Dipping Into Reserves

The Problem – The Unbudgeted Expense: Everything seems to be growing except the coffers: boards are faced with mounting operational expenses and increased delinquencies, without the same matched growth in revenue.  And, unfortunately, not all expenses are planned – emergencies will come up. For example, if there is a big snow storm and the association is over-budget on snow removal already, what is the solution?

The Proposed Solution to the Problem – Borrow from Peter to Pay Paul: Being faced with tough budget decisions, some boards are tempted to dip into the association’s reserves. A reserve fund is an account set aside by the association to pay for common area or other improvements that must be repaired/or replaced on a periodic basis. Often the association will contribute to the reserve account on an annual basis, through the budget process, so the required sum will be ready for use by the time the components needs repair or replacement.

For example, a condominium association will need to replace its roofs after a certain number of years. The board will determine the life span of the roof, how much it will cost to replace it, and contribute that amount to the reserve account over a number of years, so that the funds will be ready once the roof needs replacing. If an association has been regularly contributing to the reserve account, it may have a sizeable sum ready for use. Naturally, if an emergency comes up, it is tempting to turn to those funds as an easy source to address the emergency expense.

The Problem with the Proposed Solution – Who’s Going to Pay Peter?  Isn’t this a little like dipping into one’s 401k? Unfortunately, in today’s economic climate, many people are depleting or at least dipping into their retirement nest egg of tomorrow in order to address urgent economic problems of today. But we’re not playing with our own money here. Board members have a fiduciary duty to make prudent decisions, including decisions involving the financial health of the association. And, if you take money from an account today, that has been set aside to pay for tomorrow’s roof replacement, what happens if the roof suddenly needs replacing today?

In addition, does the association even have authority to borrow from the reserve funds? Colorado statute does not provide authority for temporary transfers from reserves to operating in order to meet emergency expenses or short term cash flow problems. And, many governing documents will require reserve funds to be used for specific purposes only.

If You’re Going to Do it, Do it Right: Even if your governing documents do not contain express authority to borrow from reserves, Colorado law affords boards broad discretion in making business decisions. If a decision is made in good faith, prudently, and in the best interest of the association, the board will not be held liable for the decision even if it later turns out to be a bad one. Therefore, if a board has researched the problem and potential solutions, weighed the benefits of borrowing from the reserves against the potential risks of having a diminished or depleted reserve, and arrived at the conclusion that borrowing form the reserves is the best solution, then follow these steps:

1. Document Authority to Use Reserve Fund: If the declaration provides authority to borrow from the reserve, then the board should document this authority in a resolution, or at the very least the minutes. If no express authority exists, the board should document the steps it has taken to make a good faith, informed, and prudent decision to borrow from the reserves.
2. Document Need to Use Reserve Fund:  The board should document its justification for borrowing from the reserve, such as:
   1. Urgency of the need for the loan
   2. Availability of funds in the reserve
   3. Use of funds will not result in any hardship or inability to meet projected expenses
3. Establish and Document a Clear Repayment Schedule:  Any transfers from the reserve account should be repaid within a specified time frame. The transfer should be clearly structured as a loan, with an obligation to repay. Again, the board can do this through a resolution, or at the very least note the transfer and repayment schedule in the minutes.
4. And, stick to the repayment schedule: If the repayment period is going to be fairly long, the association should consult its CPA regarding potential tax consequences related to interest on the money to be paid back to the reserve account.
5. Consider Amending Your Declaration and/or Adopting A Policy Allowing the Temporary Transfer of Reserves to the Operating Account: Most declarations do not have specific authority to borrow from reserves. Amending to include that authority will reduce liability exposure to claims for improper use of association funds.
6. Alternatively or in addition to amending the declaration: The board should consider adopting a policy that establishes when borrowing from reserves is appropriate, and when and how the loan will be repaid, mirroring the steps we have discussed above.
7. Consult your Attorney: Before borrowing from reserves, consult the association’s attorney to review the authority for the loan and options for moving forward.

For additional information on this topic, please contact one of our attorneys at 303.432.9999.