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Protecting sectional title funds

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This article by Mike Addison* was first published in the third-quarter 2013 edition of Personal Finance magazine.
“Bodies corporate lose millions”, “Funds missing” … I’m sure you’ve seen headlines such as these on newspaper stories about bodies corporate that have lost money as a result of dishonesty or mismanagement of one kind or other.

Body corporate funds can be a temptation for people who have access to them. May the next story not be about your body corporate.

Having said that, I must emphasise that you should not automatically assume that sectional title management cannot be trusted or is corrupt. Standards are in place, regulation and levels of education are improving and, thanks to the efforts of the National Association of Managing Agents (Nama), managing agents have, without government intervention, raised the bar for good conduct. There are excellent service providers out there, but do your homework and choose a managing agent who belongs to Nama and has some sort of fidelity cover.

Fidelity cover usually refers to insurance against losses arising from theft by, or the dishonesty of, employees. (Perhaps it should be called “infidelity insurance”.) For our purposes, the terms “fidelity cover”, “fidelity insurance” and “fidelity guarantee” mean more or less the same thing: cover that a body corporate and/or a managing agent can buy to insure owners against theft or dishonesty perpetrated by trustees, employees of the body corporate, and managing agents and their staff.

Typically, in the sectional title environment, there are owners, the body corporate, the trustees and the managing agent.

An owner is a person who owns a unit in a sectional title scheme. (A unit comprises a section plus an undivided share in the common property.) The owner may also hold exclusive-use rights to parts of the common property.

The body corporate is a legal person, formed on the first sectional title transfer in a scheme. Any registered owner automatically becomes part of the body corporate. Owners pay levies and exercise a vote at general meetings in terms of their participation quota (percentage of ownership based on floor area as shown on the sectional plan).

The Sectional Titles Act and the prescribed management rules (PMRs) issued in terms of the Act set out the functions and powers of the body corporate and state that these must be performed and exercised by the trustees (usually without payment).

The trustees, who are normally elected by the owners at the annual general meeting (AGM), have a fiduciary responsibility to look after the common interests of all the owners collectively.

The managing agent is appointed by the trustees to perform various tasks, which may include keeping the scheme’s accounts, collecting levies and arrears, assisting with budgeting, providing paralegal services, and keeping records and minutes.

How is fidelity cover addressed in the PMRs?

PMR 29(2)(b) is very clear and reads as follows: “[…] the trustees shall take all reasonable steps […]

(b) to procure to the extent, if any, as determined by the members of the body corporate in a general meeting, a fidelity guarantee in terms of which shall be refunded any loss of moneys belonging to the body corporate, or for which it is responsible, sustained as a result of any act of fraud or dishonesty committed by any insured person, being any person in the service of the body corporate and all trustees and persons acting in the capacity of managing agents of the body corporate”.

More simply put, trustees need to take the matter of fidelity cover to a general meeting (meeting of all the owners) for a decision on how much fidelity cover should be purchased. This is a legal requirement.

Of course, ideally, the owners of a sectional title scheme should take responsibility, too. If you cannot know all the ins and outs of sectional title regulation, you can ask questions and hold the trustees and the managing agent to account.

Trustees need to be aware of what the prescribed rules say about insurance, and PMR 29(2)(b) is the one most often overlooked.

Managing agents are not inclined to give this area of trustee responsibility enough attention, probably because it’s a touchy subject. After all, it can’t be easy to advise your client to take out insurance against your possible dishonesty. So really, it’s left up to the trustees, and they may not want to acknowledge that fidelity cover is designed to protect against lapses of honesty on their part, too. Hence the vast number of under-insured bodies corporate and the losses that become the subject of newspaper headlines.

What should the trustees do?

First, don’t assume that PMR 29(2)(b) in its original form applies in your scheme. It’s surprising how many schemes have amended this rule to be particular about how much cover should be purchased; so check whether PMR 29(2)(b) or its equivalent applies.

Second, decide how much fidelity cover the owners should consider at a general meeting. Engage with the scheme’s managing agent, insurance adviser and auditor in this regard.

One approach is to base the minimum amount of cover on the maximum amount of money held in the scheme’s current account during any calendar month, plus the anticipated maximum that will be held in the reserve fund during the year. Let’s say the total is R500 000. Based on that amount, you can obtain quotations for fidelity cover from the body corporate’s insurance adviser or broker – and be sure to provide a copy of the rule, so there is no doubt about the scope of the cover required.

Note that many standard insurance policies exclude managing agent dishonesty, so if the scheme has a managing agent, this risk must be included.

With some insurers, the premium changes little whether you insure for R1 million or R500 000, so it may well pay to over-insure at the same cost. Your broker can best advise you on this.

Third, put the matter of “fidelity insurance per PMR 29(2)(b)” on the agenda of the next AGM. Assure the owners that the trustees are taking cognisance of this important rule and propose that the body corporate carries fidelity cover of R1 million for an annual premium that might be as little as R4 000 a year, or less than R400 a month.

This rule can be revisited periodically – that is, table it every year or every second year.

Bodies corporate come in different sizes and are managed in various ways, so there’s no hard-and-fast rule as to how they should go about arranging fidelity cover, or how much they should buy. It depends on various factors, such as the body corporate’s banking arrangements, whether or not the trustees control the funds and authorise payments, how surplus funds are controlled and invested, and whether or not the managing agent is operating a trust account for body corporate funds.

Here are six common scenarios that can help you to determine the type of fidelity cover your scheme should purchase:

1. The scheme is self-managed and the trustees control the funds of the body corporate.

It would be prudent for the body corporate to base its fidelity cover on the maximum amount in the scheme’s current account in any one month, plus the maximum expected surplus, or reserve, funds in the scheme’s investment account.

For example, a complex of 30 owners, each paying a levy of R1 000 a month, would probably have a peak balance of R50 000 a month, plus about R200 000 building up as a surplus, to, for example, repaint the building every five years or so. Thus, fidelity cover of R250 000 would be appropriate.

The trustees can simply ask the body corporate’s insurance broker to increase the fidelity cover limit on the body corporate’s existing insurance policy, or to provide a separate policy for this.

A standard insurance policy usually covers the body corporate (the insured) against dishonesty, theft or fraud by the trustees and the employees of the body corporate, such as an estate manager, but it usually excludes cover for dishonesty, theft or fraud by a managing agent. However, in this scenario, because there is no managing agent, the trustees need not search for wider cover.

Take care, though: a professional trustee (a qualified person who is paid for his or her services and may not necessarily be an owner) may not be properly covered in terms of the trustee indemnity provided by a standard insurance policy. Different policies have different definitions of a trustee, and there are opposing views among insurers as to whether or not a paid trustee would be covered.

There are also some “experts” who are prepared to stand in as trustees for a fee; in some cases, they are co-opted rather than elected. The sectional title rules allow for co-opted and alternate trustees, and, although they need not be elected by the owners, they would have to be approved by the serving trustees. Again, the body corporate’s insurance broker should be asked to factor this into the scheme’s fidelity cover requirements.

2. The body corporate has a bank account or accounts in its own name and employs a managing agent, but only the trustees have signing powers and control over the scheme’s current account and its surplus funds.

The solution in scenario 1 applies. Remember, the fidelity cover in a standard insurance policy normally excludes the managing agent, so, as long as the managing agent is not given signing powers, the fidelity cover as arranged in scenario 1 should suffice, assuming the scope for dishonesty is limited to funds in the scheme’s bank account (or accounts).

3. The body corporate maintains bank accounts in its own name but delegates signing authority to the managing agent, wholly or partially.

The delegation of signing authority means that the body corporate’s funds are not protected by the fidelity cover in its standard insurance policy, because theft by the managing agent is usually excluded. And because the funds are kept in the body corporate’s name, with the managing agent having only signing powers, the Estate Agency Affairs Board (EAAB) Fidelity Fund does not cover them, either.

In order to have sufficient fidelity cover, the body corporate must:

* Ask the managing agent to purchase a fidelity guarantee from an insurer for an appropriate, specific sum of money; and

* Procure its own specific cover, as suggested in PMR 29(2)(b). This is important, even when the managing agent has fidelity cover.

It is my educated guess that the vast majority of managing agents do not have their own fidelity insurance policy over and above the EAAB’s Fidelity Fund. The Fidelity Fund does not cover funds held outside of a trust account, so protection needs to be sought outside of the EAAB’s fund.

Therefore, when the body corporate’s funds are managed outside of a trust account, the managing agent and the body corporate need to purchase additional fidelity insurance. A trustee should sleep better at night knowing that the managing agent who looks after the building and the body corporate’s funds has both professional indemnity cover (for errors and omissions) and fidelity cover.

The managing agent can easily purchase such cover if he or she has been underwritten by an insurer and holds his or her own policy. The scheme’s insurance broker should advise the body corporate and the managing agent in these circumstances.

Some body corporate policies, such as Fidcure, can be written at lower premiums if the managing agent has a policy with the same underwriter, because the insurer/underwriter can understand the risk. The underwriter has, after all, checked the managing agent’s credentials to some degree and already received some premium for the same risk.

4. All the body corporate’s funds are held in the managing agent’s trust account in terms of the Estate Agents Affairs Act.

The managing agent’s trust account is usually termed a composite trust account – or, in less complimentary language, a bucket account.

A managing agent is legally defined as an estate agent and is therefore obliged to register with the EAAB, have a trust account and have certain qualifications, National Qualifications Framework levels, and so on. The body corporate can assume that the EAAB will provide cover against theft or dishonesty on the part of the managing agent through the Fidelity Fund certificate (FFC) that it is obliged to purchase annually from the board.

But the EAAB covers the funds of owners only where the registered managing agent commits acts of fraud or dishonesty; it does not cover such acts by an employee of the same agent. Furthermore, the claimant has to prove the claim and demonstrate that he or she has taken all necessary action against the agent. Also, only funds held in the specifically styled trust account would be covered.

So, trustees must make sure that:

* The funds are in fact operating in trust (otherwise there is no cover) by checking bank statements and/or asking the managing agent’s auditor. You can find out who the auditor is by searching for a registered agent or agency on the EAAB’s website,

* The managing agent renews the certificate annually. You can check whether an agent is trading with a valid FFC by phoning the EAAB on 011 731 5600, or by asking the agent for a copy of the certificate.

Both the body corporate and the managing agent should still purchase fidelity cover from an insurer as additional security, especially if there are any concerns over whether a FFC exists or the Fidelity Fund will meet claims.

5. The body corporate’s funds are held in the managing agent’s trust account in terms of the Estate Agents Affairs Act, but the body corporate is allocated a separate, or sub account, within the trust account.

This is often a better arrangement than the one in scenario 4, because the body corporate’s funds are not mixed up with the funds of other bodies corporate. The trustees are thus able to check on the funds of their body corporate via statements of account provided by the managing agent.

The EAAB Fidelity Fund provides protection against dishonesty by the managing agent, as in scenario 4. Again, the prudent body corporate and managing agent will purchase additional fidelity cover, as in scenario 3.

6. Funds for the day-to-day running of the scheme are held in the managing agent’s trust account, but surplus funds are held in the name of the body corporate – in other words, outside of the trust account, in a call account or the popular Nedbank Corporate Saver account.

In this case, it is important that the trustees bear in mind that the surplus funds will not be covered by the EAAB’s Fidelity Fund.

The need to take out fidelity insurance will depend on whether the trustees or the managing agent has signing powers over those surplus funds. If the managing agent does, the body corporate might have to purchase fidelity cover against dishonesty by the managing agent.

Trustees cannot be expected to be up to date with all the technicalities of sectional title insurance, all of the time. This highlights the importance of ensuring that the body corporate’s affairs are in the hands of a reputable, properly insured, qualified managing agent and insurance adviser/broker.

To recap: trustees and managing agents should read PMR 29(2)(b) carefully and then ask an insurance broker to recommend, in writing, a policy that will provide the required cover.

Trustees should check that the managing agent has sufficient fidelity cover, at least through the EAAB Fidelity Fund, but preferably by way of additional insurance. Then it’s time to put the issue of fidelity cover on the agenda of the next AGM and to get the owners’ approval of any increases recommended.

* Mike Addison is a director at Addsure, a specialist intermediary in sectional title insurance.