How Can a Community Association DBS Transfer Risk?
All Rights Reserved © Joel W. Meskin 2019
This article is in regard to developer/builder/sponsor (DBS) controlled boards and the importance of coverage for the Wrongful acts of these DBS appointed board members while they’re on the board in their capacity of board members. It is also imperative at such time when volunteer homeowner members take over control of the association that they determine the best strategy to protect both the appointed board members and the homeowner board members at the time of transition of control. The builder’s board members are excluded from the association’s D&O policies in terms of their roles or authorities as DBS. They are, however, covered in terms of their actions and authorities, activities in regard to association board membership (and acting within their fiduciary duty to the association). However, not all policies cover DBS members in the same way as past homeowner board members once they are no longer on the board.
The nature and extent of insurance coverage for DBS board members on a community association director and officer liability insurance policy (D&O) must be understood before a DBS risk strategy can be developed.
No community association D&O policy provides coverage for the DBS in his or her capacity as a DBS. All DBS activities, including construction defect claims are expressly excluded in the normal course. When coverage is provided, it is solely provided to the DBS representative serving on the community association board. These DBS board members have the same duties and obligations as those required of unit owner volunteer directors and officers.
A frequent misconception that must be clarified is that there is never coverage for the DBS entity. Rather, the only coverage is for the DBS representatives appointed to the board.
The DBS are the individuals or entities that initially form and establish virtually all associations and are, in the normal course, the original “declarant.”
When the DBS declarant forms the community association, they are normally the 100% owner and control the formed community association. This ownership can take many different forms. The DBS may operate the project and not establish the association until the DBS is finished or a certain portion of the development is completed. Some states require that the actual community association be organized at the inception of the project and may have rules regarding transition, which may also be included in the governing documents.
At some point, the DBS prepares the governing documents, including the Articles of Incorporation (in the normal course), Declaration of Covenants, Conditions and Restrictions (CC&R”), Bylaws, and any association rules within the board’s authority.
Once the association is formed, the DBS, in the normal course of business, “appoints” the initial board member(s) who are DBS representative board members. The DBS may also, in some instances depending on the size of the DBS, be the initial board him or herself. The DBS representative board members, as well as the community association entity are the Insureds under the policy on day one. Without the “legal entity” being formed, a D&O policy cannot be written, at least in a typical not-for-profit D&O program. Without an association being an organized legal entity, it has no legal standing to defend itself. No carrier wants to defend a defenseless entity.
At specific benchmarks set forth in the governing documents, or pursuant to state statute, DBS representative board members exit the board and unit owners join the board. At some point defined in the governing documents, the association transitions to full unit owner control.
CAVEAT: when a DBS and or a DBS representative is on the board and controls the board he or she has a primary fiduciary duty to the association and owes the association a Duty of Loyalty and a Duty of Good Faith.
CAUTION: be sure that the DBS representative board members are covered when they exit the board to the same extent and degree as any other “former” board members. In some policies they are, but in some not. In other policies they may be covered for a specific period of time. And some policies provide “no” coverage for DBS board members at all when they exit the board.
Typical DBS Exclusions
CAVEAT: The limitation of providing coverage for the DBS representative should be quite evident. First, the policies are extremely low premium policies — an average of $1,500 in most states. Second, no D&O policy wants to take on the responsibility of the DBS for construction defects, representations, warranties or allegations that the DBS failed to properly fund the association while in control.
Sample Exclusion No. 1:
“Brought against any Insured which directly or indirectly relates, in whole or in part, to such Insured’s capacity as: (a) a builder, declarant or sponsor of the Organization, or (b) an affiliate of a builder, declarant or sponsor of the Organization; Including but not limited to any Claim based upon, arising from, or in consequence of any actual or alleged conflict of interest, self-dealing, or disputes relating to the construction or development of the Organization, the implementation and/or collection of assessments, or the establishment and/or maintenance of reserve accounts.
Sample Exclusion No. 2:
“Made against any Insured which directly or indirectly relates, in whole or in part, to such Insured’s capacity as:
(a) a builder, declarant or sponsor of the planned community, or
(b) an affiliate of a builder, declarant or sponsor of the planned community;
including but not limited to any Claim based upon, arising from, or in consequence of any actual or alleged conflict of interest, self-dealing, or disputes relating to the construction or development of the planned community, the implementation and/or collection of assessments, or the establishment and/or maintenance of reserve accounts;
Builder or Developer Board Member means any natural person appointed or elected to serve on the board of directors of the Named Insured by the builder, sponsor, or declarant of the Named Insured, and who was both a director or officer of the Named Insured and a director, officer, employee or agent of such builder, sponsor, or declarant of the Named Insured.
DBS Strategies to Minimize or Transfer Risk
What a DBS must avoid are the potential conflicts of interest including any appearance of impropriety. Remember, people see and hear what they want to hear. Many DBS board members realize this and purchase a D&O policy when the DBS first establishes and controls the board. What we recommend to a DBS as a risk management tool is that as soon as a project for a common interest development is started, form the not-for-profit organization, purchase a D&O policy for the organization and appoint a board. (Some states require that the not-for-profit entity be established as the development begins.)
What we further recommend is that the DBS make sure that their representatives sitting on the board and controlling the board follow all the governing documents and statutory protocols. In addition, we recommend that all decisions that could be made by the board of directors in the normal course, be done in that forum. The purpose of this is to protect the board and prevent the subsequent unit owner controlled board from claiming a conflict of interest.
We also recommend that as soon as the first unit is sold that the unit owners be invited and welcome to attend all board meetings. In this regard, even while the DBS representatives control the board, transparency will obviate conspiracy theories and new unit owners will have an opportunity to hear issues discussed and participate. This is also valuable, because when the DBS begins the development, they have an idea of what the demographic will be purchasing in the association. However, it may turn out that a different demographic begins to purchase. The DBS may have anticipated an older demographic and planned walking trails and individual pools spread around the complex. However, it may be that young families with children begin to buy and the DBS decides that maybe tot lots and a large community type pool and other child-friendly amenities may be more appropriate. If they have unit owners sitting there, the chance that there will be a claim of bait and switch is less likely, because members were right in the thick of any such discussions, debates and considerations, even though they may not have been voting members.
Another recommendation we make is that the DBS commission a transition study prior to passing control to the unit owners. (Many DBS boards do this already and have realized the value.) This should be paid for by the DBS, but conducted by an independent party such as a reserve specialist and/or attorney whose sole client is the anticipated unit-owner controlled board. At this time, any issues that may arise from a construction defect standpoint, a reserve standpoint or a fee and assessment standpoint can be put on the table and negotiated or resolved. This will reduce potential issues down the road, or the ability of the association to file complaints, because the independent third party would be representing the association, not the DBS.
Which D&O Insurance Policy Should be Selected
When it comes to D&O insurance for a DBS controlled board or a DBS on the board, there are a few issues to be particularly cognizant of before selecting a policy.
What we recommend and encourage is that when the change in control takes place (from DBS control to unit-owner control), the existing policy goes into run-off mode and the new unit-owner controlled board purchase a new policy. The key reason for this is that the DBS is able to better control the destiny of coverage for its DBS representatives on the board. For example, the DBS wants to be able to have a policy where the DBS board member(s) is (are) provided coverage when they exit the board. Otherwise, who would ever volunteer to take that position? Other policies may not provide coverage at all, or may not cover the DBS representative(s) once they leave the board. In addition, the DBS controlled board policy limits are not shared with the new unit owner controlled board. Finally, the DBS must understand the available extended reporting provisions and cost for the policy, and how and when it is available. Beware of a trap for the unwary.
- 1. The DBS must remember that not every D&O policy is the same and many are very different.
- 2. Remember, if the DBS representative board member (“DRBM”) is not covered by D&O, he or she is covered out of the DBS’s Pocket. (Check the labor code)
- 3. Many DBSs or their DRBMs think: Let’s get the cheapest policy, because we will only be on the board for a limited period of time. If we spend less, we will be made king or queen in the eyes of the buyer/unit owners and our employer.
- 4. The DRBM is only covered for what the association is covered for. If you get the best policy, you get the best coverage. If you buy a bare bones policy, you get bare bones coverage. Insurers rarely give anything for free.
- 5. Whether you are the DRBM or a Unit owner controlled board member, you have a duty of care or a fiduciary obligation to the association’s interest above that of your own personal interest, or the interest of the DBS (big assumption by most unit owners is that the DRBM is proceeding for the interest of the DBS and not the association. Perception is reality for unit owners, so the DBRM must be extra cautious.) Remember, perception is reality.
- 6. Find the Community Association Insurance Specialist who is experienced analyzing a DBS’s exposure vis a vis a common interest development and the corresponding insurance and risk management.
- 7. Do not let the agent give you their price until they tell you why the policy being presented is the best for the association. Once they tell the price, no one will truly listen to which is the best policy and coverage for the association.
- 8. The DBS should remember that these are claims made and reported policies, so they need to make sure that when they do not any longer control the board that the unit owner controlled board does not itself move to an inferior policy, or a policy that does not cover the DRBM. Again, if it is not covered under a policy it is covered by the DBS.
- 9. The DBS should make sure all normal D&O coverage issues are considered.
- 10. DBS beware! The DBS should make sure that when it purchases a D&O policy that is makes sure that once the DBS representative is no longer on the board, that the policy treats him or her as it would treat any other “former” board member. Most policies do not.
This topic is one that isn’t on the forefront of what is typically discussed by association boards, but with close to 350,000 associations in the United States, there is a great deal of success to draw from for the DBS and the Unit Owner controlled association.