“Arbitrary and Capricious” Confronts the “Business Judgment Rule” at 137 Duane Street

This was originally published on the SGR Blog.

What Standard Applies in Article 78 Proceeding Challenging Decision of Board of Managers?

Proceedings challenging board decisions under Article 78 of the Civil Practice Rule are governed by the test of whether the disputed action was “arbitrary and capricious”. But challenges to the action of members of the boards of residential condominiums are governed by the “business judgment rule”. So which standard governs when a condominium unit owner questions the conduct of the board of managers?  A recent case addresses that question.

Notoya Green, as Trustee of a family trust, sought an Article 78 order: annulling and setting aside, as arbitrary and capricious, the rejection by the Board of Managers of Diamond on Duane Condominium, of her alteration application with respect to the renovation of two units; and  compelling the Board to consent to the requested alterations or deeming that no consent was required under the building’s governing documents.

Green resided with her family in residential condominium  Unit 2C at 137 Duane Street in Manhattan, which she bought in since 2010. After residing in the building for several years and starting a family, Green became interested in expanding her living space and expressed an interest in purchasing the space next to Unit 2C, a separate room designated in the Condominium’s Offering Plan as Commercial Unit 5. The Commercial Unit at the time was a “Sponsor Unit” not owned by a separate entity. Green contacted the Sponsor with an offer and the offer was accepted.

Green alleged that the Board engaged in numerous acts of obstruction to thwart the sale of the Commercial Unit. And asserted that the Board was opposed to the sale because the Commercial Unit had been used for several years as an office for the Condominium’s superintendent, for which the Board paid no rent. At first, the Board objected to the sale by arguing that Green had not obtained a right of first refusal but withdrew that argument after Green pointed out that the Condominium Declaration did not provide for a right of first refusal for the sale of a Sponsor Unit.

According to Green, the Board then attempted to impede the sale a second time by informing her that there were outstanding common charges in the amount of $61,309.98 for the Commercial Unit. Green claimed that the sum was grossly inflated by the Board given that the monthly common charges for the unit were $60.76, meaning that it would have taken over 85 years for such an amount to accrue. But Green nevertheless agreed to indemnify the Commercial Unit’s seller for the claim of common charges owed and closed on the sale of the Commercial Unit in September 2018.

Green submitted an alteration application to the Board in April 2019, detailing her plans to combine her Residential Unit with the Commercial Unit by tearing down the wall between the two spaces. On May 28, 2019, the Board rejected her application and informed her that the Condominium’s Declaration and By-Laws prohibited her from combining the two units. Those documents did not permit the combination of a residential and commercial unit.

Green alleged that her husband then attempted to negotiate with Leo Pustilnkov, a Board member, regarding how the alteration application might be approved. Pustilnkov offered to approve the alteration only on the condition that Green find another suitable space for the superintendent to work in the building. And also alleged that Pustilnkov attempted to coerce her to purchase a different adjoining unit in the building, ostensibly so the superintendent could still use the Commercial Unit.

Green filed a proceeding in landlord/tenant court to evict the superintendent from the space, which resulted in a stipulation in which the Board agreed to turn over possession of the Commercial Unit on August 21, 2019.

Green then filed the  Article 78 proceeding seeking to annul the Board’s rejection of her alteration plan, on the grounds that the rejection was made in bad faith and was arbitrary and capricious — because the Condominium’s governing documents did not expressly prohibit the alteration sought. And Green also claimed entitlement to an award of legal fees pursuant to the By-Laws, which provided that such fees may be recovered by an aggrieved unit owner in a legal proceeding related to the Board’s breach of the By-Laws, rules, or other regulations.

The Board argued that its decision to reject the combination of  the two units was a legitimate business decision protected by the business judgment rule. Asserted a counterclaim for breach of fiduciary duty against Green’s husband, a board member, arguing that he engaged in improper self-dealing by utilizing information gleaned from Board meetings to negotiate the purchase of the Commercial Unit. And also sought an  award of legal fees based upon the same provision in the By-Laws cited by Green.

The Court’s role in the Article 78 proceeding was to determine, upon the facts, whether the determination had a rational basis in the record or was arbitrary and capricious. A determination is only deemed arbitrary and capricious if it was without sound basis in reason, and in disregard of the facts. However, if there was a rational basis for the determination, there could be no judicial interference.

While challenges to administrative agency decisions always take the form of Article 78 proceedings, challenges to the propriety of corporate board action have been lodged as derivative suits, injunction actions, and all manner of civil suits, including Article 78 proceedings.

In the seminal case of Levandusy v One Fifth Ave. Apt. Corp, the Court of Appeals held that, regardless of what type of proceeding has been initiated, the applicable standard under which to evaluate condominium and co-operative board decisions was the business judgment rule, which differed from the typical Article 78 arbitrary and capricious standard.

In light of the instructive Levandusy holding, the Court evaluated the Board’s decision not under the arbitrary and capricious standard, but rather under the business judgment rule.

Under the business judgment rule, the Court’s inquiry was limited to whether the board acted within the scope of its authority under the bylaws and whether the action was taken in good faith to further a legitimate interest of the condominium. Absent a showing of fraud, self-dealing or unconscionability, the Court’s inquiry was so limited and it would not inquire as to the wisdom or soundness of the business decision.

Under the business judgment rule, Board decisions are generally upheld unless the actions are taken in bad faith or in furtherance of a purpose that does not serve the goals of the condominium. Absent such circumstances, the Court would defer to the Board’s judgment as long as it acted consistent with its by-laws.

As a preliminary matter, the Court noted that the sole question presented was whether the Board’s denial of Green’s application to combine her residential and commercial units was protected by the business judgement rule. Her allegations that the Board attempted to “thwart” her purchase of the Commercial Unit were moot as she did eventually purchase the Commercial Unit, and thus there was no decision rendered by the Board pertaining to the purchase of the Unit itself that the Court could evaluate in the Article 78 proceeding.

In support of her argument that the Board’s denial of her alteration application was improper and not protected by the business judgment rule, Green relied on the following two provisions of the Condominium’s Declaration that pertain to Commercial Unit alterations:

  • Except to the extent prohibited by law, a Commercial Unit Owner shall have the right, without the requirement of consent of the Board of Managers, the other Unit Owners or anyone else, (a) to make alterations, additions and improvements, whether structural or nonstructural, interior or exterior, ordinary or extraordinary in, to and upon its Unit or any Limited Common Elements appurtenant thereto and (b) to install any ducts, stacks, chutes, or chases reasonably required in connection with the renovation of the Unit or any limited Common Element appurtenant thereto provided (i) that the nature and location of such installation does not interfere materially with the use then being made of any other Commercial or Residential Unit or any Limited Common Element and (ii) that the then owner of the Unit complies with zoning requirements and all other laws, ordinances and regulations of all governmental authorities having jurisdiction.Commercial Unit Owner (including the Sponsor or its designee with respect to Units owned by it or such designee) shall have the right (i) to change the layout of the Commercial Unit, and (ii) to change the size and/or number of the Commercial Unit including subdividing a Commercial Unit into additional Commercial Units or combine two or more Commercial Units into one such Unit, including, without limitation incorporating into such Unit a wall[.]

And a similar provision in the By-Laws of the Condominium:

  • The Commercial Unit Owners will have the right to make any structural addition, alteration or improvement in or to the Commercial Unit or any Limited Common Element appurtenant thereto with the requirement of consent of the Board of Managers or any other Unit Owner, if it does not affect the portion of the Building utilized by any other Unit Owner.

Green argued that those provisions provided that Commercial Unit owners may make alterations without Board approval as long as the alterations do not affect another unit owner or a common area of the building. And the Board erred in denying the application because the proposed alteration merely involved knocking down a wall between her adjourning units The Board’s denial of the application was undertaken in bad faith “retaliation” against Green because her purchase of the Commercial Unit took office space away from the Condominium’s superintendent.

The Board argued that, while the governing documents afforded commercial unit owners wide discretion in alterations they wished to make within their units, the governing documents were completely silent regarding the combination of residential and commercial units. The provisions cited by Green conveyed no entitlement to engage in such combinations without Board approval. The determination that such combinations were barred was in and of itself a decision that was subject to the protection afforded by the business judgment rule.

Notwithstanding Green’s correct assertion that such combinations were not explicitly precluded in the governing documents, the Court had no grounds to challenge the Board’s judgment to not allow unit owners to undertake alterations not expressly permitted. Therefore, the Board acted within the scope of its authority when it issued its denial of Green’s alteration application.

Green contended that, even assuming, arguendo, the Board was within its authority to deny the alteration, the decision nevertheless was not protected under the business judgement rule as it was made in bad faith. However, Green’s claims that the denial was issued in retaliation were completely unsupported by the evidentiary record.

In her papers, Green claimed that she and her family believed they were treated differently as they are the only African American family in the building . The only support provided for that assertion was a list of non-African American building residents who were permitted to perform major alterations in their units. However, none of the examples cited involved a combination of residential and commercial units. Green did not introduce any factual link between the race of her family and the circumstances surrounding the Board’s denial of the alteration application. The claim of disparate treatment was disregarded by the Court as unsubstantiated.

Green did not provide any documentary evidence to corroborate her assertions that the Board attempted to bribe her family into purchasing a different Commercial Unit on the condition that the alteration application would then be approved. The only communication provided was a series of emails between Green’s husband, Fred Mwanngaguhunga, and Pustilnikov discussing the additional space for sale in the building.  The email chain concluded with her husband informing Pustilnikov that they were not interested in purchasing another unit. And nothing in the chain reflected an express or implied threat from Pustilnikov to withhold approval of the alteration. The only other documentary evidence submitted was the rejection letter sent by the Board, which merely stated the reasons for the rejection of the alteration and did not convey any bad faith intent.

The Court concluded that Green simply had not shown that Board acted outside the scope of its authority, in a way that did not legitimately further the corporate purpose or  in bad faith. The Board’s denial of the alteration application was thus a decision made within its authority and protected by the business judgment rule.

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