secured creditor has some “hard asset” that it can take from the debtor and convert to cash to satisfy the unpaid debt. The non-judicial lien and foreclosure process was designed as a relatively straight forward method for the association to acquire a security interest in the owner’s unit and, as a last resort, convert that interest into cash to collect unpaid assessments. As stated above, this model assumes sufficient equity to satisfy the unpaid obligation.
Since this model no longer works in many cases, the only options are processes used to collect unsecured debt and legislative action. The lowest cost unsecured creditor collection process for CIDs is Small Claims Court and the appropriate legislative action is for California to adopt the “Priority Lien” plan in effect in at least twenty-two other states. Neither of these options represents a perfect solution to the problem, but clearly they have become significant tools to improve CIDs’ ability to collect unpaid assessments.

Small Claims Court:
As part of the recent revision of the non-judicial foreclosure process (Civil Code §1367.4) the California legislature strengthened CIDs’ ability to utilize the small claims court process (Code of Civil Procedure §116.540 (i) & (j)). Significant boundaries and issues with this process are:

Since an CID is not a “natural person” (CCP §116.221) its small claims limit is $5,000 and less than $2,500 per case if more than two cases per year are required (CCP §116.231); Uneven decisions by small claims court “judges” (CCP 116.725 provides for a motion to correct a clerical error or erroneous legal basis error). The time and costs associated with the process; Even if you get the judgment, the collection process can be arduous; and You must be able to find and serve the debtor.

This last requirement could prove the most daunting. Most HOAs do not have the information about the debtor that they need to serve the debtor and to collect on judgments. Before granting credit most lenders gather significant information regarding the debtor. In this case a CID becomes an unsecured creditor the moment the owner is delinquent on their assessments. The typical information gathered is:

Social Security Number; Driver’s License Number; Bank account information (may be found in EFT authorizations and check based payments); Professional licenses (MD, Real Estate, CPA, Attorney, Insurance, etc.) Employer contact information; Next of kin contact information; and Credit reports

Up to now the CIDs have generally not collected such information and the legal ability and process to do so must be fully vetted by our legal brethren. Several critical questions that they need to answer are:

Can CIDs use their “reasonable rules and regulations” power to acquire such information and, if so, what do those rules and regulations look like? Can CIDs like cooperatives veto a buyer due to bad credit? Can CIDs require “security deposits” by owners to minimize their credit risk and if so how much is reasonable? What are the risks to CIDs that gather and maintain owners’ sensitive credit information?

Without these tools the CID’s ability to pursue the unsecured creditor is severely compromised. Moreover, if CIDs are to use this venue to collect delinquent assessments, they must have industrial strength accounting systems and providers. While the law (cited above) allows small claims court representative to be “…an agent, a management company representative, or bookkeeper…” (Lawyers are not allowed to represent clients in small claims court), such representative may not be “…employed solely to represent the party in small claims court.”

The Priority Lien:
The Uniform Common Interest Ownership Act (1994) (UCIOA) §3-116 allows an HOA to collect up to six months of unpaid assessments from foreclosing lenders. Currently, at least twenty-two other states have adopted this element of the UCIOA. Up to now it has not been adopted in California. Space does not allow a fuller discussion of this option. However, it has been a useful tool in these other states and it is clearly time for the industry trade associations and legislative advocates to pursue this option.

Conclusion:
Small Claims Court, a Priority Lien law, and Lawsuits are powerful tools that must be deployed in the CID assessment collection process. In addition Bad Debt Collectors can be used for foreclosed upon properties. Industry trade associations and related professionals must develop small claims court templates; pursue the priority lien option with the legislature; and move quickly and promptly on unpaid assessments.

Mr. Haney’s accounting firm, Haney Accountants, Inc., has delivered an outsourced accounting service to Common Interest Developments (CIDs) for over thirty years. His service includes billing and collecting the assessments from start to finish. His career includes four years as a senior vice president and CFO of a national bank. His comments here are intended to increase the reader’s awareness of this issue and to suggest strategies for consideration. They are not intended as legal advice. An appropriate response to this situation requires collaborative efforts by industry trade associations, their professional advisors, and the California legislature. He can be contacted at or toll free 888.786.6000 x325

© Donald W. Haney, 2011