Nine Into Eleven: Accounting for Common Interest Communities in Bankruptcy

• Jurisdiction: United States,Federal
• Publication year: 2017
• Citation: Vol. 33 No. 2

Nine Into Eleven: Accounting for Common Interest Communities in Bankruptcy

C. Scott Pryor

NINE INTO ELEVEN: ACCOUNTING FOR COMMON INTEREST COMMUNITIES IN BANKRUPTCY

C. Scott Pryor^*

Abstract

Ever more Americans live in a common interest community such as a homeowners' association or condominium. Common interest communities restrict the uses owners may make of their property but provide benefits to the owners. The community association pays for these benefits by levying assessments on the owners' property. Common interest communities offer a wide variety of benefits that can be divided into two sorts: public and private. Local municipalities typically provide public benefits at taxpayer expense; private entities usually afford private benefits at the consumer's expense.

Like both public and private entities, common interest communities can experience the problem of financial distress. The ultimate solution to financial distress is relief under the Bankruptcy Code. Private entities are eligible for relief under chapter 11; public entities—municipalities—are eligible for relief under chapter 9. Chapter 9 affords municipalities significant protections compared to private entities under chapter 11 because of the irreducible political sovereignty of municipalities. Nonetheless, even though common interest communities also provide public goods, they are eligible for relief only under chapter 11 and thus lack the protections afforded by chapter 9.

Chapter 11 of the Code should be amended in two ways to afford common interest communities some of the benefits of chapter 9. Specifically: (1) the standard of the best interests of creditors in a proposed chapter 11 plan of reorganization should not be evaluated against a hypothetical chapter 7 liquidation; and (2) a common interest community should be able to cram down its plan without regard to retention by the community of its assets. Without these amendments, common interest communities in financial distress

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and their members will be less likely to reorganize, and the cost of providing public goods will revert to the local community and its taxpayers.

Introduction

Throughout the past century, the American civic landscape has been increasingly populated by a previously unknown form of property ownership: the common interest community ("CIC"). In a CIC, the sizes of individual lots may be smaller than those in developments that are not common interest communities, but the common areas are certainly greater in the CIC.¹ CICs take three forms: condominiums, homeowners' associations, and cooperatives.² Three features of CICs are most salient to those who live in them. The first feature is the vesting of title to common areas of a residential development in an association that property owners control.³ Title to the common areas is not given to the public but is instead vested in a non-profit corporation.⁴ This association, in turn, is controlled by the community's property owners, not by local municipal government.

The second notable feature is that the community's property owners are bound to the benefits and burdens of association ownership of common property by means of easements and covenants, generically known as equitable

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servitudes.⁵ The relationship between a property owner and the association is thus tied to the legal fact of ownership of property in the community, not contract among the members of the community.⁶ Finally, a CIC's property owners pay the association's costs of maintaining the common areas and services through the power of assessment, which is vested in the association, founded upon the servitudes, and buttressed by a lien and the power of foreclosure in the event of nonpayment.⁷

The origins of the contemporary panoply of CICs⁸ can be traced to Ebenezer Howard's early twentieth century book, Garden Cities of To-Morrow.⁹ Howard's utopian vision of municipal socialism found itself transformed in the American context into private ownership of one's residence with community ownership of "common areas."¹⁰ Each of the particular forms of CIC has its own unique historical and legal structure,¹¹ but important for this

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Article are the three common features described above plus a fourth, uncommon one: the possibility that the association will experience financial distress.¹²

The typical common law mechanism for creating a CIC is through equitable servitudes, popularly known as conditions, covenants, and restrictions ("CC&Rs"), which are imposed on the land from the community's inception.¹³ "Running with the land," CC&Rs bind current and future property owners regardless of any particularized assent.¹⁴ In addition, the association can, through its board, enact additional rules that are equally binding on its members.¹⁵ As a practical matter, the community association, not individual property owners, exercises the power to enforce the CC&Rs.¹⁶ CICs thus exercise powers analogous to local public governments. Indeed, the scope of

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the CC&Rs and subsequent rules the association makes can cover an extraordinary range of activities beyond the jurisdiction of municipalities¹⁷ and free of federal constitutional limits.¹⁸

Given their unique legal structure, CICs occupy a peculiar middle space between private entities and public ones.¹⁹ Their legal form is commonly a private non-profit corporation, but their purpose includes providing public as well as private goods.²⁰ Like their municipal analogues, CICs provide public goods, such as roads, streetlights, and security, as well as shared amenities like swimming pools, parks, and open areas.²¹ Like private organizations, CICs often provide private goods ranging from yard care to luxury clubhouses.²²

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Yet, like both public municipalities and private organizations, CICs can experience financial distress.²³ sometimes the distress follows a natural disaster if the community association was underinsured.²⁴ other times, a community finds itself with insufficient funds as expenses of care for common areas like roads, roofs, and swimming pools increase with age.²⁵ In addition, a national economic recession or deteriorating local economy, leading to a collapse of real estate values, can cause owners to fail to pay their assessments.²⁶

Private action usually provides the tools to resolve such distress. Sometimes state law can enhance private action. Yet in other situations, those tools will be inadequate. The power to compel payment of association debts under state law with tools like garnishment of association reserves does not take into account the effect on third parties—the owners of private property in the community. The association, and not the owners of property in the community, is the object of the collection action even though it is the owners who will ultimately pay. At this point, when private and state action end, bankruptcy law begins.

The recent history of chapter 9 municipal bankruptcies has largely come to an end. Names like Jefferson County,²⁷ San Bernardino,²⁸ Stockton,²⁹ and Detroit³⁰ once dominated accounts of the Great Recession. Each municipal bankruptcy was larger than the one before it, but now, thanks to low interest

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rates and a steadier American economy, municipal insolvency has disappeared from the twenty-four-hour news cycle.³¹

Yet the fundamental causes of municipal financial distress remain. Apart from local factors driving a municipality into chapter 9,³² two systemic factors are common to municipal bankruptcy: debt overhang³³ and declining revenues.³⁴ Debt overhang describes the situation in which a city finds it impossible to borrow because of the large amount of existing debt. A prospective lender is unwilling to advance new funds because its loan will simply pay down existing debt.³⁵ The obligations that give rise to municipal debt come from two sources. The first source comes from benefits—pension and health care principal among them—promised to retired employees.³⁶ The second source of debt overhang is simple over-borrowing.³⁷ Declining revenues, the second factor common to municipal bankruptcies, can be attributed to de-industrialization, deregulation, the continuing effects of suburban flight, and reduction in federal funding.³⁸ Less revenue, combined with ever-higher financial obligations, drove Stockton and Detroit into chapter 9.³⁹ While bankruptcy added nothing to either city's revenue, both reduced their debt overhang by reducing retiree benefits and shrinking their bond debt.

Beginning in the late 1990s, CICs started to suffer from the effects of financial distress. Unlike municipalities, however, the typical causes of

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financial problems for CICs do not include debt overhang. Rather, some CICs have experienced financial difficulties through the combination of reduced revenues and increased operating expenses.⁴⁰

For example, the useful life of many of the structures that make up a community—condominiums and townhomes—is around forty years.⁴¹ Without sufficient reserves,⁴² maintenance expenses of many CICs will begin to increase and assessments with them. Deteriorating community infrastructure and increasing assessments lead first to an exodus of owners and then to falling property values.⁴³ If left unchecked, a vicious cycle of worsening community services, increasing assessments, falling property values, and, ultimately, unpaid assessments can drive a community into insolvency.

Most of these communities struggle through their distress unilaterally through a combination of raising assessments and reducing services.⁴⁴ When such tools prove inadequate, a CIC's creditors can use state law tools such as garnishment of bank accounts to compel payment.⁴⁵ Garnishment of a community's reserve and operating accounts will ultimately reduce the value of private property in the community because maintenance will be deferred. Unlike municipalities, however, federal bankruptcy law does not provide an effective means by...