The Business Judgment Rule Or The Reasonableness Standard: What To Do If A Court Must Examine Not Only The Process But The Decision

Eventually, lawsuits are an unavoidable fact of life for an association. The authors have defended associations in lawsuits that are filed by a member who is highly critical of the board’s decision. These suits allege that bad decisions were made in such matters as financial decisions to enforcing the association’s rules.

In a lawsuit that concerns a board’s decision, how the court decides to review the decision is vital. The issue is not completely settled in Connecticut. Classically, two methods of reviewing condominium board decisions have emerged: the Business Judgment Rule versus the Reasonable Standard. This article will examine both rules and will provide tips on what an association may do to limit its exposure to a lawsuit.

The Business Judgment Rule
Connecticut’s Supreme Court, in the case of Rosenfield v. Metals Selling Corporation, described the Business Judgment Rule as “a rule of law that insulates business decisions from most forms of review. Courts recognize that managers have both better information and better incentives than they. The press of market forces . . . will more effectively serve the interests of all participants than will an error-prone judicial process. . . . The business judgment rule expresses a sensible policy of judicial noninterference with business decisions made in circumstances free from serious conflicts of interest between management, which makes the decisions, and the corporation’s shareholders. Not only do businessmen know more about business than judges do, but competition in the product and labor markets and in the market for corporate control provides sufficient punishment for businessmen who commit more than their share of business mistakes.” It also recognizes that courts are hesitant to become a “super board member” that passes on every decision made by the board.

The Business Judgment Rule has been applied to condominium associations, especially in New York. In Connecticut, the Business Judgment Rule has been codified in the Non-Stock Corporation Act at Connecticut General Statutes § 33-1104 (b). This statute holds that “In discharging his duties a director is entitled to rely on information, opinions, reports or statements, including financial statements and other financial data… ” The exception to the doctrine is when the board acts fraudulently, in bad faith, with arbitrariness, or when there is a conflict of interest.

Bad faith, fraud and arbitrariness are difficult standards to prove under the law. Each doctrine requires proof of actions that amount to more than mere negligence. For bad faith, a plaintiff would have to marshal enough evidence to show what is referred to as “evil motive” or “willful” wrongs. For fraud, the plaintiff would have to show an intentional breach of trust for personal gain. Arbitrariness requires a decision made with no basis in facts or consideration of the underlying circumstances of the decision.

All these exceptions focus on the process of a board action. The Business Judgment Rule is designed to focus on the process, not to the eventual decision. Directors are allowed to make decisions that turn out badly. What is important is whether they used honest, or good faith, decision-making processes to reach that decision.

The Reasonableness Standard
The other standard that courts use in reviewing a board’s decisions is the reasonableness standard. This standard is prevalent in Florida. The reasonableness standard will review whether a board’s decision has a legitimate reason and whether that rule is reasonably related to fulfilling that reason. Therefore, the reasonableness standard will not only review the process of making the decision, but will also determine whether the eventual decision was reasonable under the circumstances.

In the Florida case of Hidden Harbour Estates, Inc. v. Norman, the Court of Appeal stated the reasonableness standard as: “the association is not at liberty to adopt arbitrary or capricious rules bearing no relationship to the health, happiness and enjoyment of life of the various unit owners. . . . If a rule is reasonable the association can adopt it; if not, it cannot. It is not necessary that conduct be so offensive as to constitute a nuisance in order to justify regulation thereof. Of course, this means that each case must be considered upon the peculiar facts and circumstances thereto appertaining.”

This standard is very fact-specific. What constitutes “health, happiness and enjoyment of life” is in the eye of the beholder. If reasonableness is the standard, the judge will determine whether the board’s decision and its processes were proper.

Connecticut’s Standard
Connecticut’s appellate courts have not yet specifically decided whether the Business Judgment Rule or the reasonableness standard applies to condominium associations. Two decisions illustrate, however, what Connecticut courts may likely decide.

In the trial court decision of Gallo v. Parke, in 2003, the court was asked to overturn the decision of a homeowners association. The court specifically rejected the use of the business judgment rule. Without so stating, the trial court employed a reasonableness standard, reviewing the association’s decision.

In 2006, the Connecticut Supreme Court decided the case of Weldy v. Northbrook Condominium Association. The Supreme Court examined the Common Interest Ownership Act (CIOA) and the board’s authority to enact rules under its own Declaration. While the Supreme Court stated that associations have “broad power”, it also favorably quoted Hidden Harbour Estates and the language regarding “health, happiness and peace of mind.”

Gallo is a non-binding decision and Weldy did not contemplate the business judgment rule. Weldy also did not discuss the reasonableness standard. It does not appear that the two rules were put at issue. The Non-Stock Corporation Act was not discussed either. It appears, however, that the Connecticut Supreme Court may adopt the reasonableness standard. Therefore, it would be wise to prepare for the eventuality that the reasonableness standard becomes law in Connecticut.

What to Do When the Board Acts
It has been the authors’ experience that almost any type of decision made by the board could be the subject of a lawsuit. Therefore, it makes sense to have the mindset that all board actions, even those that appear to be uncontroversial at the time, may someday be put under the judicial microscope during litigation. Because there is a chance that the reasonableness standard may become law in Connecticut, it is the authors’ opinion that boards should take steps to make their process and reasons for their decision known, especially since litigation may not commence until a couple years after the decision was made. Therefore, we would suggest the following practices when board decisions are made:

  • If a professional has been consulted, the identity of the professional should be noted in the minutes of the board meeting and what the professional recommended.
  • If data was used in making the decision, the board should retain the information for at least three years and also state in the minutes that it was considered.
  • Committee reports should be kept and maintained.
  • No rule or regulation should unfairly or disproportionately affect any group. Obvious examples are rules that affect those with disabilities. Another example may be a rule that disproportionately affects unit owners who lease their units as opposed to residential owners.
  • When a rule or regulation is adopted, the board should record in the minutes what prompted the need for the rule, how the rule will help the community as a whole, and what the rule is intended to accomplish.

As stated, not all lawsuits can be avoided. A wise board of directors, though, can take steps to minimize the exposure of a lawsuit if it takes steps to perfect the record and protect itself. The way to protect itself is to keep in mind that some day a court may be tasked with deciding whether the rule is reasonable and, therefore, make the process and decision-making as transparent as possible.

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