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BOARD OPERATIONS

A Reminder: Under Business Judgment Rule, Judgments Must Be Reasonable

Richard Siegler and Dale J. Degenshein in Board Operations on May 21, 2013

75 East End Avenue, Upper East Side, Manhattan

Business Judgment Rule Reasonableness
May 21, 2013

May a co-op's managing agent reject a potential buyer of unsold shares solely on the basis of the co-op's "financing rule"? That was the issue addressed in the recent case Elias v. Orsid Realty Corp. after Orsid, seemingly reasonably, adopted that board's own policy.

In 2010, when two apartments were being sold, Orsid asked Elias and Senbahar to see that their purchasers met the terms of the financing rule or risk losing the sales. On April 26, 2010, the management company informed Elias and Senbahar that it would not consent to selling Apartment 5C — for which the contract had been signed in February —– because the potential buyers proposed to obtain 75 percent financing, violating the rule.

In response, Elias and Senbahar sought a declaratory judgment that their shares were not subject to the financing rule adopted by the board, and sought a corresponding injunction prohibiting Orsid from applying the rule to the sale of their shares. Orsid then sought a summary judgment.

The Court Rules

In reaching its decision, the court relied on the language of the proprietary lease and the rationale behind the board's use of the financing rule on tenant-shareholders. Unlike the board, it stated, Orsid was not permitted to "unreasonably withhold or delay its consent to the sales of unsold shares."

The court acknowledged that the financing rule was intended to safeguard the co-op's interests in the financial stability of its shareholders. Orsid, acting on the co-op's behalf, owed a duty to protect the interests of tenant-shareholders by reviewing prospective buyers' finances for financial integrity. The court reasoned, however, that buyers who propose to finance more than two-thirds of the purchase price were not necessarily financially weak; and by limiting its analysis of a prospective buyer to only the proposed financing of the purchase price, Orsid excluded other factors bearing on a buyer's financial adequacy, and consequently, the co-op's interests.

Boards must be mindful their

actions may be protected

by the Business Judgment

Rule but still not be acceptable.

And there were plenty of other factors: At Orsid's request, applications to purchase Elias and Senbahar's unsold shares had included potential buyers' employment records, income tax statements, contracts of sale and applications to and commitments from financing institutions – documentation not considered by Orsid in cases where the buyer failed the financing rule. The court concluded that consideration of only the financing rule, to the exclusion of all other factors that may bear on the buyer's finances, was unreasonable.

The Takeaway

This case reminds us there is a difference between the Business Judgment Rule and a requirement that a board or its agent act "reasonably." Under the rule, a court defers to a board if its actions are taken in good faith, with honest judgment, for the lawful and legitimate furtherance of corporate purposes. Although some of the case law is unclear, typically, the Business Judgment Rule will not apply if the document at issue — a proprietary lease or bylaws, for example — requires consent to be "reasonable" or "not unreasonably withheld." Cases have said that this reasonableness standard requires that the board or its agent take actions "legitimately related to the welfare of the cooperative." 

In many circumstances, this is a distinction without a difference. As demonstrated in this case, however, boards and their agents must be mindful that there can be actions that may be protected under the rule but may not be acceptable.

It has been the law for several years that a managing agent has the right to impose the rules of a cooperative if the proprietary lease requires the agent — and not the board — to approve purchasers of unsold shares. Here, the court determined that the board's rules could be applied in principle. But because specific language in the lease required the managing agent to be "reasonable," it could not reject a purchaser solely because the financing was in excess of the amount permitted by the board.

This decision is subject to appeal and therefore could be modified or reversed.

 

Richard Siegler is a partner in the New York City law firm of Stroock & Stroock & Lavan. Dale J. Degenshein is a special counsel for that firm. Danielle Grunwald, a law school graduate awaiting admission to the bar, assisted in the preparation of this article.

Illustration by Liza Donnelly. Click to enlarge

 

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