Bruce Cholst, Partner, Herrick Feinstein in Legal/Financial

The business judgment rule often serves as a perceived safety net for boards, shielding them from legal scrutiny. However, this rule is not an impenetrable shield and boards should be aware of the nuances. Simply put, the business judgment rule states that, with four exceptions, a court cannot overrule a co-op, condo or HOA board-issued rule or policy no matter how strongly the judge may disagree with it. However, there’s a fifth consideration when it comes to the business judgment rule, and that is the political impact of a particular policy. Boards should not only focus on meeting the four legal requirements for business judgment rule protection but also be aware of potential community backlash. 

The four exceptions. The first exception to the broad protection of the business judgment rule arises if a rule or policy is inconsistent with the building’s governing documents. Boards must adhere to the authority granted by these documents, and any deviation could lead to legal challenges and the voiding of the regulation. Second, the proposed policy or rule must comply with all statutory requirements and all aspects of existing case law. If it’s illegal, 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 shareholders or unit-owners. 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 valid corporate purpose is going to pass that test.

A fifth consideration. Even if a board’s rule satisfies the legal requirements of the business judgment rule, it may face opposition from residents if it is unpopular with the community it serves. Boards need to tread carefully even when a rule or policy satisfies each of those four legal requirements for protection under the business judgment rule. It may be so unpopular with the community that the board runs the risk that the residents at the next board election are going to challenge the board, overthrow it in a proxy fight, and then reverse the policy. 

A case study. Recently, we represented a Suffolk County HOA where the board banned the use of pickup trucks anywhere within the community’s property grounds. The board thought pickup trucks were contrary to the upscale image it was trying to promote for the community. Discrimination, while subjective, is not illegal unless it falls within the 19 protected categories, and social class is not one of them. The ban faced strong opposition from residents and a group of them challenged the rule legally. Because it passed all four of the business judgment rule tests, the court upheld the regulation. However, the judge told the plaintiffs and the owners challenging the regulation that they had political remedies rather than legal ones. Residents picked up on the hint. They staged a proxy fight at the next annual meeting. They won, threw out the entire board and replaced it, and immediately repealed the ban. So the board’s purpose, because it was out of line with the community’s thinking, was undermined and defeated. The case perfectly illustrates that fifth principle, which is to make sure regulations are not too far out of line with the pulse of the community.