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Conflict of Interest

Oct 02, 2018

David Berkey, Partner, Gallet, Dreyer & Berkey

Section 713 of the Business Corporation Law deals with directors with conflicts of interest and how that might cause issues for a cooperative or a condominium. The statute is designed to promote full disclosure.


A conflicted or “interested” director is defined in the statute as a person who has a relationship either as a director or officer or investor in another entity that is seeking to do business with that director’s cooperative or condominium. If the interested director wants to steer the business to his related entity or an entity in which he has a financial interest so he can gain some financial advantage from the transaction, he and the board have to follow the dictates of Section 713.


Conflict of Interest 

No contract or other transaction between a corporation and one or more of its directors, or between a corporation and any other corporation, firm, association or other entity in which one or more of its directors are directors or officers, or have a substantial financial interest,shall be either void or voidable for this reason alone, or by reason alone that such director or directors are present at the meeting of the board, or of a committee thereof, which approves such contract or transaction, or that his or their votes are counted for such purpose. (Business Corporation Law, Sec. 713 and 727)


Transactions approved by a condo or co-op board that deal with entities related to board members are sometimes avoidable. Those transactions can be set aside if the interested director voted in favor of the transaction without telling his fellow board members about his conflict. To prevent that situation, board members should disclose all the material facts of their interest in the related entity, whether or not they have a financial interest in a transaction that's being considered by the board.  If full disclosure is made and the contract or transaction is approved by a majority consisting of disinterested directors – and you do not count the vote of the interested director – the transaction will not be open to criticism.


If you can't get a majority of the board consisting of disinterested directors – and that often happens with sponsor-controlled boards – then what you need to do is a unanimous vote of the disinterested directors approving the transaction for it to be one that cannot be set aside. If you can't get all of the disinterested directors to approve, then you have to go to the disinterested shareholders or unit-owners and get them to approve the transaction by majority vote.


If the transaction was improperly approved – for example, the president has a relationship with the company that is now being contracted to paint the building – then the board can set aside that transaction, set aside the contract. If the parties to the contract, such as the painting company, cannot show that its contract was fair and reasonable, it can be set aside. Unfortunately, we have had many situations where board members steer business to a friend or company in which they have an interest, and it turns out that the contracts weren’t reasonable and the price was above market value. Those contracts needed to be set aside.


How do we learn about these transactions? The New York State Legislature decided this was becoming a problem, so it passed a new law, Section 727, effective in 2018 that now requires disclosure of all transactions where there are interested directors on the board.


Two things have to happen under Section 727. First, every director has to be given a copy of Section 713, so they understand what it is to be an interested director.  Then, the board has to submit a report to the shareholders or unit-owners every year. Signed by each board member, it should contain information on every contract that was voted on by the board in which one or more board members had a conflict.


They have to list all the contracts voted on by the board, they have to list the name of the contract recipient, the contract amount, the purpose of the contract, the voting record, the date on which the vote occurred, and how each director voted. And then they have to say when the contract is going to be valid and how long the contract will last. You have to file the interested directors information every year. If, by chance, there were no contracts that year or if there were no contracts with an interested director, the co-op or condo still has to render a report stating this.


There are some practical problems that you should consider. We've seen situations where a board member's company contracted with the board to provide a service (painting, plumbing, general contracting work, landscaping), and we’ve also encountered cases where or a board member’s law firm or accounting firm has been hired by the co-op/condo. These are clearly interested transactions where the board member should not be voting. They are transactions in which a majority vote of disinterested board members need to approve. Or if you don't have the majority, a vote of every disinterested director approving the transaction.


Slightly more complex are situations where you have real-estate brokers sitting on the board. The perception your shareholders or unit-owners have when a real estate broker is serving is that the broker is controlling the application process and is going to make sure that his contracts are approved and he gets his commission. You need to remove that perception. The real estate broker should recuse himself or herself from the vote on sales. You should have independent board members vote either as part of an interview committee or as members of the whole board. This shows that the interested broker who's getting a commission has not participated in the transaction.


Other situations that we've had which are somewhat troublesome, but not clear, are conflicts or situations where a board member's relative controls the company which is seeking to contract with the board member’s co-op or condo. There you need full disclosure of the facts. You need to know whether or not the board member has any financial interest in his family member's company. If he's not getting any money from the transaction and it's just a familial relationship, technically the director is not an interested director.


Some co-ops and condos, however, decide that the conflict still exists because of the family relationship, so they adopt codes of conduct, requiring that a board member in such a scenario recuses himself or herself from the deliberations and the vote when they have a family member seeking a contract.


The toughest situations are when you have sponsor representatives on the board. In many cases, a sponsor will control the board for a period of time. If the sponsor wishes to enter into a contract with a management company that it controls, or if it signs a contract with some other company in which it has a relationship, then the sponsor is subject to 713 and 727 and has to file a report.


Here’s a horror story. There was a building in Manhattan that had a sponsor that had the ability to have control of the board but chose not to and allowed the resident-owners to run the board. During that period, the board voted to hire a law firm to investigate the sponsor and the condition of the building. It also filed a lawsuit against the sponsor for defective conditions. The following year, the sponsor took back control, fired the lawyer, ended the lawsuit. Some owners sued, and the court found the sponsor's actions to be invalid and allowed the law firm to continue its investigation and the suit to go forward.


There are other situations. Board members who are parties to lawsuits with their co-ops or condos come to mind. You have to look at each of them for their particular situations to determine if the board member has a financial interest in any matter under consideration. For example, if a board filed a condo lien against the unit owned by a board member and the board was going to decide whether or not to compromise the lien or settle the matter with that board member, the individual against whom the lien was filed should not be participating in the vote. It has to be done by the independent board members who don't  have a financial relationship with the party against whom the lawsuit was brought or the lien was filed.


Finally, I'll tell you about the lawyer's role. We advise board members and explain to them that they're fiduciaries. So Section 713 applies to them, and we explain the test of being a fiduciary. It was set forth almost 100 years ago by Judge Benjamin Cardozo when he said that many forms of conduct are permissible in a workaday world. But those bound by fiduciary ties are like trustees and are held to a standard that is stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive is the standard of behavior. That's what board members have to strive for.


Hopefully, board members with questions will consult their lawyers, and hopefully they will all comply with the dictates of 713 and 727. If they do, contracts will be properly approved and sunshine will be shed on the transactions, and shareholders and unit-owners will know that their board has been acting properly.

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