Financial protection and the Board

I am on the board of a (low-rise) co-op in Manhattan. For the past several years, we’ve been having problems with our management company. They routinely withhold information from the board and hire/fire contractors (and cut checks) without the board’s knowledge or consent. Most recently, they arranged for commercial rent to be paid directly to themselves, and none of the rental income is reaching the building’s bank account. When the board requests copies of contracts, invoices, and/or checks, the management company simply does not respond. We are looking to change management companies, but would like to legally protect/recapture monies owed to us (both current and future commercial rent) before we make the change. What would you suggest that we do?

I’m always amazed that highly intelligent, sophisticated, and cynical New York City metropolitan area co-op/condo owners place so much faith in management companies and others in managing their financial affairs. By extremely rough and admittedly dubious calculation (assuming 10,000 co-ops and condos with $1 million average annual budgets), over $10 billion flows through management company coffers during any given year. Even innocent mistakes – comprising one percent of this total (also by rough and dubious calculation) could cost co-ops and condos $100 million per year in the aggregate. If you throw in deliberate defalcation, then much more could be at stake and, under the current system, is regularly lost.

This problem evolves from apartment owners acting like passive and resigned taxpayers. They know that mistakes, inefficiencies, and outright corruption consume an obscene percentage of government revenues but remain unwilling or unable to respond because of the seeming impossibility of accomplishing anything worthwhile, and the perception that each individual’s shares of such losses is of small consequence.

One solution is for apartment owners to act like what they are: investors. New York area co-ops and condos should move in the direction of private businesses in managing their finances and other affairs. No court application of constitution principles can rob them of that right. Here’s what I suggest:

1. All co-op stockholders and condo unit-owners should adopt the mentality of private equity investors. Regarding finances, co-op/condo owners tend to allow a select few – the board members – manage their finances with little reporting and even less oversight. Certainly, the periodic crisis arises but by and large co-op/condo owners hope and pray that a large portion is spent wisely and honestly, and comfort themselves with the thought that any losses will be spread over the many.

I suggest that apartment owners shed this “lazy fare” perspective and adopt the “laissez-faire” view that application of good business practices will best serve their interests. The board-run associations are the ones whose apartment owners demand that their boards manage the finances like a private equity investor who has bought a substantial interest in a company.

2. Board members must be competent, tough, and hardworking. Those managing the financial affairs of co-ops and condos will make mistakes on a regular basis no matter which management company is retained. The only way to mitigate this is for apartment owners to elect board members who are competent, tough, and hardworking enough to deal with the inevitable challenges. It is simply unacceptable for a board to consist of too many members willing to pass the buck to incompetent or corrupt managers, and to accept the consequences. It is up to apartment owners to vigilantly ensure that the right directors are elected and receive support and encouragement to stay in office.

3. Boards should upgrade their financial controls. With all involved acting with substantial honesty, there is great potential for financial recording and reporting to go bad. Bookkeeping departments of management firms are responsible for entering thousands of receipts and charges each month for the scores of co-ops and condos that they represent. These lead to a corresponding number of deposits and debits in their bank accounts.

The main oversight of this are the monthly management reports that boards typically require and the annual audited financial statements by the independent accountants. The system requires reform to upgrade the quality and quantity of financial oversight by the management companies and outside accountants. The current problem is that co-ops and condos are obsessed with paying as little as possible for management and accounting. As a result, they get what they pay for. I suggest that enhanced services should be offered at a price, and then boards can decide whether it is worth an extra $10,000 or more a year to protect the safekeeping of their millions of dollars of revenues, expenditures, and investments.

4. Boards should be smart about hiring management companies. Boards also should be willing to pay more for higher quality management companies that retain higher quality managers and back offices. It is simply inexplicable that co-ops and condos insist on bargain-basement prices for management of properties worth hundreds of millions of dollars. No sane investor would do that. The companies and the managers also are the critical links between the apartment owners and their boards on the one hand and the outside world on the other. Their competence, effort, and integrity should reflect the value of the assets and lives that they are preserving and protecting.

5. Boards should not be shy about investigating and reporting problems. There was a spate of recent publicity about the murder in Connecticut of a wealthy businessman who was under investigation for stealing millions from investors and lenders regarding his schemes. It turned out that years earlier he had been caught stealing millions from his Upper East Side co-op. The board apparently had reported this to the authorities but nothing was done possibly because he repaid the money. If he had been jailed for what he did to his co-op, then maybe he wouldn’t have been so readily able to steal from the investors and lenders in his subsequent ventures.

Co-ops and condos must tirelessly report to their authorities their victimization at the hands of corrupt board members, managers, and others, and insist on results. That is the most cost-effective way of recouping lost funds. That also will provide the specific deterrence lost in the case of the murdered businessman, and also maybe even some general deterrence. If the courts insist on subjecting homeowners’ associations to the constitutional standards applicable to governments, then co-ops and condos should be entitled to receive priority use of governmental police power to preserve their financial resources.

Board Power

I heard there was a case in New Jersey that may curb the powers of board members. Have you heard about it and does it have implications for New York co-op and condo owners?

I have heard of it and it is part of a trend by the courts to view co-ops and condos as so-called “governmental entities,” which would potentially allow them to restrict the power of boards to make decisions.

The case is Committee for a Better Twin Rivers v. Twin Rivers Homeowners’ Association, a February 2006 New Jersey Appellate Division decision. It held that a homeowners’ association operates enough like a government for its members to be entitled to the free speech protections usually only enforced against federal, state, and local governments. The New Jersey Supreme Court will hear arguments this year. If endorsed by the state’s highest court, this decision could have serious implications for the power of co-op and condo boards throughout the country, including New York. In fact, a quick search reveals that mention of the Twin Rivers decision already has found its way into the law journals of the Vanderbilt and University of Michigan law schools.

The Twin Rivers court considered the enforceability of policies regulating residents on association property concerning various types of speech or expression: “policies restricting signs on residents’ lawns, charging assertedly excessive fees for use of the community room, refusing to afford equal coverage to [residents’] views in the [association’s] newsletter, withholding access to financial documents, disenfranchising [a resident] for refusing to pay a fee and failing to provide alternative dispute resolution for his dispute, weighting [the association’s] voting according to property value.”

The court held that community association members’ “rights to engage in expressive exercises – including those relating to public issues in their own community, such as...election of candidates to the…board… – must take precedence over the [association’s] private property interests.”

Some might argue that most New York City co-ops and condos have nothing to fear from this case from across the river. After all, the Twin Rivers court dealt with a planned unit development consisting of privately owned condominium duplexes, townhouses, single-family houses, apartments, and commercial buildings covering one square mile. Others would point out that the Twin Rivers court was interpreting free speech rights under the New Jersey Constitution. Most New York area co-ops and condos are a far cry from the small-town development at issue in the Twin Rivers case. Moreover, in the most recent, readily analogous New York State appellate case, 1998’s Ansonia Assoc. Limited Partnership v. Ansonia Tenants’ Coalition Inc., the Appellate Division, First Department, denied the claims of New York City condominium unit-owners that their free speech rights were impinged by an injunction barring them from discouraging sales or rentals of apartments at the Ansonia.

However, a closer look at Twin Rivers reveals that the court has a level of discomfort with largely unfettered association board decision-making. And that has implications even when constitutional rights are not at issue.

The Twin Rivers homeowners’ association defended its policies and rules in part by claiming that the Business Judgment Rule should provide the standard by which association rules regulating expression are judged. The application of this standard resulted from the New York high court’s 1990 decision in Matter of Levandusky v. One Fifth Ave. Apt. Corp., and spread to New Jersey and many other states. In providing association boards with the freedom of private business boards to act within the scope of their authority (unless there was bad faith, self-dealing, or discrimination), the courts rejected the application of standards more typically applicable to review of government decisions: the “arbitrary and capricious” standard, and the unreasonableness standard.

The New Jersey court responded in a very troubling way to the Twin Rivers Business Judgment Rule trump card. The court first combined the carefully delineated Levandusky distinctions – “In a variety of instances, the [rule] has been held to be subject to overriding requirements of reasonableness, good faith and fiduciary responsibility” – and then conflated its eviscerated Business Judgment Rule with constitutional standards intended to control governmental overreaching. It said that associations of individuals owning private property must act reasonably toward each other, and worse yet, if their association looks enough like a small town, they also must provide their members with constitutional protections. In one fell swoop, the Twin Rivers court proceeded down the slippery slope of governmental regulation and court review of a large chunk of private associations’ interactions with their members. If the New Jersey Supreme Court upholds Twin Rivers, this can mean trouble for New York City and beyond.

With regard to the Business Judgment Rule, the New York courts have moved slightly in the direction of New Jersey. In spite of the Ansonia case, the day could soon arrive when New York applies constitutional standards to co-op/condo board decision-making. For example, that could mean that co-op/condo apartment owners may be entitled to constitutional “due process” rights with regard to imposition of fines and other sanctions for alleged violation of house rules. And the free expression rights of the U.S. Constitution, as well as the New York State Constitution, may be deemed to protect apartment owners campaigning for board election.

In short, New Jersey courts are classifying community associations as governments. New York could soon follow – and that could mean more red tape for board members.