The Successor Developer Conundrum in Distressed Condominium Projects
To be or not to be, that is the question.” This issue was raised by a famous playwright centuries ago, although it is doubtful he had distressed condominiums in mind. A foreclosing lender or bulk purchaser acquiring unsold units in an unsuccessful condominium project (the acquirer) often has to weigh the puzzling considerations involved in intentionally or unintentionally becoming a successor developer. The Florida Condominium Act defines a developer as one “who creates a condominium or offers condominium parcels [ i.e., units] for sale or lease in the ordinary course of business. . . . ” In essence, the statute creates two classes of developers: those who create the condominium by executing and recording the condominium documents and those who offer condominium units for sale or lease in the ordinary course of business. The focus of this article will be on one who sells or leases condominium units in the ordinary course of business, but did not create the condominium regime.
There are advantages that may accrue with the status as successor developer discussed in greater detail below. These advantages may include acquisition of certain developer-retained rights under the condominium documents and the ability to control the condominium association by electing or designating a majority of the directors of the condominium association board of directors. On the other hand, there may be certain disadvantages. These may include potential warranty liability or liability for financial mismanagement of the condominium association. Disadvantages may also include loss of the ability to control the condominium association.
The above advantages and disadvantages may seem contradictory with respect to the acquirer’s ability to control the board of directors of the condominium association. This is the area of most confusion regarding successor developer status, which will be explored in some detail in the subsequent discussion.
Advantages of Becoming a Successor Developer
As noted above, there are certain advantages of becoming a successor developer. Frequently, the declaration of condominium reserves for the benefit of the developer rights, which are extremely important to the operation of the project. These may include the right to perform alterations to units without the approval of the condominium association, the right to maintain model units, the right to maintain a sales office and a leasing office, exclusion from certain restrictions on leasing, and the right to be excused from the payment of assessments on owned units by merely paying any deficit in operating expenses after collection of assessments from the other owners, frequently referred to as guaranteeing the budget.
An acquirer’s ability to exercise these reserved rights may be dependent on the acquirer having obtained from the original developer an assignment of the original developer’s rights under condominium documents. Even a partial assignment may confer certain rights such as the ability to transfer units without affording the condominium association a right of first refusal. However, if the acquirer does not receive such an assignment, its ability to exercise such retained rights is more problematic. The analysis in the arbitration cases in this area has focused on whether the declaration of condominium specifically provides for such rights to be exercised by a “successor or assign.” In Palm Court Owners Ass’n v. Palm Bay Development Corp., Arb. Case No. 95-0131 (August 14, 1996.), the arbitrator determined that, without any assignment of the developer’s rights, the successor developer was unable to continue to use a unit as a model unit and as a sales office. Alternatively, it could be argued that the developer rights under the condominium documents are contractual in nature, and without an express assignment they do not pass to an acquirer. The law in this area, however, is not well developed, so that an acquirer failing to obtain an assignment of developer’s rights risks loss of such reserved rights after acquisition of the units.
Disadvantages of Becoming a Successor Developer
In addition to the disadvantages noted above, there may also be claims for prior mismanagement of the condominium association, such as failure to fund association deficits and reserves, failure to hold directors’ meetings, and failure to elect a unit owner representative to the board of directors. Claims may relate to failure to produce association records if the transfer has triggered a required turnover of control of the condominium association to the nondeveloper owners.
The law in this area is extremely limited. An oft-cited case is Chotka v. Fidelco Growth Investors, 383 So. 2d 1169 (Fla. 2d DCA 1980). In Chotka, the construction lender foreclosed, completed construction of some of the common elements, and instituted a sales program to dispose of the foreclosed units. Although the court held that the lender could be responsible for “express representations made to the buyer, for patent construction defects in the entire condominium project, and for breach of any applicable warranties due to defects in the portions of the project completed” by the lender, the court specifically noted that such liabilities in this case were asserted on a common law theory and not pursuant to the Florida Condominium Act.
The court, in Ocean Beach Resort, Inc. v. Rodack, 586 So. 2d 363 (Fla. 3d DCA 1991), specifically dealt with the application of the Condominium Act to a successor developer. Ocean Beach purchased 62 units of the 66 units in a converted motel condominium from the lender, which had acquired them through foreclosure. Subsequent to its purchase, Ocean Beach spent approximately $400,000 in repairs and renovations. It then sought to specially assess the owners for $204,580 of the repair costs plus a two months working capital contribution and a reserve contribution for future roof and plumbing repairs. When some of the owners refused to pay the assessment, their units were liened and Ocean Beach brought an action to foreclose the liens. The lower court dismissed the foreclosure action, finding that all of the costs sought to be recovered by Ocean Beach were its development costs, benefitting only its units. The appellate court reversed the lower court’s determination on the $204,580 for repairs, indicating that at least a portion of such repairs could be included in an assessment against the other owners if the repairs related to the common elements. The record did not disclose the source of the repairs and renovations. In a confusing discussion, the appellate court sustained the lower court’s determination on Ocean Beach’s inability to collect the roof and plumbing reserve and the two-month capital contribution. The court interpreted both the roof and plumbing reserve and capital contributions in the nature of reserves, for which the developer converting the project to condominium ownership bore sole responsibility under the conversion provisions of the Florida Condominium Act. Since Ocean Beach did not convert the property to condominium ownership, the court indicated that Ocean Beach did not inherit the original developer’s obligations for capital items under the conversion portion of the Florida Condominium Act. Nevertheless, the court refused to permit Ocean Beach to collect reserves from owners. It is far from clear why the unit owners could not be charged with reserve payments, since the original developer had lost the project through foreclosure and most likely lacked the resources and inclination to perform its obligations under the Condominium Act.
Typically, when a project progresses downhill, the original developer is not careful in distinguishing between its assets and those of the condominium association. It is common, in such projects, that board meetings have not been held, reserves not collected, and no unit owner representative elected to the board of directors. These inadequacies need to be addressed and raise an area of potential exposure for the acquirer. Most of these operational matters can be rectified without substantial expense by taking appropriate curative action in complying with the dictates of the Condominium Act once the acquirer obtains title to the unsold units.
It may be more difficult to escape liability for warranty claims, especially patent construction defects imposed by Chotka. A lender facing a defaulting borrower may be left with a Hobson’s choice. If, in acquiring the collateral for its loan, the lender inherits liability for the borrower’s defective workmanship, does it have to choose between relinquishing control of its collateral or assuming liability for existing defects? Such a result makes a foreclosing lender or bulk buyer, in essence, a guarantor of construction by others. Successor warranty liability also creates issues if several bulk sales are involved in a single project. Would all of the purchasers of bulk units assume warranty liability? How would such liability be allocated among the purchasers? It is noteworthy that the division’s concept of successor developer contained in F.A.C. §61B-15.007(1) does not impose warranty liability on a successor developer merely by meeting its definitional characteristics. The Florida Vacation Plan and Timeshare Act, F.S. §721.05(10)(e), specifically addresses potential successor developer liability and exempts a successor developer from liability for a predecessor developer’s actions unless the transfer by the predecessor developer is a fraudulent transfer or is a transfer to a related party.
Offering Units in the Ordinary Course of Business
Although an acquirer may attempt to avoid being characterized as a developer, it may be impossible to avoid such characterization. The test for determining whether one is a developer, as noted above, is whether the acquirer is offering units for sale or lease in the ordinary course of business. What constitutes an offering of units for sale? In a declaratory statement issued by the Division of Florida Land Sales, Condominiums and Mobile Homes, now known as the Division of Florida Condominiums, Timeshares and Mobile Homes, it was determined that offering units for sale at above market prices did not constitute an offering for sale within the context of the Condominium Act. In this regard, it should be noted that the developer in this case acquired units from a foreclosing lender and conceded that it may market them above their market value. This declaratory statement, however, is instructive, since the division lists three factors to consider in determining whether there is an offering for sale: 1) Is there a listing agreement in effect for the sale of the units; 2) is the pricing of units at or above market value; and 3) is there evidence of print advertisements for sale of units. Although not specifically mentioned, a related factor would be whether the developer maintains a sales office for the sale of units. The issue of what is market value may be somewhat problematic in the unsettled state of the market at this time, especially since lenders may be dumping units at fire sale prices to clean up their balance sheets. However, if the acquirer is employing a sales agent, maintaining a sales office, and is offering units in some form of generally recognized media advertisements at prices below the initial offering prices, it would be difficult for one to contend there is no offering for sale.
Why is offering units for sale significant? If the acquirer is not offering units for sale but merely operating a leasing program, i.e., offering units for lease, it will have unfavorable consequences on its ability to control the condominium association. The acquirer operating a leasing program, however, will not have to undertake a filing of offering materials with the division generally required of a developer offering condominium units for sale if it is merely leasing for periods of five years or less. In this respect, the definition of developer with respect to leasing for filing purposes, offering for lease for periods of more than five years, differs from the definition contained in F.S. §718.103(16), which has no minimum term requirement.
The concept of selling or leasing units in the “ordinary course of business” is another required attribute of a developer. In First Federal Savings and Loan Ass’n v. Department of Business and Professional Regulation, 472 So. 2d 494 (Fla. 5th DCA 1985), the court had to determine the status of a lender who had acquired 11 units by a deed in lieu of foreclosure. The lender sold one unit to one buyer and 10 units to another buyer. The division assessed a fine against the lender for failing to file offering materials with the division prior to its sale of the units. The court, in reversing the fine, held that the sales were not made by the lender in the ordinary course of business. In an ironic note which appears particularly relevant to the current financial crisis, the court stated: “Under the stipulated facts in the record, this was a failed loan and salvage operation. If this were ‘ordinary’ for a mortgagee, it would not long continue in the lending business.” Note, however, that other courts have not immunized a lender offering acquired units from developer liability.
The division has defined “ordinary course of business” in §61B-15.007(1) of the Code as selling or leasing more than seven units per year in a condominium containing at least 70 units and five units per year in a condominium containing less than 70 units. In other words, anyone selling or leasing more than seven units in a condominium containing 70 or more units is deemed a developer under the Code.
Although this test appears straightforward, its application to distressed condominiums is more problematic. A lender acquiring title to unsold units through foreclosure does not become a developer “for filing purposes” under §61B-15.007(3) of the Code if it transfers all of the foreclosed units it acquired to a bulk purchaser in a single sale. This may appear somewhat helpful but is not entirely consistent with the First Federal case. Furthermore, it only works in practice if the bulk sale occurs shortly after the foreclosure is completed. Unless the foreclosing lender is content to pay the carry costs on the foreclosed units and not attempt to sell or lease them, then any offering for sale or lease of individual units prior to a bulk transfer extracts the lender from the safe harbor of the regulation and confers upon the lender the status of developer.
Note the limitation of the safe harbor in the regulation relates only to filing purposes. This is not of major significance since it limits the foreclosing lender’s obligations only from filing an amendment to the condominium offering materials in connection with a proposed bulk sale. It does not purport to exempt such lender from potential exposure to construction and financial claims relating to the project and prior financial mismanagement of the condominium association. These potential sources of liability are not addressed in the Code and remain as a dark cloud and inhibiting factor over the bulk acquisition of condominium units.
Control of the Condominium Association
The most important aspect of acquiring title to a large block of unsold units is the ability of the acquirer to control the condominium association through control of its board of directors. The Florida Condominium Act and most condominium documents confer on the board of directors the sole authority for the operation of the condominium in almost all aspects. The board adopts the association budget, employs the management company, authorizes contracts, and determines the general operations of the condominium. If the acquirer acquires a substantial block of unsold units, it would want to protect its investment by determining the manner of operation of the condominium. Try to explain to someone acquiring 70 percent of the units in a condominium that it may not be able to control the level of maintenance and see the quizzical response. The ability to elect or designate individuals to the board of directors and thereby control the board of directors depends to a large extent on whether the acquirer of the unsold units is deemed to be a developer.
If the acquirer did not obtain what the division considers an assignment of developer rights, the transfer of all of the unsold units by foreclosure or a bulk purchase automatically triggers a turnover event. Upon a turnover event, a developer loses the right to elect a majority of the directors to the condominium association’s board of directors. In such cases, an acquirer may pay assessments but have no right to determine the level of assessments, or the items for which assessments are imposed. In addition, the owners may seek to hold the acquirer responsible for delivery of documents to the condominium association required after a turnover event has occurred.
A turnover event may be avoided under the Code if the lender or bulk purchaser has received an assignment of developer rights. The division defines an assignment of developer rights as a written instrument that includes an assumption of all liabilities under the declaration of condominium, the Condominium Act, and the rules. It specifically includes the assumption of warranty liability. Lenders to developers of condominium projects frequently take an assignment of developer’s rights under the condominium documents to allow them to enjoy the advantages of developer status. These documents, however, typically assign rights without the assumption of any liabilities. Whether rights without the concomitant liabilities can be assigned may be an open question but, under the Code, such assignment would not qualify as an assignment of developer rights. It is extremely unlikely that an acquirer would voluntarily agree to assume potential unlimited and undisclosed liabilities in order to qualify as an assignee of an assignment of developer rights within the meaning of the division’s rule. Any assignment of developer rights received by a lender or bulk purchaser without an assumption would, therefore, not qualify as such an assignment under the division’s rule. The division’s rule requiring an assumption appears unrealistic especially in a distressed condominium project forcing an acquirer to face potential unlimited liability. A more realistic and workable concept would not require an acquirer to assume liability to qualify as assignee of developer’s rights. Such a change in the Code would avoid the automatic triggering of a turnover event upon a foreclosure or bulk sale when the transfer has succeeded to the rights of the original developer.
The failure of an acquirer to become a successor developer under division’s rule may have certain advantages. Section 61B-23.003(f) of the Code indicates that if no assignment conforming to the rule is obtained by the acquirer, and if the acquirer becomes a successor developer by offering units for sale, then it may vote its units to elect a majority of the directors of the condominium association, assuming the acquirer holds more than 50 percent of the voting interests. This is true even though, upon an event triggering a turnover of control like a foreclosure or a bulk sale, the developer loses the right to elect a majority of the board of directors. It may be confusing that a developer loses the right to vote for a majority of the board after a turnover event, but a successor developer may enjoy such rights. Apparently, a successor developer does not stand in the original developer’s shoes in this regard at least as far as the division is concerned. Also note that when a developer loses the right to elect a majority of the board of directors by reason of a designated level of sales, it cannot regain such right by reacquiring units previously transferred. In other words, if by some chance the acquirer reconveyed its units to the original developer, the original developer could not regain control of the condominium association.
An acquirer who is merely leasing its units may be deemed a successor developer and under §718.301(1)(d) of the condominium law. Such activity would create a loss in the acquirer’s ability to elect a majority of the board of directors. But a recent change by the division to §61B-15.007 of the Code, however, appears to allow an acquirer who is merely leasing units for a term of five years or less to escape being characterized as a developer and thereby allowed to elect a majority of the board if it holds a majority of the voting interest in the condominium association. This rule appears somewhat at odds with the definition of developer under §718.103(16), but is a welcome attempt to ameliorate the unfavorable consequences of the loss of the ability to protect a substantial investment.
There are other related issues regarding assuming the status of a developer. In Bishop Associates Ltd. Partnership v. Belkin, 521 So. 2d 158 (Fla. 1st DCA 1988), the court held that the acquisition of over 60 percent of the units in a condominium by 10 separate limited partnerships, all under common control, did not insulate them, in the aggregate, from being considered a developer. Since all the limited partnerships were only leasing their units and not offering them for sale in the ordinary course, they could not vote for a majority of the board of directors. Interestingly, the original developer still retained some units that were being offered for sale, but this did not inhibit the court from concluding a turnover of control event had occurred.
Another issue faced in a bulk transfer relates to the typical requirement that a transfer of units by a developer to a purchaser normally triggers a requirement for the payment to the condominium association of a working capital contribution by the purchaser. In Horizons North Condominium No. 1 Ass’n v. Norbro 1, 551 So. 2d 526 (Fla. 3d DCA, 1989), the condominium association claimed that a bulk transfer by the original developer to Norbro of 60 units accounting for approximately two-thirds of the units in the condominium, triggered the payment by Norbro of a working capital contribution equal to two months worth of assessments on each of the units acquired. The court noted that Norbro had obtained an assignment of developer’s rights from the original developer, Lennar (most likely without any assumption), and held that Norbro was not to be considered a purchaser within the meaning of the condominium documents. It is not clear whether Norbro’s status would have changed had it not obtained an assignment of developer’s rights.
There is additionally the issue of the consequences of triggering a turnover of control of the condominium association by the transfer of the unsold units to the acquirer. As indicated above, if there is no assignment of developer rights as envisioned by the division’s rules, the transfer of the unsold units will trigger a turnover event, assuming at least 90 percent of the total units in the condominium are no longer held by the original developer. Following a turnover, the developer is required to deliver certain documents to the condominium association, including a certified audit of the association’s operations from the date of commencement of the condominium until the occurrence of the developer’s relinquishment of control of the association. Who is responsible for this audit, the single purpose entity that has either lost title to the units to the foreclosing lender or sold all of its remaining assets to the bulk purchaser? The division’s rules appear to insulate the acquirer from producing such an audit. Section 61B-23.003(7)(g) of the Code indicates that the acquirer is responsible for producing an audit only for the period the acquirer is able to control the condominium association by electing its designees to the board of directors by voting more than 50 percent of the voting interests. In order to produce an audit for any period of time, however, an accountant will need to have accurate information as to the financial status of the condominium association as of the start date for the beginning of the period. If this is not available, it may be impossible or extremely expensive to certify the audit for the interim period from the commencement of control by the successor developer to the relinquishment of such control. Even if the acquirer is willing to fund the cost of a complete audit from the commencement of the condominium, it may be impossible or prohibitively expensive to produce one because of either the unavailability of the books and records or the failure of the original developer to keep appropriate books and records. Similarly, certain other books and records required to be delivered to the condominium association following a turnover event may be unavailable or not maintained by the original developer.
As a side note, the acquirer may try to prevent a turnover or to save documentary stamps on a bulk transfer by acquiring the interests in the original developer entity rather than the units owned by such entity. While this appears unlikely in the light of assumption of all of the liabilities of a developer in a troubled project, an arbitration case of the division indicated that since the transfer of interests did not change the nature of the entity that was the original developer, no turnover of control was triggered by the transfer of the interests in the entity.
Finally, one needs to consider the income tax consequences of becoming a developer. Here the acquirer may be whipsawed between its desire to retain control of the condominium association and the unfavorable tax consequences involved in being deemed a dealer under the Internal Revenue Code. If the bulk purchaser merely holds units for rent, it may be able to claim capital gains tax treatment upon an eventual bulk sale of its units. In such case, however, it might have to cede control of the condominium association since a turnover event occurs when units are not being offered for sale and a leasing successor developer is prohibited from exercising its voting power to elect a majority of the board of directors of the condominium association. (The new division rule may alleviate this consequence but it may not be consistent with the Condominium Act.) If it attempts to retain control by offering units for sale, then it will be deemed a dealer under the Internal Revenue Code since it is, in essence, offering inventory for sale in the normal course of business. Such status will subject the purchaser to ordinary income tax treatment upon the eventual sale of the units.
As noted in the above discussion, the status of developer under the Florida Condominium Act brings with it substantial baggage. It is difficult to avoid becoming a developer under Florida law based on the expansive definition contained in the law. The consequences flowing from being deemed a developer are less clear. If the opportunity arises to acquire an assignment of developer’s rights, without any assumption, it would be helpful in assuring entitlement to reserved rights that may be available to the original developer under the condominium documents. The limited law available in this area, however, makes it difficult to assess the extent of potential liability that may accrue to the acquirer by reason of being deemed a developer. Additional legislation would be helpful to clarify the law in this area since the unsettled state of the law is inhibiting the ability to stabilize distressed projects throughout the state. Statutory modification of the definition of a developer similar to that contained currently in Ch. 721 would be extremely helpful by exculpating an acquirer from successor liability for prior actions, except in certain limited instances where the successor is not a good-faith purchaser. In addition, the legislature might consider establishing a fund to address future warranty claims in failed projects somewhat similar to the Florida Homeowners’ Construction Recovery Fund to protect unit owners in failed condominium projects. This fund could be funded by an increase in the registration cost of new condominium projects payable to the division. It should be noted that an attempt to modify the Condominium Act by creating a new Part VII to provide temporary relief for bulk acquisitions through July 2011 by insulating acquirers from developer liability passed the House as HB27 in the 2009 session, but its counterpart, SB880, was not enacted by the Senate. Perhaps the legislature will reconsider this proposal next year.
1 Fla. Stat. §718.103(6).
2 See Pencor Financial Corp. v. Majestic Tower I Condominium Ass’n, Arb. Case No. 95-02-02085 (January 24, 1996).
3 Compare Glen Cove Apartments Condominiums Master Ass’n, v. Welt, Arb. Case No. 93-0075 (May 30, 1995), with Vivienda at Bradenton II Condominium Assn v. Brittain, Arb. Case No. 95-004 (September 1, 1995).
4 Ocean Beach, 586 So. 2d 363 (Fla. 3d D.C.A. 1991).
5 Sawhney Holdings, Inc., DS 2002-02 (March 18, 2002).
7 First Federal Savings, 472 So. 2d 494 (Fla. 5th D.C.A. 1985).
8 See Chotka, 383 So. 2d 1169 (Fla. 2d D.C.A. 1980).
9 See Fla. Admin. Code §61B-23.003(7).
10 See Fla. Admin. Code §61B-23.007(c).
11 See Fla. Admin. Code §61B-23.003(f).
12 Story v.. David William Hotel Condominium, Arb. Case No. 95-0251 (December 28, 1995).
13 Fla. Stat. §489.140.
Martin A. Schwartz is a partner in the Real Estate Department of the Miami law firm of Bilzin Sumberg Baena Price & Axelrod, LLP, and is a member of its Distressed Property Group. He is also a member for The Florida Bar’s Condominium and Planned Unit Development Committee.
This column is submitted on behalf of the Real Property, Probate and Trust Law Section, John B. Neukamm, chair, and William P. Sklar and Richard R. Gans, editors.