New York's Cooperative and Condominium Community

Habitat Magazine Insider Guide



Business Judgment Rule

Preventing A Mutiny

Paula Chin: Welcome to Legal Talk, a conversation about governance issues that New York's co-op and condo boards are tackling today. I'm Paula Chin with Habitat, the New York City magazine for co-op and condo board directors. My guest is Bruce Cholst, a partner at the law firm Herrick Feinstein. Boards sometimes think the business judgment rule is a safety bubble that pretty much anything they say and do is protected, but it's not an ironclad shield and there are nuances they need to be aware of.
Bruce, can you give us an example of how a board might misstep and what the consequences would be?
Bruce Cholst: Sure. And thank you Paula for having me on this episode of Legal Lessons. It's always a pleasure to participate on this program. Simply put, the business judgment rule states that with four exceptions, when a co-op, condo or HOA board issues a rule or policy, a court cannot overrule it, no matter how strongly the judge may disagree with that rule or policy. No matter how stupid, arbitrary, capricious or misguided the judge might believe that policy to be those four exceptions constitute the primary potential missteps of which boards need to be aware when they seek protection under the business judging rule. If a board does not tread carefully and its rule or policy falls within any one of these four exceptions, a court may overrule the board, invalidate the policy or restriction, and might even hold the board liable for monetary damages. These four exceptions are as follows.
First, if the rule or policy is inconsistent with the association's governing documents, then the association, the board just doesn't have the authority to issue that regulation or restriction.
And therefore it could be voided by a court if challenged legally. Secondly, the regulation must comply with all statutory requirements and all aspects of existing case law because it's illegal, if it's against the law, then a court is going to invalidate it. Third, the regulation cannot, in its application, constitute a breach of the board's fiduciary duty to its owners because the court's not going to sanction that.
And it's not withstanding the business judgment rule, it's going to overrule the regulation. And finally, the courts impose a requirement that any board regulation must be in furtherance of a legitimate corporate purpose. That's a very easy test to pass. Anything that even smacks of a valid corporate purpose is going to pass that test.
But if, for example, a board decides to fund a trip for itself to the Mardi Gras order to see how associations can promote parties. That, for example, would not be a legitimate corporate purpose and probably not pass that test.
But there's a fifth area in which boards also need to tread carefully, and that's when even when a board's rule or policy satisfies each of those four legal requirements for protection under the business judgment rule, it may be unpopular with the community that the board runs, the risk that the community residents at the next board election are going to challenge the board, overthrow it in a proxy fight, and then reverse the policy. And that has happened on several occasions. So a board's room making. Can't be out of line with, that drastically out of line with the pulse of the community.
And that's really another pitfall of which board should be aware.
Paula Chin: Bruce, I understand there's a case out in Suffolk County where the board ran into precisely this trouble. Can you tell us about it?
Bruce Cholst: Sure, I'm familiar with that since I litigated it on behalf of the h Suffolk County HOA, which I represented.
And in that case, the board passed a rule banning the use of pickup trucks anywhere within the community's property, on the ground that they thought that pickup trucks were downscale and therefore contrary with the image, the upscale image that this board was trying to promote. And there were numerous pickup trucks, even though existing vehicles were grandfathered, that new ones were prohibited and the community was up in arms.
They challenged the rule legally. Because it passed all four of those tests, which I just described, the court upheld on the grounds of the business judgment rule, upheld the regulation. But the judge specifically said, I don't necessarily agree with the rule itself, but I am forced to obey the law.
And upheld it on ground, uphold the regulation on grounds of the business judgment rule. But, and this is really crucial, the court said that the plaintiffs, the owners who are challenging the regulation have political remedies, not legal remedies, quote unquote. And the community residents picked up on the hint,
they staged the proxy fight at the next annual meeting. They won, they threw out the entire board, replaced it, and immediately repealed the ban. The board's purpose because it was out of line with communities thinking it was undermined and defeated for that reason. So this case is a perfect illustration of that fifth principle, which is to make sure that your, the regulations are not too far out of line with the pulse of the community.
Paula Chin: So when the judge noted that owners had political unit owners had political remedies, he did mean precisely this. In other words, sort of social activism.
Bruce Cholst: Exactly. And political remedies, meaning they could go to the polls and reverse the board's judgment that way.
Paula Chin: Now, were you surprised at the judge's ruling? I suppose on one level you could look at the ban as a little bit classist and discriminatory.
Bruce Cholst: Yes. I personally agree with that assessment. However the thing about discrimination is that boards can be as discriminatory and arbitrary as they wish, as long as they don't discriminate on areas which are, there, there are 19 protected categories which in which boards cannot discriminate.
They're called protected classes, and as long as boards' discriminatory activities, steers clear of those 19 protected categories, the discrimination is not illegal and therefore it's within the purview of the business judgment rule. Social class is not one of those 19 protected areas, and therefore, legally speaking, it's not discriminatory.
Paula Chin: That's interesting. What would you say is the takeaway for board directors here, Bruce?
Bruce Cholst: I think the takeaway for board directors is to think about the political dimensions of what they're doing when they do impose restrictions and not just concern themselves with the four exceptions which give them which, which would work business judgment rule protection. Be aware of what they're doing politically because that, this aspect could come back and act as a boomerang and undermine the purpose of their regulation. And from a a, an owner's point of view, I think the takeaway is consider political remedies as well as legal remedies and pay attention to the business judgment rule. As you said, it's a very powerful shield for a board and maybe consider the political alternative.
Paula Chin: And in this case, it's not only that the board's ban was overturned, but the board itself got ousted, which is a pretty severe consequence. Bruce, this has been really informative. Thank you so much for joining us.
Bruce Cholst: My pleasure.

Bruce Cholst, Partner, Herrick Feinstein

Exceptions to the rule. The business judgment rule states that courts cannot overrule board policy no matter how strongly a judge may disagree with it as long as it’s 1) consistent with the governing documents, 2) complies with the law, 3) furthers a legitimate corporate purpose and 4) doesn’t violate the board’s fiduciary duty. That’s an easy test to pass. But there is a fifth area where boards have to tread carefully — making a decision that’s so unpopular that owners rise up and revolt.  

Cautionary tale. I worked on a case in Suffolk County where a homeowners association board passed a rule banning the use of pickup trucks anywhere on the community property on the grounds that they were downscale and contrary with the upscale image it was trying to promote. The owners sued, but the court upheld the policy on the grounds of the business judgment rule. The judge, who was opposed to the policy, noted that the owners had political remedies, and they picked up on the hint. They staged a proxy fight at the next annual meeting, threw out the entire board and voted in a new one that repealed the ban. 

Letter of the law. You could look at the board’s ban as classist and discriminatory. But as long as actions taken by a board steer clear of the 19 protected categories — and classism isn’t one of them — the discrimination is not illegal. So the court’s ruling wasn’t surprising. Still, boards need to think hard before making decisions that may fall within the exceptions protected by the business judgment rule, but are way out of line from the pulse of their community. That kind of mistake could boomerang and come back to bite you — with very severe consequences.

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