Condo foreclosures, delinquencies and the new 9 months rule (Illinois Senate Bill 2664, ISBA FORECLOSURE BILL)
If you are a member of a condo board then you will eventually be forced to deal with owners that are delinquent in their payment of their monthly assessments. Unfortunately, severe assessment delinquency is often coupled with an impending foreclosure. After all, if a unit owner is not making their monthly assessment payment to the association, it's a good bet that the owner is struggling to pay their mortgage. If a foreclosure occurs within your association you have a financial interest in handling the situation correctly.
Being completely unaware of a foreclosure, or taking no action while it is in process, will almost certainly lead to the association losing out on hundreds or thousands of dollars. Going too far with legal action, on the other hand, can end with the association owing thousands of dollars in legal fees that are unable to be recovered. The key is knowing what tools the board has available and using them properly. In short, correctly analyzing the specific foreclosure situation and using the legal options available to the board in order to recoup as much of any past due assessments as possible.
With the passing of Senate Bill 2664, the legal tools available to condo boards in Illinois with regards to foreclosures are likely about to change. In my opinion the changes are a positive move in the right direction, but certainly others will disagree. Regardless of your opinion on the merits of the bill, all board members should be well versed in these upcoming changes.
Handling delinquencies in an Illinois condo association
The legal methods available to a board to treat delinquencies within an association are straight forward. When a unit owner becomes significantly past due, and the board wishes to take action to force payment, the board must initiate the legal collections process. The timing of this step is up to the board's discretion unless there are rules in place within the association's governing documents that define a specific trigger point. Most boards use 45 to 90 days past due as the milestone for initiating the collections process.
The first step in the process is serving the delinquent owner with a 30-day demand letter. This document, which should be drafted by an attorney, notifies the owner that he or she has 30 days in order to pay the balance of their outstanding debt. Failure to do so provides the board with the legal right to proceed with the typical next step in the collections process; filing a possession suit. The price charged by an attorney to draft and serve a demand letter is normally $150 to $300. The law allows for this cost to be added to the delinquent owner's balance. As long as the owner pays the debt, the association will be reimbursed for this out-of-pocket cost.
If the owner pays the balance within the prescribed 30-day time period, the issue is resolved and life goes back to normal. If the owner has not cleared the debt, however, the board has the option to file a law suit in which the association will be seeking a money judgment and temporary possession (control) of the unit. The goal of gaining possession of the unit is normally to rent the property and pay off the owner's debt with the incoming rental income. The cost to the association for gaining possession of a unit, including court costs and legal fees, is normally $2,000 to $3,000.
The law allows for these legal fees and costs to be added to the delinquent owner's balance, just like the 30-day demand letter, but there is a catch. (A catch that most attorneys fail to mention) The judge ruling on the case has complete discretion over what portion of the legal fees can be charged to the delinquent owner. In my experience I have never witnessed a judge grant the association the full amount of the fees being charged by the attorney. A fair estimate in my experience is that only 50% of legal fees are ever approved by the judge. This leaves the association paying, on average, $1,000 to $1,500 in legal fees that cannot be recouped.
Outside of this expense, if there are no other factors in play, it will often make sense for the association to elect to proceed with the filing of the possession suit. The unit will eventually be rented, and the incoming rents will pay off the debt owed to the association. Unfortunately, the board's decision whether or not to proceed with the possession suit is not always so straight forward. The biggest "monkey wrench" that can complicate this decision, and the collections process overall, is a foreclosure. If a mortgage holder (bank) initiates a foreclosure, the collections process increases in complexity. In fact, it can become a bit of a nightmare.
Background on Condo Foreclosures in Illinois
If an owner fails to make successive mortgage payments, the bank will eventually file a foreclosure law suit in which they seek sole ownership of the property. When the foreclosure suit has concluded, the bank becomes the legal owner of the unit.
There are two primary reasons why a foreclosure causes such havoc on a board's collections efforts:
- A foreclosure limits the amount of time that an association has to recover a delinquent owner's debt. Once the foreclosure is complete, the association immediately loses all possession rights that they may have been granted through a possession case. The goal in pursuing a possession case is to rent the unit and receive rental income sufficient to pay off the delinquent owner's debt. Once the bank becomes the owner, however, the association loses all control over the unit, the tenants and the rental income.
- The bank is not responsible for any of the previous owner's debt! The bank starts with a clean slate and does not "take on" the debt from the previous owner. If a foreclosure is happening, the association has a limited amount of time to recoup past due assessments from the unit owner.
It should be noted that even after a foreclosure completes, the association does have the ability to use other legal means to force repayment. For reasons that are outside of the scope of this article, these strategies, such as wage garnishments, rarely make financial sense. Generally speaking, once a foreclosure has completed the association is "stuck" with the remaining debt.
Due to the risk of inheriting an owner's unpaid debt, the board needs to be careful when deciding whether or not to use expensive legal resources. Every penny spent by the association going after a delinquent owner is a calculated risk. With a foreclosure in process, there is a good chance that money spent on legal fees and other possession-related costs will never be recovered.
Since the duration of a foreclosure, from start to finish, can vary wildly, it makes these decisions even more difficult. On one hand, foreclosures are taking an average of 20 months to complete in 2014. This would presumably provide a decent amount of time for the association to gain legal possession of a unit, and rent it for a handful of months, before possession is lost to the bank. On the other hand, the foreclosure may end in a settlement or be otherwise fast-tracked, leaving the board with a large legal bill and no results.
Significant delays in the possession case, unforeseen issues with the unit after gaining access and a host of other issues can eat up a considerable amount of precious time and money. Each of these potential snags increases the odds that the association will end up in a worse financial position than if they took no action against the delinquent owner. You have no confident way of knowing.
There is one last wrinkle related to condo foreclosures that complicate matters slightly, but also provides a bright side for the association; the 6-Month Rule.
The 6 Month Rule
The language in the Illinois Condominium Property Act, commonly referred to as the 6 Month Rule, states that the association is potentially able to recoup a portion of a delinquent owners' unpaid debt if a foreclosure occurs. This means I fibbed a little when I suggested that once the foreclosure completes, all unpaid assessments owed by the former owner are lost. As the name suggests, the rule allows the association to recoup up to 6 months of the former owner's unpaid assessments.
There are a few important points to the 6-Month rule that warrant clarification:
- The amount that can be recouped cannot exceed what was owed by the previous owner. For example, if the former owner was fully paid up on his or her assessments throughout the foreclosure process, the association is not eligible to recoup anything.
- In order to be eligible to recoup funds under this rule, the association must have initiated a collections action against the delinquent unit owner before the foreclosure process was completed. This is very important as we will discuss later.
- The maximum amount allowed to be recovered is calculated by adding up all assessment charges (including special assessments) for the 6 months immediately preceding the initiation of the collections action. For example, if the board initiated the collections action against the delinquent unit owner in December of 2014, the period to be analyzed would be the 6 months preceding December. (June-Nov) The sum of all normal monthly assessments, and any special assessments charged to the unit owner during the period, becomes the maximum amount that can be recouped.
- The law is vague on this point, but most attorneys suggest that the legal fees and costs associated with performing the "initiation of a collections action" can also be added to this maximum amount. I am unaware of any case where these legal fees have been successfully contested in court.
- This calculated amount under the 6-Month Rule is not paid by the bank. The amount must be paid by the party that purchases the foreclosed unit from the bank. This is important to understand since these funds will not be paid to the association until the bank successfully sells the foreclosed unit. This can take some time.
The most important aspect of the 6-Month Rule, as it relates to a board's collections effort, is that the association must initiate a collections action in order to secure the future funds. If the board fails to take action against the delinquent unit owner before the foreclosure process completes, the association will be left empty handed. This is one reason why it is critical for boards to remain vigilant in the monitoring of delinquencies and foreclosures within their association.
Ultimately the 6-Month Rule means that if the board initiates a collections action against the delinquent owner, before the foreclosure process has completed, the association will eventually get a good chunk of money from a future buyer. While this sum may not cover all of the past due assessments owed by the delinquent owner, it certainly is better than absorbing the full unpaid balance.
From a strategy perspective, often the best approach is to secure the "6 months" and take no further action. Think about it. If a foreclosure process is in full swing, it is difficult to determine how much time remains before the process completes and the bank takes ownership. Shelling out thousands of dollars to an attorney to seek possession of the delinquent owner's unit only makes financial sense if you are confident that, at a minimum, you will have time to recoup the legal fees by renting out the unit. Otherwise you are simply throwing money away. You won't hear any complaints from the attorney, but this is where the board must think for themselves using the best information available at the time. More often than not, if a foreclosure is in process, the smart decision is to only take the action required to meet the criteria of the 6-Month Rule and do nothing further.
Meeting the criteria of the 6 Month Rule
An expected question at this point would be "what constitutes the initiation of a collections action"? Interestingly enough, this is an issue that is still being debated by attorneys and industry members today. Up until recently, the consensus was that the "action" required in order to meet the criteria for the 6-Month Rule was serving a 30-Day Demand Letter. This is the first step in the legal collections process so it is logical that this would be equivalent to initiating a collections action.
A new twist has come in the form of recent court rulings in which the buyers of foreclosed units have argued the merits of the 30-Day Demand Letter. These buyers have argued that they are not liable for the calculated 6-Month Rule since a demand letter does not constitute the initiation of a legal action. To the surprise of many, the courts have ruled in favor of these buyers. The court concluded that the board must go further, and actually file a possession suit against the delinquent owner, in order to meet the criteria and secure the funds associated with the 6-Month Rule. Due to these cases we have been forced to modify our recommendations to board members slightly.
I should note that even as I write this article most of my colleagues, including attorneys, maintain that a demand letter is sufficient to meet the requirements of the 6-Month Rule. As a management company we continue to have associations recoup the full amount allowed by the 6-Month Rule, based solely upon their issuance of a 30-Day Demand Letter to the unit's previous owner. I have not yet personally witnessed an association affected by these rulings, and I see no rapid change in the behavior of the industry. That stated, there is a risk that should a board issue a 30-Day Demand letter, and take no further action against a delinquent owner, the party that purchases the unit from the bank may force the issue in court. If this were to occur the buyer would likely be cleared of being required to pay these charges. This is yet another risk that must be weighed by the board when dealing with collections issues when a foreclosure is involved.
Moving forward in 2014 and beyond
Considering the current complexity of the collections process when a foreclosure is involved, it is welcome news that things may soon get a bit easier to navigate. Senate Bill 2664, the ISBA Foreclosure Bill, will do away with the complex 6-Month Rule and replace it with a more user friendly version that I am terming the 9-Month Rule. This bill re-writes the former "6-Month Rule" section of the Illinois Condominium Property Act and puts into place the following: (My recap, not the language in the bill)
- In the case of a foreclosure the association now has the right to recoup unpaid regular assessments on behalf of the former delinquent owner for a calculated period of up to 9 months. (Increased from 6 months to 9 months)
- The calculation of the maximum amount is based upon 9 months of regular monthly assessments. No longer can special assessments be included in the calculation. In short, multiply the former owner's normal monthly assessment amount by 9, and this is the maximum amount that can be recovered.
- The only charges or fees that can be included in the recovered amount are unpaid regular monthly assessments, attorney fees and costs of collection. The total amount can never exceed the 9-month maximum.
- There is no longer a requirement for an "initiation of an action". No action is required by the association to be eligible to receive these funds.
One of the big changes here is the maximum amount that can be charged to the party that buys the foreclosed unit. The association can no longer include special assessments and the total is no longer uncapped, but the new maximum is based upon 9 months of monthly assessments versus 6 months. Far more important as it relates to a board and their collections strategy is the removal of any sort of required action in order to secure the rights to these funds. This is huge. The board will now have the choice to take no action and they will still be eligible for the 9-month lump sum.
What we are going to see is that today's strategy of Send a 30-day Demand Letter and take no further action will soon be replaced with Take no action at all. And this is a good thing in my opinion. This is $150 to $300 less that an association must pay out-of-pocket to secure their rights to these future funds. Just like today there are many cases, I'd argue more often than not, when the best move is for the board to secure their rights to the recovery funds and take no further action. With these new changes it will now makes sense in most cases to simply do nothing, spend no valuable resources on legal fees, and wait for your 9-Month reimbursement.
With the recent court challenges that we reviewed earlier, suggesting that boards now must file a full possession suit in order to meet the criteria for the 6-Month Rule, this change could not come at a better time. If this bill is veto'd by the Governor, boards would be required to pay for a costly possession suit in order to secure the funds associated with the 6-Month Rule. In many cases the math would dictate that the 6-Month Rule isn't worth invoking. It would cost the association the same, or even more, in legal fees to meet the criteria for the 6-Month Rule than the funds that they will eventually recover. The benefit of the rule to an association would be lost.
As time lines related to foreclosures change in the future I may alter my approach, but if this new law comes into effect my advice to a board that has a foreclosure in process will be simple:
- Take no legal action against the delinquent unit owner. The risk is too high that the foreclosure will conclude before you can recoup your money via renting the unit.
- Wait for the 9-Month Rule payout that you will receive when the bank sells the unit.
This approach will save the association money and reduce the time and stress involved with dealing with delinquencies. All-in-all this will be a nice improvement over the current complexity boards are currently forced to deal with.
The reaction from the condo industry
Many industry forces that claim to represent the best interests of condo boards are against this bill and are arguing that it will hurt associations. The primary argument against the bill is related to a cap being placed on the amount that can be recovered from the eventual buyer. I agree that limiting the maximum amount that can be recouped is less preferential to an uncapped maximum like we have today. Of course the only situations in which this actually makes any difference is when there happens to be a special assessment that was charged to the delinquent owner during the 6 or 9 month window used to calculate the maximum. This issue will affect such a small percentage of the actual cases that this argument against the bill is pretty weak. The other main argument being used is related to shortening the time-frame that the board has to respond to a request from a purchaser for information. If a management company is in place the time frame has been reduced from 30 days to 14 days. Self-managed associations will have 21 days to respond. A bit of a pain, certainly, but not much to get riled up about.
In practice I believe the vast majority of condo associations will end up benefiting from the changes in this bill. Most associations will ultimately "net" a larger amount of recouped funds with the new 9-month approach. Moreover, for all of the reasons reviewed earlier, this bill will certainly make things much clearer for the board. Considering the lack any legitimate concerns over this bill, it makes me wonder why industry folks would be against it.
A more realistic reason driving the industry's fight against this bill may have nothing to do with the best interest of condo associations. The real impact of this bill is that associations' need for legal resources will decrease dramatically. If the association no longer has to take legal action in order to secure the reimbursement funds, the attorney is no longer in the picture. With collections representing a healthy percentage of condo-related legal work, this bill is not great news for law offices in Illinois.
One could reasonably question the motives behind the recent court rulings related to the legal measures that an association must take to meet the standard for "initiating a legal action". Forcing the board to file a suit in order to meet this criteria means even more reliance on attorneys and ever-increasing legal fees. Not a bad turn of events if you are an attorney.
Despite the pressure against this bill it has successfully passed the Senate and now only needs to be signed by the Governor to become law. Hopefully this happens since for most associations this bill should end up be a blessing.