FHA, Lenders and Litigation: A Volatile Mix

Published on: October 24, 2011

There’s actually some good news to report on the Federal Housing Administration (FHA) condominium certification front, along with some news that isn’t good at all.

The good news first – because there’s not much of it: Responding to pressure from the Community Associations Institute (CAI), FHA officials decided to back off of one provision in the new certification guidelines that would have required condominium managers or management companies to obtain fidelity bond coverage in addition to the fidelity insurance most condominium associations already carry. As initially drafted, this provision required associations to compel their management companies to carry fidelity coverage equal to the community’s operating budget and reserves.

But CAI pointed out that:

  • The coverage the agency was requiring is not generally available, if it is available at all; and
  • Most condominium associations have fidelity policies that cover their managers and management companies – coverage that the laws in some states, including Massachusetts, require. The FHA requirement, CAI argued, would be both expensive and redundant, increasing the insurance cost a lot but not enhancing the coverage at all.

Persuaded by that logic, the FHA withdrew the insurance requirement, substituting language specifying that association insurance policies must name the manager and/or management companies covered and list them individually as additional insureds – a requirement that associations should be able easily to meet. CAI continues to object to naming the specific management company, which the association thinks is unnecessary and ill-advised.

A Logical Argument

Unfortunately, equally logical arguments have not persuaded the FHA to rethink several other problematic certification requirements CAI has been urging the agency to change. We discussed many of these issues in a previous alert. One issue that has not gotten much attention yet, but should, involves the FHA’s rigid and largely unfathomable position on litigation generally and construction defect litigation in particular.
FHA officials have made it clear, through both public statements and recent decisions, that they will not approve the certification of any condominium association in which a construction defect claim is pending. Associations seeking certification or recertification must demonstrate that any construction defect claims have been resolved, either by negotiation or a court decision, and that all defects alleged in the dispute have been “addressed.”

A judgment in the association’s favor isn’t sufficient, nor is it enough to demonstrate that the required repair work is under way; the repairs must be complete. This policy creates a tangle of potential problems for communities pursuing construction defect claims or contemplating doing so, primary among them:

  • Litigating construction defect claims or settling them can take months if not years – on top of the time required to repair the flaws. During this period, however long, unit owners will not be able to refinance their units with FHA loans or sell to buyers who need FHA financing – no small concern, given that the FHA insured 46 percent of all residential mortgages originated in 2010. That figure may have been higher this year; it is unlikely to have been much lower.
  • It’s not at all clear what the FHA means by the requirement that alleged defects must have been “addressed.” For litigation purposes, associations will typically include every identifiable defect, however minor, on the list of flaws for which the contractor is responsible. Some of those defects might have to be repaired immediately; other repairs may be delayed and some may not be essential at all. But the FHA’s position appears to be, if a defect is noted, it must be corrected before the condominium can be certified.

No Wiggle Room

And there doesn’t seem to be much wiggle room in that stance. If construction defect litigation is pending or under way, a lender might accept a hard dollar estimate of the litigation costs, but there is no way to know what those costs will be until the litigation is complete. It is also impossible to estimate how much of the repair costs the association will have to absorb (another figure lenders want) until the parties reach a settlement or a court awards a judgment.

The FHA’s concern about construction defect litigation is understandable, because in theory, at least, it speaks to the condition of condominium buildings and the financial ability to repair them. However, the FHA and lenders generally are overly sensitive to any litigation.

A recent experience in a community association we represent illustrates the problem. Three owners were trying to refinance with the same lender. It wasn’t an FHA lender, but the mindset is very similar to what we’re encountering on the FHA front. The lender reviewing the loan applications asked the association if there was litigation pending, which, in fact, there was. . In this case, the association, pursuant to a court judgment, had foreclosed on an owner who had failed to pay her share of a special assessment levied for a bank loan the board had obtained to finance essential repairs.

The owner then filed a federal suit alleging truth-in-lending violations, which apply to financial institutions but had no legal application or relevance to a condominium association at all. It took the Court nine months to dismiss the case. In the meantime, the lender demanded to know: The likely outcome of the litigation, the legal budget to handle the case, and most important, the amount at stake in the litigation. It was impossible to answer the last question because the former unit owner had not detailed how much she wanted. Although the case clearly did not pose a major financial risk to the condominium, this lender claimed that without knowing how much was being sought in the suit the lender could not assess the risk and therefore could not approve the loan.

Following the dismissal of the suit, the unit owners who were seeking to refinance tried again, but the foreclosed unit owner filed an appeal. The lender asked the same questions, we provided the same answers and the lender responded with the same intransigence: Because the risk couldn’t be quantified, the loan couldn’t be made.

Again, this wasn’t an FHA certification issue, but it reflects the same risk-avoidance mindset evident in the certification requirements. Because lenders exercised poor judgment in the past (responsible for the housing bust), they’re being told not to exercise any judgment at all. Lenders and their regulators apparently have decided that the way to eliminate indiscretion in the future is to eliminate all discretion today. If lenders can’t precisely quantify a risk, they run away from it. So a ridiculously frivolous lawsuit, lacking a specific dollar demand and brought by a single pro se plaintiff can limit refinance and resale options for an entire condominium.

There is no way to precisely quantify the risk of litigation in a condominium community, (although you can predict with certainty that there will be some). The FHA’s concern about the financial stability of condominium communities is understandable and justified. But it’s the failure to repair serious defects, not the prospect of a suit against the developer or contractor responsible for them that would most threaten a community’s stability and marketability. Still, the FHA certification standards are clear – a community with an unresolved construction litigation claim won’t pass muster.

Given that reality, some communities are wondering if they should forego construction defect litigation, even if they have a legitimate claim. The short answer is – no. There may be good reasons to reject the litigation option, but securing FHA certification, important thought that is, isn’t one of them.

To Sue or Not

The board has an obligation to preserve the value of the community and protect the interests of owners. Given the choice, most owners would almost certainly prefer to recover the cost, or at least some of the costs, of repairing serious defects, even if the inability to obtain FHA certification will be problematic for some individual owners.

Foregoing litigation wouldn’t solve the certification problem anyway. The board would still have to disclose the construction defects, and the FHA won’t approve certification until the problems are resolved. A community might win certification more quickly by foregoing litigation, but it would preclude the possibility of being compensated for the repair costs- probably not a great trade-off in most cases.

Some boards are hesitating to pursue construction defect claims for reasons unrelated to FHA certification – because they fear the developer responsible will walk away from the project, allowing the bank to take it over. This would not necessarily be a bad outcome for the community, however. Persuading a developer voluntarily to assume responsibility for repairing construction flaws outside of litigation, will be difficult even if the developer is solvent, and virtually impossible if he is not. Financial institutions will have greater capacity to finance the repairs and a strong incentive to do so, because they will want to facilitate the sale of units to protect their investment.

In deciding whether to pursue a construction defect claim, boards should undertake the same kind of risk analysis the FHA certification guidelines require of lenders, but with more common sense. The first essential step is to obtain an engineering study at the time of transition, to identify any defects and get a realistic estimate of the cost of repairing those problems. Boards should then weigh the projected cost of repairs against the cost of litigation (which includes time, energy and stress as well as legal fees) and the likelihood of collecting a judgment from the developer if a court awards one. Generally speaking, the more serious the flaws and the higher the projected repair costs, the stronger the argument in favor of pursuing the defect claim – and vice versa.

The important point for community associations is, don’t let the FHA certification tail wag the litigation dog. The decision to litigate or not should be based on what is in the community’s longer-term financial interests, not on how litigation might affect the short-term prospects for securing FHA certification.