Some say Accounting issues are always dull—this one sure isn’t!

The Announcement that the CA has received a $1.8 million reimbursement from the Developer for prior miscalculations of the Subsidy payment was welcome news. It is an interesting issue with many facets;

· Is not the Developer, like the Residents, bound by the covenants?

· Why was the repayment terms negotiated in secret without
resident awareness. What happened to the focus on Transparency?

· Were the interests of Residents best served by this arrangement?

· Why is an operational shortfall being used to restore the Reserve Fund
(a contractual responsibility of the developer)?

· What is the fiduciary duty of the Board of Directors?

· What are the ramifications of this experience?

For thoughts and more questions about when a gift is not a gift read on…….

Just what did happen to the Developer’s Subsidy payment?

The Announcement that the CA received a $1.8 million reimbursement from the Developer for prior miscalculations of the Subsidy payment owed was welcome news.

But as more details about the transaction are revealed, the more questions develop as to how did this “miscalculation” occur and what was the rationale for the deposition of the funds associated with the repayment to the CA.

There is an old saying in Texas: “don’t look a gift horse in the mouth”; [explanation for City folks and non-Texans—the horse may be very old and therefore have substantially less value than first glance.]

Such appears to be the case with the “Subsidy’ transaction, except the Developer’s payment should in no way be considered a gift. Developer payments each year should be in conformance with the CC&R’s, which after all, were written by the Developer. The Audited financial statements would suggest that the practice calculating the subsidy and making payment each year has not been followed. Residents must conform to the CC&R’s; there is even a formal committee—Covenants—that assures compliance. No less should be expected of the Developer.

The “misinterpretation” of the subsidy calculation was the second major accounting snafu that has come to light in the past few years. In 2002/03, Bill Liesey once before discovered an “error” in the accounting for the Reserve Fund[s]. Independently, a group of residents also noted a very large and unusual transfer [$539,000] from the Reserve Fund to the Operating Fund in the 2003 Audit. That prompted many questions about the precipitous decline in the Reserve Fund. Following a meeting with the Developer, a Town Hall meeting was held to discuss the issue and answer questions. A subsequent written agreement was finally inked with significantly improved financial benefits to the residents over what had been originally proposed. That process had some elements of openness and Transparency.

The process to correct the “Subsidy miscalculation” and to reallocate funds to various accounts, in contrast, took place “out of the Sunshine”, behind closed doors, and in secret; it was approved by a vote of 2 to 1 by the Finance Committee. Hardly, an overwhelming endorsement!
The “Agreement” was then approved by the Board by “unanimous consent”; whatever that is? So much for Transparency!

The basic question is: were the Resident’s interest well served by this process of deliberations and final agreement? Or….
Did the Developer sell the CA a very Old Horse?

Had there been a more open discussion of this issue; had normal meeting and comment rules been followed; had a Town Hall meeting been held like was conducted following the Reserve shortage, perhaps some of the following questions might have been asked; And perhaps answered.

Questions on Process

Were the meeting and actions consistent with the Finance Committees rules?
SCT FC Resident Comment Policy
Approved 8/22.05
“Before adopting a policy or procedure, the Committee shall give interested residents a reasonable opportunity to submit data, views, or arguments, orally or in writing.”

Why was “Action without a formal meeting” provision utilized for Board action ?
The initial discovery of the “misinterpretation” was in May and the Auditor submitted his report detailing the funding shortage on August 11, 2005. That would seem to allow for a more routine, deliberative process to take place.

Questions regarding specifics of the transaction

What was the basis for “misinterpretation”?
Whose responsibility is it to see that the Developer follows the rules?

Section 9.5 seems rather clear. During the class B control period, the Developer has two options:

“The Declarant may annually elect either to pay assessments on all of its unsold Lots or to pay the shortage [or operating deficit] for such fiscal year.”……
“If the Declarant elects to pay the shortage, such payment shall be
made within 30 days after receipt of the fiscal year’s audited and certified financial statements.”

The official Auditor report showed a difference in the amount of Developer’s past payments and the shortage in payments to be $2,194,947.

Why was that amount reduced to $1.8 million?


Reduction of $196,333 representing Charter Clubs; the accounting treatment may be technically correct. But, are Charter Club members aware that if the Club has net receipts (“profit”) at year-end, it will used to reduce the Developer subsidy to the CA?
This accounting treatment also raises issues about a new policy
of not funding Charter Club asset replacements from the Reserve Fund. The new policy reduces the Developer’s obligation by $700 per $1000 of the Fully Funded Balance for assets removed from the Reserve Fund.
Won’t Charter Clubs [e.g. woodshop and others] that are
increasing member dues to buy new equipment with club revenues
be reducing the subsidy owed by the Developer? A double hit?

Reduction of $173,352 for reserves provided by developer; The Auditor previously cited in the 2003 audit that the Board DID NOT fund Reserves in accordance with policy and the Reserve Study for the 2004 budget. Amount of shortage was $231,333. Did the Auditor review include an assessment of whether the Reserve Fund was funded in accordance with the Reserve Study recommendations?

The $1.8 million was then allocated among various Funds, including one newly created Fund; $809,262 to Operating Fund; $416,000 to the Reserve Fund and $600,000 to a new “Capital Fund”

Of the $1.8 million, only a little over $800k ended up in the Operating Fund.
Had the Subsidy calculation been done each year as apparently required, would not
all subsidy payments been credited to the Operating Fund?

The Developer agreed in writing in May 2005 to fully fund the Reserve Fund to 70% of Fully Funded Balance [FFB] when 95% of the 5000 homes were closed. Doesn’t the allocation of $416,000 to Reserves merely reduce the Developer funding obligation by a like amount?
Is this a proper use of Operating Funds?

A new account was created and funded in the amount of $600K. This sounds like a reasonable approach to have a Capital Account for new capital acquisitions. But, would the new fund merely replace funds for new amenities that the Developer would normally fund? Should any expenditure from this new fund be deferred until SCTX is completed?

Had a Governance process incorporating a minimal degree of Transparency been followed, perhaps these questions would have been answered before Board Action was taken on this matter. And, just possibly, different judgments could have been reached. This clearly demonstrates the need for full and complete Transparency in the CA’s Governance practices.
______________________________________________________

Covenants Compliance and Enforcement

Near the conclusion of the Board of Directors meeting of January 24th, there were some statements regarding the Developer’s obligations to follow CC&R’s and the role of Directors in enforcing Covenants.

A recent Community Associations Institute publication speaks rather directly to this issue. Below is a verbatim excerpt from Chapter two of that publication.

“Developer-Appointed Directors…. The potential for conflict becomes more pronounced for these directors who find themselves in a difficult situation. Their fiduciary duty requires utmost loyalty to the association,
while possibly owing allegiance to the developer.
There are numerous legitimate reasons for developer control of the association during the development period. This control allows for developmental flexibility and protects the developer’s interest in the project.
However, the primary obligation of association directors, including developer-appointed directors, is to make decisions in the best interests of the association.

For developer-appointed directors, this obligation may conflict with the developer's interests. Such directors may prepare the budget so that the assessments are unrealistically low to attract purchasers and to aid them in qualifying for mortgages. While this practice may facilitate sales for the developer, it may also ignore necessary operating expenses and sacrifice the quantity and quality of services provided by the association. If the directors fail to adequately fund operating or reserve accounts, they may be liable for having breached their fiduciary duty and may be personally liable to the association. In fact, courts have held that developer-appointed directors are subject to even closer scrutiny than owner-elected directors.

The developer-appointed director is also exposed to liability for failing to adequately enforce the association's covenants, including assessment collection and rules enforcement against the developer. The Florida Court of Appeals, in B & J Holding Corp. v.Weiss, 353 So. 2d 141 (Fla. Dist. Ct. App. 1978), established that developer-appointed directors who fail to collect assessments from the developer face significant liability for this breach of fiduciary duty, even when the assessments were to pay for litigation against the developer.
An important point to note is that a developer-appointed director, just like any other director, is exposed to personal financial liability for his or her conduct. The developer's corporate structure does not protect the developer from personal liability for actions as an association director. Furthermore, liability imposed for breach of the developer-appointed director's fiduciary duty may not be dischargeable in bankruptcy.

Developer-appointed directors must remain loyal to the association. The developer can minimize his or her risks by transferring control of the board to the owners, while reserving developmental rights.”

Reference:
Sellers, Tonia C. and Jay S. Lazega, “Conflicts of Interest: How Community Association Leaders Honor their Duties”, Community Association Press, chapter two – Board Conflicts, pp 7&8

What next????

Reserve Funding

The Finance Committee has been charged with making a recommendation to the Board: whether to have the Developer fund the Reserves at 70% of Fully Funded Balance [FFB] at the 95% of 5000 homes—probably in early 2007 OR delay Developer funding until 95% of 7500 homes—probably 2011.

Clearly, the intent of the Agreement to fund the Reserve Fund was for the Developer to deposit those funds in early 2007 following a determination of the precise amount based upon a new Reserve Study. All factors considered it would appear that it would be in the best interest of the Residents for the Developer to comply with the timing of payment (early 2007) specified in the Agreement. Policies are now in place that specifies the amount of Resident assessment that is allocated to the Reserve Fund[s]. The new Reserve Study will recommend annual amounts to be budgeted based upon the CA assets [Amenities] identified and the projected maintenance and replacement costs. Policies are now also in place to prevent spending of Reserve Fund monies on items not qualifying as “replacement or repair”. Finally, the CA could begin earning a return on the funds of a properly enhanced balance in the Reserve Fund. Bottom line—Developer should fund the Reserves sooner than later!

Governance

Many feel Governance could be improved by adopting a Transition trigger point at 75% of homes sold rather than the 95% which is now in the CC&R’s. This would change the threshold of homes sold from 7125 to 5625 which would give our governance structure more time to adjust from Developer to resident control. The 75% trigger is the law in California and we understand that it has been very well received by both the developers and residents. It makes for a very smooth transition.

Developer control would have passed to residents in 2007 had not the 2500 home expansion been announced. There is no good reason from a Resident perspective to delay that transition to resident control until 2011. The Developer does not want to pass control, perhaps because they believe residents may not control costs and thereby increase the developer's subsidy. As noted in the above article, the Developer could minimize interest conflict risks by transferring control of the Board to the owners, while reserving developmental rights.

Residents that want continued Developer control apparently feel that there is a need for a safety net as the residents are not capable of governing themselves. That assessment of SC residents seems to be a real damnation of resident's Governance capabilities. Base upon the record residents have made in addressing financial issues as well as the overall Community performance, we believe the Residents are quite capable of governing themselves. We call upon the Developer to add an additional Resident Board member as previously suggested and to begin a process to transition to Resident control of CA operations based upon the 75% of homes sold.

Newsletter Objective
Our goal is to foster transparent discussions and actions regarding the issues confronting our Community Association. We welcome an open dialogue regarding the actions proposed and why they are proposed. And, we would very much appreciate additional input from the many residents that have offered ideas, concepts and details about how to address issues confronting the Community Association. We welcome comment on the problems outlined as well as the solutions—both positive and negative [hopefully constructive].

Our Mission
Our mission is to make Sun City Texas a community with a solid financial base with an active adult environment. If you support our mission please forward this email to your neighbors and friends. If your neighbors or friends do not have access to the internet, make them a hard copy. Only with your support will we be successful with the proposed actions. If you wish to have your name added or deleted from the email data base, email jackstro@verizon.net

Future newsletters will focus on the financial aspects of Operations, Future Plans and how different approaches may be utilized to address poor financial results. For additional information and past [Archived] newsletters see:

http://scinform.blogspot.com/

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