What Happens When a Homeowners Association Goes Bankrupt?

Most people familiar with homeowners’ associations (HOAs) relate to monthly assessments and board hearings and the occasional small fine for leaving a garbage can on the street too long after trash pickup day. However, HOAs are organizations that run on money, just like any business or government agency. And, when the money is mismanaged, HOAs can also go bankrupt as well.

HOA bankruptcies can occur due to mismanagement, internal theft in the form of embezzlement or fraud, or economically hard times. Theft remains the rarer of the two possibilities with bad board management decisions being the usual culprit. During lean times, numerous foreclosures can also sap an HOA of critical revenue streams as the number of paying members decreases.

The common occurrence involves overspending beyond the assessment revenue stream the HOA normally brings in. HOAs are funded by monthly fees charged to every homeowner in the particular HOA district. Once the district is filled to capacity with homes, the revenue can only grow if the fees are raised. If, however, the HOA incurs larger expenses then the amount of money paid in, it begins to take on debt. At some point, the debt becomes more than the HOA can manage, just like a poorly disciplined credit card account, and the HOA then faces the possibility of going into default on its liabilities.

Frequently, according the American Homeowners Resource Center, the first signs of problems with an HOA occur when it decides to start withholding financial information from its members and/or having closed meetings to discuss financial matters. When the HOA can’t disclose what’s happening with its funds, members should be worried.

For HOAs, the preferred bankruptcy filing is Chapter 11. Unlike Chapter 7 under the U.S. Code, which involves liquidation of assets to pay off creditors, Chapter 11 instead allows a reorganization of financial management. This begins with a freezing of all liabilities. Then the HOA discloses all assets and income streams to the bankruptcy court. Under the process the daily management is still retained by the HOA, while big decisions need court approval. Once a repayment plan is developed and approved, the HOA manages under the eye of a court trustee until it can function again outside of bankruptcy.

HOAs function as a pseudo government agency over a neighborhood area. It is agreed to by the residents when they buy into the HOA jurisdiction. When the HOA goes bankrupt, the default management would then likely go to the local city or county. This is not a favorable idea from a local government perspective since it means taking on a problem. The court isn’t interested in being an auction house for a board that has very few physical assets either. As a result, reorganization tends to be favored by the bankruptcy court and local government since it makes the problem of the bankrupt HOA go away.

When the HOA enters bankruptcy officially the bankruptcy court takes over. A court trustee handles management aspects, reporting and decision making. The trustee officer can compel action and can order the seizure of assets to make sure the court’s direction is followed.

Realty Times points out that a well-managed HOA should never be allowed to get near the point it must consider bankruptcy as an option This includes performing HOA strategic planning, saving an HOA nest egg, borrowing carefully, and communicating finances with members. If exercised properly, the HOA should normally be able to function within its revenue stream without over-commitment.

Alternatively, members can also separately lobby for municipal penalties or legislation that incurs criminal damages for intentional bad management of an HOA’s finances. Such codes can be put into place in the form of city ordinances or county regulations.