The (Post-Enron) Model

In the wake of the scandals of the past few years that have rocked the boardrooms of Enron, Worldcom, Tyco, and, now, AIG, the code of corporate ethics has been rewritten both as a matter of law (the Sarbanes-Oxley bill) and practice, which now often goes beyond what is legally required to a policy of zero tolerance. Although such legislation is not applicable to co-ops or condos, given the changed regulatory climate it is probably only a matter of time before their practices, too, come under judicial, legislative, and public scrutiny.

There is a need for fundamental reevaluation of the underlying system. Where else in corporate America do you find unpaid and untutored boards in charge of enterprises with multi-million-dollar budgets and assets in the many hundreds of millions? Every company I know, at least in theory, has a chief executive officer who is paid for his or her expertise, an in-house management team to help define and implement policy, a professional board (of inside and more objective outside directors) to exercise oversight, and a shareholder constituency which itself, or through its representatives, trains its sights on performance.

Few of these built-in checks and balances exist in the sui generis model of co-op and condo governance, which puts the burden of management on the shoulders of unschooled residents, and gives them legal authority (under the ever-expanding business judgment rule) to carry out that role, but doesn’t require them to have the requisite knowledge or provide them with the depth of management that does.

As if that’s not problematic enough, almost all management functions are parceled out to third-party companies, which themselves outsource to other firms’ operations such as payroll, maintenance, and notice, further removing them from any centralized control. Because there are so many tasks to perform, and so few set boundaries, it’s often hard to tell where the board’s role ends and the managing agent’s begins, creating a structural gap that leaves the building caught in the middle. As a result, whether the issue is handling transfers and sales, or a building’s investments or capital projects, too many things can fall through the cracks. This deficit is exacerbated by the fact that given present-day industry economics, most management companies have too little time to answer the too many masters and, on an institutional basis, lack the increasingly comprehensive skill sets necessary to run client buildings with corporate efficiency.

Similarly, other critical functions, such as that of general counsel and auditor, are handled by outside parties. But unlike traditional corporations, which generally have legal and financial professionals (and probably an audit committee) as part of their management to interact with outsiders, co-ops and condos generally do not have such controls. Because of this vacuum in their functional hierarchy, outside counsel often wind up serving as decision-makers rather than legal advisors. And unless the building has more than a nominal treasurer, it must rely on independent accountants to audit the building’s financial operations, who, in turn, depend on whatever controls may (or may not) exist in their outsourced managing agents.

Who’s watching who and is anyone really minding the store? Under the present system, there is simply no guarantee that anyone really is in charge because each party – managing agent, lawyer, engineer, contractor, accountant – operates more or less independently of one another and of any meaningful central authority. Boards want to do what’s best, but aren’t always trained to know what’s right, so that outside agents, not the board, may wind up in de facto control of the building, a role reversal that can have potentially troublesome consequences.

What then is the answer?

First, as with any company, there needs to be a fully engaged chief executive officer who is up to the task and bears ultimate responsibility for running the building and overseeing all outside agents. Although there is a “president” atop the organizational chart of condos and co-ops, as anyone in the trenches knows, this role is defined more by the individual who fills it than by any objective criteria, and can range from self-appointed despot to mere figurehead. If your building has a resident leader who stands comfortably at the helm, count yourselves fortunate.

Otherwise, one option is to establish a new role – a coordinator – an objective and skilled professional, expert in co-op and condo governance, but unaffiliated with either the inside building directors or the managing agent – to serve as a kind of functional CEO, accountable to the board and with the capacity to carry out its mandate. The coordinator could help rationalize the building’s business practices by creating an organizational setup specific to its needs and the board’s abilities; delineating lines of authority and responsibility among board members, and between the board and managing agent (and other professionals); and then identifying and addressing the tasks that otherwise might be left to happenstance. The presence of such a credible and objective outside professional could also serve as a buffer between boards and shareholders.

The culture of management companies also needs to change. Agents have to be spread less thinly and trained more broadly, admittedly a development that has a price tag. In addition, the fact remains that agents spend substantial sums of other people’s money, so incentives should be devised to encourage performance and cost efficiencies.

Boards, too, need to alter their mindsets. If the directors in your building function as a unified and informed whole, I salute them. Too often, however, a small subset of directors carries out the building’s business, a situation that may go unnoticed by owners but which, in today’s era of heightened legal scrutiny, exposes fellow board members and shareholders to serious risks, including punitive damages. To avoid such consequences, directors need to be aware of both the scope of their responsibilities and the restraints on their power, a grounding that could readily be provided by the designated coordinator.

Shareholders also bear responsibility, often being content to sit on the uninformed sidelines until some crisis erupts. Changed circumstances, however, demand new approaches. Perhaps some sort of service should be mandatory for all, a practice that at the very least would acquaint owners with the complexities of the enterprise in which they hold a significant financial stake.

There is no free lunch. But the costs of implementing these systemic reforms should be more than offset by the savings that can be achieved not just within individual buildings, but on a larger scale by beginning to alter the way business is done within the co-op and condo community as a whole. Beyond strictly economic benefits, regularizing and professionalizing the way these organizations are run may help them begin to approach the standards demanded for the rest of corporate America.

Sylvia Shapiro is an attorney who specializes in real estate law. She is the author of The New York Co-op Bible (revised edition), scheduled for publication this month.