Navigating the relationship between an HOA and bankruptcy can be a complex matter affecting the Board of Directors and the homeowners of the community.
For communities already grappling with aging infrastructure, poor financial management, governance challenges, or insolvency, bankruptcy may be an option for the Association to consider. For residents, it can be a wake-up call to get involved in Association governance and ensure responsible financial management. For boards, it underscores the importance of proactive planning, transparency, and fiscal responsibility.
While it is relatively rare for an Association to declare bankruptcy, it raises important legal and practical questions for residents, creditors, and the association’s leadership.
This article explores the basic concepts of bankruptcy as applied to Associations. Including when it may be best to consider bankruptcy as an option, and how best to prepare for a bankruptcy filing.
What does Bankruptcy do, and what types of Bankruptcy are available to Associations?
The Automatic Stay
While Bankruptcy filing is most commonly associated with the idea of insolvency and large debt loads, the single most powerful protection of any bankruptcy filing is the immediate impact of the automatic stay.
The automatic stay goes into effect upon the case filing (under any chapter) and forces all creditors of the Association to cease collection activity, including:
- The continuation of or the filing of lawsuits
- Shutting off utilities
- Foreclosing on Association-owned property
- Collecting any debt owed prior to the bankruptcy filing
- Filing liens against the Association
- Any collection efforts
Chapter 7
As a corporate entity, Associations may file for bankruptcy under Chapter 7 or Chapter 11 of the Bankruptcy Code. While Chapter 7 is available to Associations, it is very rarely a viable option for an Association.
In Chapter 7, the Court appoints a Chapter 7 Trustee who sells off the Association’s assets. This may include common property, Association-owned real property, the right to collect assessments, claims against third parties, etc.
The Proceeds are then used to pay off creditors of the Association, then the case is closed. The Association or corporate entity does not receive a discharge of any unpaid debt after liquidation. Eventually dissolving and ceasing to exist.
For Associations (and most corporate entities or partnerships), filing for Chapter 7 is usually not beneficial. In limited situations, it would be wise to seek a second legal opinion if your Association were advised to file a Chapter 7 case.
Chapter 11
Chapter 11 is available for businesses looking to reorganize their debts and continue operations. In a Chapter 11 case, the Association becomes the “debtor in possession,” meaning it retains control of its operations while undergoing bankruptcy. The association must file detailed financial disclosures and propose a reorganization plan that outlines how it intends to repay its creditors over time. Debtors in possession enjoy a great deal of flexibility when proposing reorganization plans, which can allow Associations to offer realistic repayment solutions.
While the Association’s creditors will be given the opportunity to accept or reject the plan under Chapter 11 balloting procedures, there is generally very little participation from creditors. In most cases, the debtor in possession can successfully confirm a plan that proposes to pay a percentage of the debt owed to certain classes of creditors and obtain a discharge of any unpaid amounts.
In 2019, Congress enacted the Small Business Reorganization Act, which created Subchapter V catered to small businesses. It is particularly advantageous to HOA communities given the reduced cost, faster timeframe, and ability to confirm a plan without a consenting class of creditors.
Another advantage that Associations enjoy in Chapter 11 cases is that, unlike for-profit entities, as a tax-exempt entity under Internal Revenue Code 501(c)(4), Associations cannot be involuntarily converted to a Chapter 7 case if the Chapter 11 plan fails or the plan never becomes approved.
In other words, if the Chapter 11 case does not work, there is no threat of forced liquidation and dissolution. If the case fails, it is simply dismissed, and the Association would be in a similar situation as it was prior to filing.
Under what circumstances should my Association consider filing for Bankruptcy?
Threat of Immediate Creditor Action
As mentioned before, the automatic stay is a very powerful tool that takes effect immediately upon the filing of the bankruptcy petition.
While it’s best never to be in a position where (for example) the water authority is going to shut off all of the water to your entire condominium building in two days or a lienholder is foreclosing on community property or income-generating property tomorrow, these issues can and do arise. A Chapter 11 case, even if it’s filed just to stop the collection action as a strategy, will offer immediate relief.
The stay also goes into effect to stop lawsuits against the Association from moving forward.
If, for example, a third party, resident, or creditor has filed a lawsuit against the Association and the Association may have good reason to believe that a damaging judgment may be issued, a Chapter 11 case can stop the case in its tracks and force the litigant to seek relief in the Bankruptcy Court. In situations where there may have been poor financial management or even fraud, the Bankruptcy filing can stop lawsuits from proceeding before damaging testimony or evidence must be produced to an adversarial party.
Unexpected Major Repairs
It is not unusual for an Association to suffer from severe structural problems, mold infestations, damage due to flooding, failed retention ponds…the list goes on. If the Association lacks sufficient reserve funds or insurance coverage to handle these major repairs, it may face financial collapse. In these cases, bankruptcy might provide a way to restructure debts and finance the needed repairs.
Financial Hardship
Even the most prepared and well-planned Association cannot function properly without the participation and financial support of its residents. If debt issues arise from the non-payment of assessments or the inability of the board to pass necessary special assessments, the Association may be faced with Bankruptcy.
Bankruptcy can have a very powerful effect on residents and forces them to face the realities of the Association’s financial condition and take action. Having seen this effect first-hand, Bankruptcy filing can be a very powerful tool used to motivate residents when all prior attempts failed.
An HOA and Bankruptcy: How to Prepare for Bankruptcy Pre- and Post-Filing
Seek Counsel
If your association has reached a point where bankruptcy may be a consideration, make an appointment to speak with the Association’s counsel. They will be most equipped to pinpoint issues specifically related to your Association and should be able to refer you to an attorney who specializes in tax-exempt entity bankruptcy filings if necessary.
If the Association meets with Bankruptcy counsel, have the Association’s attorney in attendance at the meeting. Make sure that the board, the Association’s counsel, and all parties agree with the advice that the Bankruptcy counsel provides. If the Association files a Chapter 11, there will be a great deal of interaction between Bankruptcy counsel and the Association, so appoint a representative (or committee) that has access to the financials as a point of contact.
Have Cash on Hand
Depending on the size of the community, complexity of the case, and locality, the attorney fee retainer can range from $10,000.00 to more than $50,000.00.
On top of that, it is important to have cash on hand to cover the operating expenses of the Association during the first several months of the case because the months following the initial filing date will be the most heavily scrutinized to ensure that the Association can propose a feasible reorganization of its debt while maintaining current monthly expenses. The Association will want to show on paper that it can operate moving forward and will need to show that on paper.
Final Thoughts
Chapter 11 bankruptcy is an underutilized but powerful tool for Associations in financial distress. It offers a chance for restructuring and survival—but not without significant challenges. Whether you’re a board member, a concerned homeowner, or a vendor working with an Association, understanding the bankruptcy process can help you navigate uncertain times with greater confidence.
Understanding the relationship between an HOA and bankruptcy filings are essential to the longevity of your community association. At NowackHoward, we provide guidance and personalized solutions to support the financial health of the community. Contact us today and let our team support you every step of the way.
