East Bay Panel Update – Director Liability

What did we learn at the East Bay Panel? A recent court case narrows the protection of the “Business Judgment Rule” for board members just a little bit more. 

Two weeks ago, we met with a great group of ECHO members at our East Bay Resource Panel. We were gathered to talk about the recent Parth case and how it affects the personal liability of HOA directors. Ann Marquis-Fisher, chair of the Panel and president of her HOA, invited attorney Mark Wleklinski to speak about the case, and David Stompe to discuss the insurance implications.

Here’s a not-so-brief summary of what we learned (it’s long because it’s important!):

Why You Need to Know Your Documents

Erna Parth was a director on the board of Palm Springs Villas II HOA. Her HOA sued her for decisions that she made while on the board, saying that she had breached her fiduciary duty. Ms. Parth, however, claimed that she should be immune from liability because of the “business judgement rule” and “judicial deference.” Also, the association’s governing documents contained language protecting director decisions.

Both the Business Judgment Rule and the principle of Judicial Deference help to protect board members from personal liability, even when they make bad decisions. So what happened here?

To understand, you need to know something about both terms.

Business Judgment and Judicial Deference

Business Judgement Rule. This rule says that Directors are not personally liable for decisions that result in damage or loss to others, provided their decisions were made in good faith, in a manner which the directors believe to be in the best interests of the corporation, and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.

In other words, you can’t be personally sued if you put your community first, did your homework, and used common sense.

Judicial Deference. Also called the “business judgment doctrine,” this principle means the courts will defer to business decisions of a board even if a reasonable person would have acted differently. The courts will also assume that directors’ decision are based on sound business judgment. In both circumstances, the suing owner must prove that an association’s decisions do not deserve this deference.

In other words: The courts are going to assume that the association made a reasonable choice, unless the homeowner can prove a specific set of facts.

The Parth Case

But back to Erna Parth. Ms. Parth, claiming to operate with the authority of the board, made a string of questionable decisions. Here are a few:

• Roofing repairs. Without consulting the board, Ms. Parth hired an unlicensed contractor to make roofing repairs. The board ultimately hired the roofer, but did not see many of the checks (signed only by Ms. Parth) paid to the roofer. The work was later determined to be both overpriced and deficient.
• Repaving projects and loans. In order to fund a paving project, Ms. Parth signed for loans totaling more than $1.5 million without the approval of the membership as required by the governing documents.
• Landscaping. Ms. Parth and other board members approved a 5-year landscaping contract in violation of their governing documents.
• Termination of management. In spite the board’s decision to table the discussion of terminating their management company, Ms. Parth hired a new management company.
• Security contract. Ms. Parth entered into a security contract on behalf of the association but without approval from the board. The board’s refusal to ratify or pay for this contract ultimately lead to a lawsuit from the security company.

You can visit this site to read the complete details of this case, Palm Springs Villa II HOA vs. Erna Parth.

What Went Wrong?

If bad decisions are protected by law, why weren’t these decisions protected? The court held that:

When courts say that they will not interfere in matters of business judgment, it is presupposed that judgment—reasonable diligence—has in fact been exercised. A director cannot close his eyes to what is going on about him in the conduct of the business of the corporation and have it said that he is exercising business judgment.

In other words, a director must be “reasonably diligent” before the court will apply the business judgment rule or judicial deference. The court also held that language in the governing documents protecting board decisions is subject to the same limits.

Limits on Board Protections

We’re going to assume that ECHO Members are not like Erna Parth. But what does this case mean for you? It means that a board member must show the court that they deserve the protections of the “Business Judgment Rule” and “Judicial Deference.”

You cannot assume that you are protected.

Here are two areas where you need to be particularly careful:

You must know your governing documents. Decisions of the board, even spectacularly bad ones, are usually protected by the Business Judgment Rule. But if those decisions violate the governing documents, the Rule may not apply.

You must investigate and decide. If the board doesn’t investigate a problem, use qualified experts, and fails to make a repair decision, their inaction does not receive judicial deference. In other words, only an investigation and decision qualifies for judicial deference, even if the decision is to do nothing.

A Note about Insurance

Most associations carry Directors & Officers insurance to provide protection against losses (including attorneys’ fees) that result from wrongdoing or negligence. David Stompe highlighted three important points:

• Always tender to insurance. Insurance companies often deny claims that are not submitted in a timely fashion. If know about a potential claim, it’s important to submit it to insurance promptly.
• Check your coverage. This may seem obvious, but coverage should be extensive, and should include claims for libel or slander (or other defamation), discrimination, and attorneys’ fees.
• Check your exclusions. Avoid policies that contain an “insured vs. insured” exclusion.