The Business Judgment Rule Is Both Shield and Sword

Copyright by, and republished with permission of, Habitat Magazine.

Many members of co-op and condo boards sleep well at night because of the Business Judgment Rule. It shields boards from second-guessing and legal challenges – provided they act in good faith and in the lawful and legitimate furtherance of a corporate purpose. But boards need to remember that the protections of the Business Judgment Rule have limits. This shield can be turned into a sword.

Two recent decisions by a New York appellate court illustrate the yin-and-yang nature of the Business Judgment Rule. In the first case, Gail Koff demolished an interior wall without authorization while combining two apartments in the Washington Irving Condominium in Harlem. When the condo board found out about the renovation, it required Koff to hire a civil engineer to assess the impact of removing the wall, and it assessed a fine of $1,500. But it did not require Koff to reinstall the wall. Rebecca Barber and Craig Hartbought Koff’s apartment in 2004.

Three years later, Mauricio Fernholz and Carla Arellano moved into the apartment downstairs from the combined apartment. They claimed that the absence of the wall in the upstairs apartment created a condition that amplified noise and vibration. Fernholz engaged an engineer who claimed that the removal of the wall was the cause of the noise and vibration. Hart and Barber then retained their own engineer, who concluded that the removal of the wall did not cause the problem. In 2011, the board retained the services of an architect who inspected the combined apartment, found that the building structure was intact, and concluded that the removal of the wall was not the cause of the noise and vibration. The board then hired an acoustical engineer to evaluate the noise level in the Fernholz apartment, but access to the unit was denied.

The board of managers rejected Fernholz’s request to require Hart and Barber to rebuild the wall, and Fernholz sued. The trial court denied the condominium’s motion to dismiss Fernholz’s claims. The court questioned whether the board had acted in furtherance of the corporate purpose and in good faith. “There are material questions of fact,” the court wrote, “as to whether the Board can be shielded by the Business Judgment Rule.”

The appeals court reversed this decision. Citing the board’s hiring of an independent expert who concluded that the removal of the wall did not cause the noise and vibration, the court concluded: “[Fernholz] submitted no evidence that the board’s actions were not taken in furtherance of a corporate purpose or that the board acted in bad faith, arbitrarily, or out of favoritism, discrimination or malice.”

So much for the yin. Now for the yang. In the second case, Richard Kallop and his mother, Joan Kallop, contracted to purchase an apartment in the Edgewater Park cooperative in the Bronx. After the board approved the sale, the Kallops gave notice of their intention to vacate their rented home, which then went into contract with a third  party.

When a dispute arose between the Kallops and the board over whether Richard intended to live in the apartment or if his elderly mother would live there alone, the board rescinded approval of the sale. The Kallops sued the co-op board, and the trial court granted the Kallops’ motion to compel the sale, on the condition that Richard Kallop use the apartment as his primary residence.

The appeals court affirmed the decision. “We conclude that [the board’s] decision to rescind its approval of [the Kallops’] purchase application…was wholly arbitrary,” the court wrote, “and thus not entitled to the protection generally provided to cooperative boards by the Business Judgment Rule.”

As this case illustrates, a shield can become a sword. So all boards need to remember that while the protections of the Business Judgment Rule may be considerable, they are not unlimited.

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