A Case Study of Fraud Concerns at a Homeowners' Association THE CASE Inception The EagleBranch subdivision opened in the early 1980 s. Located in an upscale suburb of a major metropolitan area, the subdivision started with plans for 133 custom homes. The common properties of the subdivision included a park with a playground, a full-sized pool, a baby/wading pool, and a building that housed restrooms and showers. After approximately 50 homes were sold, the developer created a homeowners' association called EagleBranch Homeowners' Association. (The definition and operation of a homeowners' association are discussed in Appendix A.) Seven homeowners volunteered to serve-four as officers and members of the board, one as a member of the board, and two as the architectural control committee. The association needed a president, vice president, secretary, treasurer, and one additional board member to prevent any tie votes on decisions. Two of these volunteers were a married couple. These charter officers worked hand in hand with the developer to file an application and the association's articles of incorporation with the state. Being the first board members of a new homeowners' association required a great deal of time to create the bylaws and policies for the association and to locate and engage service providers to maintain the common properties. The board members were a congenial group and enjoyed working together. To some extent their meetings were like a productive social event. Some of the policies and procedures established by the board included the following: Treasurer: - A checking account would be opened in the name of EagleBranch Homeowners' Association. The treasurer would be on the signature card and be responsible for recordkeeping for the account. All receipts and disbursements of cash would be made by the treasurer from this account. The treasurer would provide a list of all cash receipts and disbursements and present it along with the monthly bank statement reconciliations to the board members at their quarterly meetings. - Annul dues owed by each bomeowner would be $450 a year. A notice would be mailed by the treasurer in January of each year stating the amount due and the due date. A stamped, retum envelope addressed to the treasurer would be included with the notice. Checks would be payable to the EagleBranch Homeowners' Association. The treasurer would purchase a stamp to use to endorse checks for deposit to the association's checking account. President: - The president would approve cash disbursements. The president would initial invoices as evidence of authorization and give them to the treasurer to pay. - The president would be responsible for making sure all maintenance work was completed on time and to specifications. - The president would be responsible for calling board/officer meetings as needed. These meetings were usually to discuss maintenance issues. Vice President: - The vice president would act in the place of the president in the event of the president's absence or inability to act and perform any other duties as requested by the boand members. Secretary: - The secretary would prepare mintes of the board meetings. This person would send the minutes to the members of the boand and provide copies to any association members who requested them. - The secretary would provide nuts and chips at the board meetings. The vice president would bring the beer. Baard Members: - The board members would determine any special assessments or changes in dues. - The board members would decide what maintenance work to do and what service provider to use. Subsequent Events By 2002, the five original volunteer board members were ready to pass on their responsibihities. Surprisingly, there had been no tumover in these positions in the approximately 20 years they had served. The group was dedicated to making their subdivision a pleasant place to live and enjoyed working together. Also, they were smart enough to realize the better their subdivision was maintained, the greater the chance their property values would remain stable or even increase. Gino, an affable resident of the neighbohood who owned a struggling pool business, stepped up to become the new president of the association. Most of the residents were happy and grateful that someone was willing to volunteer for this position. To streamline operations and save on the cost of maintaining a post office box for the HOA, Gino had all bank statements and bills sent to his home address. He was able to quickly hand-pick four volunteers to replace the others, i.e., three officer/board members and one board member. Gino felt it was important for the volunteer board members to feel comfortable serving on the board so he made sure that the insurance to limit the liability of the board members was kept up to date. Gino has remained president of the HOA to the present day. During the summer of 2013, it came to some of the residents' attention that not all was well with the HOA. Below is a recount of recent events. December 2012 Gino held a special meeting for all the homeowners to vote on a 10 percent increase in the annual dues, which had not increased since 1996. Gino pointed out the costs of maintaining the common areas had increased while dues had not. Also, repairs were needed to the pools and the playground equipment, all of which had been in use for 27 years. Because swimming pools were Gino's area of expertise, he spent most of the meeting talking about the pools. Although the pools appeared in general to be in good repair, several problems needed to be addressed. The rebar was coming up through the big pool in two places and in the baby/wading pool in one place. Those needed to be fixed and the pool resurfaced. Several tiles were broken or loose; the pool needed an acid cleaning; the filter equipment was in danger of failing; pumps were wearing out; and the safety covers on all the drains needed to be replaced. Also, the baby/wading pool had a leak. The bottom line, according to Gino, was that without an increase in dues, the pools would have to be filled in. Gino passed around a list of homeowners' names with two boxes to the side of each name for a yes or no vote for the dues increase. The increase passed unanimously. May 2013 The HOA held a meeting for members of the board and the homeowners. Again, swimming pool issues were the major topic. Homeowners complained that during the off-season of October to April none of the pool repairs discussed at the December 2012 special meeting had been done despite an increase in dues to cover them. It was now May and time for the pools to open so the repairs could not be made for another six months. Gino took this as an insult and a criticism that he was not doing a good job as president of the association. Gino countered that he had been taking care of the association for several years with no pay and no show of appreciation from the homeowners. He justified the need for the increase in annual dues by saying the pool maintenance company, which was not Gino's company, was charging the HOA $650 per month. He failed to mention the pool maintenance contract was for only six months per year because no pool maintenance was performed from October to April. He also pointed out that during the off-season he had the leak in the baby/wading pool fixed and resurfaced at a cost of $4,000 to the association. Gino stated that the water bills the previous summer were unusually high because of the leak in the baby/wading pool. A homeowner suggested that Gino get other homeowners to help him with things like neighborhood beautification and social activities, whereupon Gino appointed two homeowners to be additional members of the board. One would be an advisor and the other (who ran a semi-successful website building company) would handle the website. Gino appointed a long-time HOA board member as the Architectural Control Committee chair. When a homeowner asked Gino to produce the bylaws for the HOA, Gino waved the homeowner's concems away and said they were "in his head." The meeting was adjourned without a vote on the new board members and their assignments. June 2013 A resident who used the pool regularly for lap-swimming exchanged pleasantries with the owner of the maintenance company on a sunny Saturday morning. During their conversation, the resident found out that the pool maintenance company had not been paid the $650 per month agxeed to orally by the pool company owner and Gino. When the resident complained about the cost of resurfacing the baby pool by Gino's pool company, the pool maintenance company owner exclaimed that if the cost for the job quoted by the resident was correct, then the repair cost approximately four times what it should have. He told the resident that, to his knowledge, no request for bids had been sent out, and currently his company was trying to repair the same leak "fixed" by Gino's company. A board member who was handling the landscaping contract became frustrated because Gino did not respond to her requests for records; he held special board meetings without her knowledge; and he made personal attacks against her in emails sent to other board members. Consequently, she resigned from the board and started airing her concerns to other homeowners. August 2013 The pool maintenance company stopped servicing the pools due to non-payment from the HOA. The owner of the company sent copies of his invoices and his notice that he would no longer provide services to the HOA to a concerned resident who had been trying to determine how and to whom bills were paid. Gino did not respond to requests for records of cash disbursements, and the new treasurer had neither seen the books nor had been asked to pay any bills. Gino explained he had not paid the pool company because the company billed some large maintenance repairs that were not cleared by Gino prior to the repairs being completed. While all this was going on with the pool maintenance company, the landscape company complained to another resident that payment of its fees had not been made in a timely manner. Late August 2013 Homeowners discovered Gino had gone before City Council to request a state grant to paint bicycle lanes and parking spaces along the main road that ran through the subdivision. Gino told members of the City Council he represented the HOA and that the homeowners agreed to this project. A homeowner who just happened to be at the meeting announced at this same city council meeting that this was the first he had heard of the project. Nevertheless, after working with a city council member, Gino was able to get the grant for this project. Early September 2013 Several concemed homeowners contacted the accounting firm that prepared financial statements for the HOA. The sole proprietor of the firm lived in the subdivision. She told the concemed homeowners they could come to her office in three days to review the books, but they would not "find what they are looking for." The homeowners visited the accounting firm only to find receipts and checks from the manual ledger missing, payments made to board members without receipts, and purchases made without justification, e.g., \$600 paid to Gino each May for the pool opening activities including the purchase of a new grill and coolers every year. Other questionable payments included a payment of $250 to the son of one of the board members for picking up trash in the neighborhood and the purchase of some corrugated metal for the pool area that ended up in the pool area of a board member's home. After the homeowners had reviewed the records for about an hour, the accountant demanded they leave. She tumed off the air conditioner and the lights-effectively shutting down their investigation. The accountant later issued a "compilation" that claimed she was "not independent" and disclaimed the information provided for her report. This was sent to the concemed homeowners shortly after their visit to her office. Mid-September 2013 Representatives from 11 families in the neighborhood met to discuss the next steps. They hired a lawyer at their personal expense who specialized in homeowners" association disputes. The lawyer suggested the following actions: 1. Do research to determine the legal standing of the HOA and follow up on some of the irregularities found by various homeowners. 2. Prepare a report and official letters to board members, including Gino, outlining concems and requesting a response within ten days. 3. Request minutes of boand meetings, audit reports, election results, bank statements, and bids and contracts related to major maintenance projects. 4. In the event the records are inadequate and/or not produced, send a notice of an intent by the homeowners to file a lawsuit against the HOA boand. If these actions did not resolve the problems with the HOA, then a potential lawsuit with forcible removal of the board members might be required. Included in this series of events would be a possible investigation by the district attomey into the alleged fraudulent activities by the board members. In the meantime, a homeowner went to the City Council to tell them Gino did not represent the homeowners with regard to the street striping project as no survey of the homeowners had been made prior to the application for the grant. The City Council members requested a survey be made of the homeowners before the project moved forward. City Council requested this because two years prior, the city had to rip out speed bumps in another neighborhood at the city's expense because the HOA president improperly claimed to represent the wishes of the homeowners. The city stood to lose either way. If the homeowners voted against the project, then the grant money would be retumed to the State; if the project moved forward without the proper approval of the homeowners, then the city could incur expenses for removing the paint. Early October 2013 Gino sent a newsletter to all homeowners advising dues would be increased again pending a series of meetings later that year to gather votes for the increase. The newsletter announced that bicycle lanes and parking spaces would soon be painted on the main road into the subdivision. Gino claimed the vote for this project was unanimous by the HOA board. Meanwhile, the homeowner who had informed the City Council that HOA members had not been given the opportunity to vote on the street striping project mailed a survey to the homeowners asking if they were for or against the project. More than half of the 133 property owners responded to the survey. Ninety percent of those were against the project. Mid-October 2013 The first round of research by the lawyer for the concemed homeowners discovered the following: - The HOA was involuntarily dissolved in 1993 because the HOA board did not file the proper forms. The state forms were not filed in 1989, and the HOA was dissolved after the four-year grace period expired. - No franchise tax form for the HOA had been filed since 1988, thereby forfeiting status with the state to operate as an HOA. - Forms required by the IRS were missing. - The county had record of the pool property, and the property was in good standing with the county. - The HOA (if it legally existed at all) was out of compliance with the 2013 HOA laws. - Until legally reinstated, any business activity conducted by the HOA was void. The Next Steps This scenario is ongoing. A large group of concemed homeowners is meeting regularly with the attomey to determine what steps to take to revive the association and the integrity of the board. The obvious first step would be a vote by the homeowners to replace the current board members and elect new members and officers. Next, the board would file all the proper forms with the state to reinstate the legal standing of the HOA. The bylaws would be revised to clearly define the daties of the board and the officers and to require some checks and balances in the doties. 1. Apply the fraud triangle to this case. Speculate on the motivation/pressures, opportunity, and rationalization of Gino and possibly other board members. 2. Identify at least 20 "red flags" for potential fraud in this case, for example, inadequate records. Why were checks written to board members? 3. Identify internal control weaknesses present in the case 4. Identify and discuss the practical logistical issues of removing Gino and the other board members. 5. What do you think of the accountant's behavior? Include in your discussion the responsibility of the accountant. APPENDLX A Definition of a Homeowners' Association HOAs are common in single-family housing developments, condominiums, and townhouse complexes and serve as the governing body for the parpose of protecting the value and desirability of the real property. Most often, HOAs are formed as non-profit corporations. When a person buys a property governed by a HOA, the owner automatically enters into a contract with the association and agrees to obey all the rules adopted by the association. These rules address such issues as what materials and colors can be used for the house roofs, what colors you can paint your house, what kind of landscaping you can do, the size and height of structures you build in your back yard, and whether election and contractor signs can be placed in yards. These rules are expressed in a document called covenants, conditions, and restrictions (CC\&R). The HOA assesses fees on homeowners. These fees are used to cover the costs to maintain common areas used by all the homeowners. These common areas may be, for example, swimming pools, playgrounds, walking paths, and tennis courts. By adhering to the rules and paying the association dues, the implication is that amenities will be well maintained. When a developer completes a subdivision and sells the first few houses, it is customary for the developer to create a homeowners' association. Some of the new homeowners volunteer to serve on the board of the association. An election is held for the association's president, vice president, secretary, and treasurer. Because these are unpaid positions that require much time, volunteers can be hard to come by. As a result, often the board members and officers are the same people. In addition to the board members and officers, an architectural control committee is established to approve or disapprove changes to the property. The laws of the state in which the development is located govern HOAs in that state. An application and other documentation required by the state must be submitted to the Secretary of Stale. The next step is to create bylaws that set out the duties of the directors and officers and outline how the HOA will operate. Finally, the directors and officers adopt covenants, conditions, and restrictions. Operation of a Homeowners' Assaciation States vary as to the strictness of their HOA laws. A frequent requirement is that the association provide times during normal business hours that records can be inspected by any HOA member. Minimum records that must be maintained and retained may include: - articles of incorporation, CC\&R, bylaws, and all amendments to these documents, - financial books and records, - account records of current owners, - contracts between the association and other parties, - minutes of meetings of the owners and the board, and - tax returns and audit records. Other common state HOA laws pertain to board meetings, tomeowners' dues, and contracts. Board meetings must be open to all members except in cases where a closed executive session is needed (e.g., potential litigation, contract negotiations). All decisions made in a closed executive session must be reported in the minutes of the meeting. All board meetings must be properly announced by written notice or at least posted where everyone can see the notice. Possible outlets for the notices are the HOA newsletter or website if those are available