Due Diligence

 

                Suppose an owner withholds payment of a special assessment because she disagrees with the board’s proposal to install wood-tone vinyl cladding over the original cedar siding.  She contends the vinyl will not look as nice and will lower the value of her unit.  The board files suit to collect the delinquent assessments.  The owner fires back a counterclaim to prevent the board from installing the vinyl siding.

                In this scenario, here’s what the board should be able to say:

  • We acted within the board’s authority under the governing documents.
  • We consulted with an appropriate expert, such as an engineer, to evaluate the current condition of the siding, expected remaining useful life and alternatives.
  • We prepared a cost-benefit analysis: continuing to maintain the original siding versus installing vinyl cladding and other alternatives.
  • We evaluated siding products for durability, warranty and insulation that would reduce energy consumption and costs.
  • We obtained competitive bids for installation of the vinyl siding, reviewed warranties, checked references and selected not just the lowest bid, but the lowest and best.

                 The decision- making process in our scenario has positioned the board to defend the counterclaim under the business judgment rule.  A court will defer to the board’s decision if the matter is within the board’s authority, the board members were informed and the decision was made in good faith and with the honest belief that the action was in the best interests of the community as a whole.

In Good Faith

                Board members have a duty of care, generally described as the duty to act in good faith and in the best interests of the entity as a whole.  They must inform themselves by seeking objective facts relevant to the particular subject matter.

                Each director also owes a duty of loyalty to the association, which means that he or she shouldn’t be influenced by potential personal gain.

                Under the business judgment rule, courts scrutinize the decision-making process, not the decision itself.  If the process is diligent and objective, the courts will defer to the board’s greater knowledge of the building and the community and will not second-guess the decision.  In our scenario, board members armed themselves with the advice of an independent engineer and have the right to rely on the engineer’s opinion, even if there are other options.

                The business judgment rule favors the association because it carries a presumption that the board’s decision is appropriate if the standard of conduct in reaching that decision was proper.  However, the owner in our scenario could overcome this presumption if she could prove that the decision was tainted by bad faith, self-interest or fraud – for example, if the contractor is related to a director, the vinyl siding was installed only on the president’s building or the manager got a kickback.

Reasonableness

                A number of states, including North Carolina, South Carolina, New York, California and Washington, apply the business judgment rule for “business” decisions such as repair projects or decisions not to repair.

                An alternative and common standard of review in many states is the “reasonableness rule.”  An owner may claim in court that the decision was unreasonable if the result was unfair to the owner.  The board then has the burden to prove that its decision was reasonable.

                By its very nature, the reasonableness rule allows the court to second-guess the board’s decision and to overturn that decision if it exhibits some element of unfairness to the owner.  In those cases, the court does not defer to the board’s decision-making.

                Even in states that apply the business judgment rule, it is typically used in disputes involving business-type decisions, primarily maintenance and repair issues.  The courts have deferred to the board under the business judgment rule in decisions relating to whether a shareholder in a cooperative should be allowed to move a steam riser, whether a board acted properly in providing spot treatment for termites (rather than fumigation) and whether the board has been diligent in attempts to repair roof leaks, even though the efforts were unsuccessful.

                Most courts do not apply the business judgment rule to the board’s “governmental” function.  While there is no bright line, “governmental” functions would include enforcement of rules and restrictions.

                The courts have not applied the business judgment rule to interpretation of the governing documents or to disputes involving membership rights and internal matters such as voting and rulemaking.

                While the business judgment rule flows from business corporations, the nonprofit community association, whether incorporated or not, differs significantly from the business world.  A business is motivated by profit, whereas the mission of a community association is to foster a quality community.  A business may lose money in a transaction, but an association may suffer an intangible loss to the fabric of its community.

                The community association also has a unique perspective that calls for a degree of deference in business-related decisions.

                First, when confronted with an owner’s challenge to the board’s exercise of its discretion in a business decision, the board must be concerned with more than the immediate issue; it also must recognize the risk to the association’s ability to remain an effective, self-governing entity.  The standard of review should afford autonomy and certainty for the board’s decision-making.

                Second, a deferential standard not only protects the board’s decision-making, but also protects the owners as a whole from a whimsy of a few.

                The business judgment rule meets these objectives by presuming a business decision will be upheld unless the owner can show the board exceeded its authority, didn’t act in good faith or acted out of self-interest.

                Before any major decision, the board should ask whether the issue relates to the association’s business or governmental functions.  For a business decision, the board should verify that the action is within its authority, seek objective information relevant to the particular issue, avoid conflicts of interest, compare all reasonable options and ensure the decision is in the best interest of the community as a whole.

                Boards should consider asking their attorneys to prepare an amendment to the governing documents providing that business decisions are guided by the business judgment rule and that governing decisions are guided by the rule of reasonableness.

 By Marvin J. Nodiff, ESQ.