When the Business Judgment Rule Works — and When It Doesn't

Your board can sleep better at night knowing your decisions are protected by the business judgment rule — but it's not absolute. In this episode, Eric Goidel, a partner at Borah, Goldstein, Altschuler, Nahins & Goidel, reveals crucial limitations to that protection, including five key areas where boards mistakenly believe they're shielded but aren't. He explains real-world examples of when courts upheld the rule and when they didn't, including a case about balcony enclosures where the same judge ruled differently on nearly identical situations. And most importantly, understand when your D&O insurance will defend you versus when it won't pay out. Habitat's Paula Chin conducts the interview. 

The business of running a building is demanding work that requires making endless decisions — some that can quickly lead your board into a quagmire of legal difficulties. Legal Talk interviews New York's leading co-op/condo attorneys to find solutions, and get some guidance, on these challenges. For more co-op and condo insights, sign up to receive Habitat's free newsletters or become a Habitat subscriber today!

Transcript

Paula Chin: [00:00:00] Welcome to Legal Talk, a conversation about governance issues that New York's co-op and condo boards are facing today. I'm Paul Chen with Habitat, the New York City magazine for co-op and condo board directors. My guest today is Eric Goidel, a partner at Borah Goldstein Altschuler Nahins and Goidel. 

Many members of co-op and condo boards sleep well at night because of the business judgment rule, which shields boards from second guessing and legal challenges, provided they act in good faith and in the lawful and legitimate furtherance of the corporation.

But boards need to remember that the protections of the rule has its limits and that the shield can sometimes be turned into a sword. Eric, let's start with an example, perhaps, where a board prevailed against a shareholder or unit owner lawsuit, thanks to the rule. 

Eric Goidel: Actually wanted to [00:01:00] use a case dealing with a condominium, not a cooperative, but where the business judgment rule was applicable, because courts have generally held that, although most condominiums are unincorporated associations, the business judgment rule that applies to cooperatives, applies to condominiums as well because they have similar living arrangements.

So the case involved a situation where there was Local Law 11 work, the exterior work that needs to be done every five years in buildings in New York City, which also brought in the balconies of a development in Queens. The engineer said that various balcony enclosures, which were four season balcony enclosures, had to come down.

While everybody else complied, three unit owners refused to take down their balconies. We brought a case on behalf of the board of managers against the three unit owners. The cases appeared separately, but [00:02:00] before the same judge in Supreme Court.

In one case, the judge ruled in favor of the board of managers. In the other two cases, the judge ruled against the board of managers. The reasoning in those cases was that in the case in favor of the board of managers, the board of managers actually had approved the installation of the enclosure and had the ability to say that it could be take down. In the other two cases, the installation predated these unit owners actually buying their units, and the board did not get involved in the process of addressing the issue of the balcony enclosures at the time of the purchase. All three cases were appealed to the appellate division. The appellate division affirmed the case which dealt with the unit owner who had approval, saying that because the board had the power to give [00:03:00] approval, the board had the power to revoke approval.

The board of managers directed our firm not to appeal the other two cases, primarily for the reason that one of the unit owners actually became a member of the board of managers during the litigation process. So there may have been a little bit of potentially some self dealing there.

But I would've been curious to know what the court would've done had we gone through with that appeal, because I think the appellate division still would've extended the business judgment to those two cases. The fact that the board did not object to the installation of the enclosures in the beginning when the unit owners purchased, should not, in my opinion, have been dispositive of the issue.

Paula Chin: Let's take a step back and perhaps you can explain where boards most often get into trouble in terms of when they think they are protected and they're not. What are the missteps they most often make? 

Eric Goidel: So Paula, there are [00:04:00] probably about five different areas where the business judgment rule will not apply or where the court may consider the judgment of a board, but will not apply, per se, the business judgment rule. First of all, it doesn't apply to anything which is outside the board's authority in the underlying corporate documents.

As examples, there have been some cases where a board has adopted a flip tax where the only the shareholders could vote to amend the bylaws or the proprietary lease. There have also been situations where a board adopted a house rule, which in essence would've been tantamount to amending a proprietary lease provision, such as in the area of insurance requirements or something like that.

Or in the context of a condominium or a cooperative, the imposition of fines. There are [00:05:00] also some gray areas potentially in a corporate document such as where a board has the power to do certain capital work for repairs or replacements, but needs a unit owner or shareholder approval to do new capital work.

So let's distinguish between, let's say, repairing the exterior under a Local Law 11 that I just discussed, or perhaps doing a wholesale replacement of the hallways and the lobbies, which are not necessarily a repair, but a total redo of those which might require unit owner approval. It doesn't protect against things where there may be a contractual obligation.

For example, where there is a requirement that a board acts reasonably, let's say some proprietary leases say a board can't reasonably withhold its consent to alterations. Or it says that a board has to act reasonably, in a request to transfer to an immediate [00:06:00] family member. So in those situations where there's a reasonableness test, a court will get involved in the issue of whether the decision of the board was reasonable.

Now there's business judgment that comes into play there. But it's not an absolute protection, as in most cases, under the business judgment rule. It also doesn't protect against things like bad faith. So for example, there have been situations where a board turned down a sales application in a cooperative because the board, a board member lived next door and didn't like the purchaser, or the board member next door felt that they had an opportunity, maybe if the sale was turned down, that they could jump in, scoop up the apartment at perhaps even a slightly lower price, and then do an apartment combination. It doesn't protect against certain legal requirements. For example, in a cooperative, the warranty of habitability. So that's a statutory protection where someone will allege that their apartment [00:07:00] is uninhabitable for some reason, some leaks, some this, some that.

The business judgment rule might come into play in that situation, if there's an argument over what is the fix, whether the board did a proper fix. The court will give maybe some discretion as to the board's decision in that case. And it certainly doesn't protect against what I'll call outside claims, so let's talk about those for a moment. Because those are the ones where the boards are at the greatest risk, even for personal liability. It won't protect against discrimination claims because that's a third party who alleges I was turned down in a sales application because of my race, religion, sexual preference.

There's, I think, 15 different classifications these days, maybe even more under the City of New York Commission on Human Rights website. So any of those, a board is going to have to give a legitimate reason. The court has the ability to look into whether there was [00:08:00] discrimination. 

Labor law issues. So you may have an employee that you are disciplining. You suspended them, you fired them. First of all, you're relegated to perhaps the collective bargaining agreement if it's a union building and if it's not a union building, you're relegated to the labor laws. 

Then the third situation I see not frequently, but occasionally is a dispute with a contractor. So you have a contract to perform some large capital project at the building, and something goes south with the contractor. Again, that's a contract that's independent of any contracts in the corporate documents, as I would call it.

And therefore the business judgment rule will not apply there as well. 

Paula Chin: , Okay. Let's say a board gets into trouble for whatever reason and a shareholder sues and it goes to court. To what extent are board members protected by directors and officers insurance? 

Eric Goidel: Sure. So the [00:09:00] duty of a carrier to defend a board when presented with a claim under a D&O policy is fairly absolute.

So the duty to provide a legal representation. So the carrier will provide the board members or the board with an attorney. If there are board members who may have different interest, maybe each board member may get appointed a separate attorney. But then you sometimes have to distinguish, or frequently have to distinguish between what's known as the duty to indemnify.

So the duty to defend is fairly absolute. There are very few situations where a carrier will not be required to represent you, but indemnification is actually writing the check. At the end of the day if a case is lost. And that will hinge upon issues such as bad faith versus good faith, or negligence versus intent.

So for example, a carrier will not, and cannot [00:10:00] write a check where there's an affirmative award of damages for discrimination in a sales application process, where a purchaser has successfully filed and won a claim either in court or before an agency for discrimination.

There won't be coverage necessarily for things like tortious interference with an outside contract. But most things, and there won't be things which are in bad faith, as the example I gave where a board member wanted to pick up the apartment next door and if there's a lawsuit there, because that was self-dealing and didn't involve a legitimate corporate interest.

But where there's a corporate interest in involved, even if a board or individuals made a mistake or not even a mistake, were somehow a bit negligent, there usually is coverage for that. 

You also don't have to be mindful of the indemnification provisions in the bylaws of the cooperative or a condominium, and many of those bylaws are woefully short, because they [00:11:00] predate amendments to the business corporation law, which occurred in the mid to late 1980s, and if you have cooperatives which were formed, many were formed in the 1970s and early 1980s, they arguably did not take advantage of amendments to the business corporation law, which greatly expanded situations where board members would be entitled to indemnification by the apartment corporation.

Also shareholders and unit owners do have the ability to withdraw indemnification where there is some evidence of bad faith or self-dealing on the part of a board member or a board. So boards have to be mindful that they should be doing the right thing because if it's clear that they did not, they may not have the protection; their own shareholders or unit owners might elect not to give it to them.

Paula Chin: So clearly one of the first things boards need to do is make sure that their provisions are up to date, as you [00:12:00] mentioned. What would you say is the other big takeaway for boards here? What do they need to know regarding the business judgment rule? 

Eric Goidel: Besides things being up to date, as we talked about indemnification. But when it comes to getting the protection of the business judgment rule, when a board adopts policies or rules and regulations or resolutions about something, let's adopt them. But also, let's put a few sentences in into either the minutes or preferably even the certificate of resolution, setting forth the rationale of the board at the time, why they were thinking what they were thinking at the time. And that'll help a court to apply the business judgment rule, especially where there may be some reasonableness test that comes into play. You should also publish those rules and policies as soon as they're adopted to your shareholders or unit owners.

There's actually a recent movement afoot in the courts to apply a four month rule statute of limitations, so to speak, to actions by boards of [00:13:00] directors and boards of managers, where if an objection is not made by a shareholder or unit owner in certain situations within that timeframe, that becomes the rule.

And I'm sure you're gonna be talking about that with some other counsel. You should promptly act when the board becomes aware of some violations. So for example the cases I pointed out with the terrace enclosures ? One they won, two they lost. They lost because they didn't act at the time that these unit owners purchased their apartments.

You should make your agreements tight. For example, alteration agreements, parking license agreements, things like that, so that there is no reasonableness issue that comes into play where a court may interject their opinion. You should also, as a board, rely upon the opinion of your experts. So your attorney, your accountant, your engineer, architect, even managing agent, because a court will often respect what a board did if they sought [00:14:00] advice from their professional, even if, again, the court might have disagreed with the outcome or the decision, but they saw that the board wrestled with the issue and tried to get proper advice.

Finally, I would say you should try, where a shareholder or unit owner tries to object to something and threatens litigation-- before the litigation, try and engage in a dialogue with the unit owner or the shareholder to convince them that the action that the board has taken is not personal and there was a good business reason to do so at the time.

Litigation should always be a last resort because nobody wins. 

Paula Chin: Eric, I think this has offered some really valuable information for our readers and listeners. Thank you so much for joining us today. 

Eric Goidel: Thank you, Paula. Been a pleasure.