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Judicial Deference to Management Decisions in Planned Unit Developments
By Vincent Di Lorenzo
Planned unit developments, whether condominiums, cooperatives or homeowners' associations, are characterized by board management. Boards make three types of management decisions: adopting rules binding on unit owners, applying existing rules to particular actions or activities of one or more unit owners and making other decisions about the planned unit development such as those about expenditures and assessments.
Although unit owners agree to be bound by a board's decisions, there is fear of unchecked board power. The California Supreme Court, for example, noted that "[b]ecause of its considerable power in managing and regulating a common interest development, the governing board of an owners association must guard against the potential for the abuse of that power." Nahrstedt v. Lakeside Village Condominium Ass'n, 878 P.2d 1275, 1281-82 (Cal. 1994).
Two doctrines guide the courts in making a decision to review or not review the actions of board members: (1) a rule of reasonableness, recognized by the Florida courts and now generally followed; and (2) a business judgment rule, recognized by the New York courts and some other jurisdictions. Both doctrines are deferential to board decisions, with the business judgment rule being more deferential. These doctrines are examined below, including articulated reasons for judicial reluctance to interfere in planned unit development management.
Some Deference: The Rule of Reasonableness
Faced with legal challenges to board actions, including rules imposed on all unit owners, state courts have formulated a restriction on a board's unbridled discretion. This restriction takes the form of a rule of reasonableness. If a rule or action is determined to be unreasonable, it is not enforced against unit owners.
The rule of reasonableness that is imposed when reviewing board management decisions should not be confused with the duty to act reasonably that is imposed in various unrelated contexts. For example, in determining whether board members have exercised due care in managing an association, courts inquire whether they have acted reasonably-in other words, as an ordinarily prudent person would act. Similarly, in determining whether a resale or leasing restriction constitutes an invalid restraint on alienation, courts ask whether the restriction is reasonable. Although the courts employ the same term, "reasonable," in each of these situations, they give it varied meanings.
The case law involving condominium and homeowners' associations is largely uninstructive on the justification for imposing a rule of reasonableness. Most of the cases recognize the rule without explanation. Five justifications, however, can be gleaned from the case law.
It is uncommon for state statutes to impose a rule of reasonableness. Instead, the doctrine is typically recognized as a common law limitation on board power or because of limits found in the association's governing documents-for example, the condominium declaration or bylaws. The leading decision recognizing and defining a rule of reasonableness as a limit on board power is Hidden Harbour Estates, Inc. v. Norman, 309 So. 2d 180 (Fla. Dist. Ct. App. 1975). The court declared in Hidden Harbour:
[T]he 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. On the contrary, . . . the test is reasonableness. If a rule is reasonable the association can adopt it; if not, it cannot.
Id. at 182.
Under this standard, "reasonableness" means that the rule must relate to the condominium unit owner's health, happiness and enjoyment of life. For example, a rule limiting the number of pets a unit owner could keep in a unit was deemed a reasonable regulation because it was "based on potentially offensive odors, noise, possible health hazards, clean-up and maintenance problems and the fact that pets can and do defile hallways, elevators and other common areas." Dulaney Towers Maintenance v. O'Brey, 418 A.2d 1233, 1235 (Md. Ct. Spec. App. 1980). The rule of reasonableness seeks to draw a balance between the desire to defer to board decision-making and the desire to avoid unbridled discretion. Admittedly, the requirement that a rule relate to the health, happiness and enjoyment of life of the unit owners is not difficult to satisfy. Nonetheless, it avoids completely unchecked management power.
The Florida courts have made it clear that, under a rule of reasonableness, the board has the burden of both articulating reasons for the rule or action-which must serve the legitimate objectives of the association such as the health, happiness and peace of mind of the unit owners-and demonstrating that the rule or action is reasonably related to the fulfillment of these objectives. See Killean Acres Homeowners Ass'n v. Keever, 595 So. 2d 1019 (Fla. Dist. Ct. App. 1992); Hidden Harbour Estates, Inc. v. Basso, 393 So. 2d 637 (Fla. Dist. Ct. App. 1981). In the Basso case, for example, the condominium board had denied a unit owner's request to drill a well. The court agreed that the board's reasons for denying the request served legitimate objectives of the association. The court, however, was not convinced the board demonstrated that its action was reasonably related to the fulfillment of the stated objectives. There was no evidence that its fears, such as discoloration of commonly owned property, would materialize.
Courts have distinguished between restrictions contained in the condominium declaration and restrictions imposed by board rule-making. Typically, courts subject only the latter to the rule of reasonableness. The former are enforced unless they violate public policy or some fundamental constitutional right or are wholly arbitrary in their application.
California has adopted a different view of the proper standard to constrain board discretion. In Nahrstedt, the California Supreme Court embraced not only a rule of reasonableness but also a standard based on the property doctrine of equitable servitudes. Specifically, the court ruled that a restriction must be enforced unless "the burdens it imposes on affected properties so substantially outweigh the benefits of the restriction that it should not be enforced against any owner." Nahrstedt, 878 P.2d at 1278. This weighing process is done with reference to the condominium or homeowners' association development as a whole.
The California rule is not widely followed to date. The decision was based in part on the characterization of condominium restrictions as equitable servitudes in the California statute governing common interest developments. It does, however, illustrate the greater deference of state courts under the Hidden Harbour standard. As the California court explained in Nahrstedt, if a restriction bears no rational relationship to the protection, preservation, operation or purpose of the affected land, then it will not be enforced. Nahrstedt, 878 P.2d at 1287. If, however, a restriction does bear such a rational relationship, it might still not be enforced based on the weighing process announced in Nahrstedt.
The Hidden Harbour standard is quite deferential. Arguably, almost any rule or action agreed to by a board bears a relationship to the "health, happiness and enjoyment of life" of all unit owners. Thus, leasing restrictions have been enforced because they serve the purpose of inhibiting transiency, fostering participation in self-management and fostering greater compliance with rules and regulations. The Hidden Harbour standard merely requires that a restriction serve the health, happiness and enjoyment of life of the various unit owners. It does not require that the restriction be necessary to serve such a purpose. Similarly, age restrictions have been enforced under the rule of reasonableness because they serve the purpose of "providing appropriate facilities for the differing housing needs and desires of varying age groups." Constellation Condominium Ass'n v. Harrington, 467 So. 2d 378, 382 (Fla. Dist. Ct. App. 1985) (quoting White Egret Condominium, Inc. v. Franklin, 379 So. 2d 346, 351 (Fla. 1979)). The opportunity for judicial review is, however, introduced by the requirement that the board bear the burden of justifying the rule enacted or action taken.
More Deference: The Business Judgment Rule
The business judgment rule is a legal doctrine that restrains a court from overturning the management decisions of a corporation's board of directors or holding the board liable for any loss resulting from those decisions. It is also a rule of deference to management discretion. The court will not examine the soundness of management decisions or actions by substituting its judgment for that of the board. Although the rule was formulated in the corporate law area, some states have borrowed the doctrine and applied it to condominium associations, cooperative corporations and homeowners' associations.
Second, courts defer to the expertise of board members. The management decisions to which the business judgment rule applies are discretionary decisions. In the corporate world, board members are chosen for their experience and expertise in managing corporations. Courts are reluctant to substitute their decisions for those of experienced managers.
Third, courts recognize the difficulty of after-the-fact reevaluation. A court enters the picture many months after a management decision has been made. At that point, reconstructing the business climate and the factual circumstances that led the board to decide on one course of action over another is difficult.
For these three reasons, courts defer to the judgments of corporate directors and officers. Are these justifications relevant in the context of decisions made by condominium associations or homeowners' associations? Both the first and third justifications for the business judgment rule are relevant. Moreover, the first justification is the one primarily cited by courts applying the business judgment rule in the corporate context. The second justification-board experience and expertise-is more questionable because board members are often inexperienced in real estate management; however, the New York Court of Appeals has noted that board members are expert on the needs of their particular development. Levandusky v. One Fifth Ave. Apartment Corp., 554 N.Y.S.2d 807 (N.Y. 1990).
Reasons for Judicial Intervention
Whether a court applies a rule of reasonableness or the business judgment rule, it will review management decisions when:
The New York Court of Appeals confirmed this limitation on the deference to be accorded management discretion under the business judgment rule in Fe Bland v. Two Trees Management Co., 498 N.Y.S.2d 556 (N.Y. 1985). That case involved the validity of a board- and shareholder-enacted resolution imposing a transfer fee of $2,500 on all assignors of shares and proprietary leases in the cooperative. After ruling that the fee was not authorized under the cooperative's governing documents and was violative of the state's business corporation statute, the court considered the effect of the business judgment rule on its decision. It ruled:
Id. at 565.
The question of what constitutes an action taken in bad faith has been answered by several courts and legal commentators. Bad faith means that the action in question, such as the enactment of a particular rule, was not taken for legitimate corporate purposes. Some courts have rephrased this limitation to provide that a board's decision will not be disturbed if it can be attributed to any rational business purpose.
Similarly, actions taken without the exercise of due care are not insulated from judicial review. The business judgment rule does not excuse board members from their management duty to exercise due care. One commentator has explained the board's duty of care, in light of the business judgment rule, in the following terms: "Virtually all courts agree that directors will not be held liable for 'honest mistakes' of judgment. But most of them also say, in effect, that directors cannot act negligently. . . . [However,] drawing the line between an honest mistake and a negligent one can be difficult." R. Clark, Corporate Law 124-5 (1986) (footnote omitted). The duty of care requires the board to collect and evaluate all material information before making a decision-such as the need for, or wisdom of, imposing a particular new rule on unit owners. The duty of due care requires that board members make "informed" decisions.
An additional fiduciary duty that has received substantial attention in the case law involving planned unit developments is the duty of equal treatment of all unit owners, or at least all unit owners in the same or similar circumstances. The rule against selective enforcement is sometimes referred to as the duty to avoid arbitrary actions and decisions.
What is the difference? The reasons for setting aside judicial deference are the same under both the rule of reasonableness and the business judgment rule-lack of board power, failure to act for legitimate purposes and breach of fiduciary duty. Therefore, the real difference between the two rules is the allocation of the burden of proof. Under the business judgment rule, the unit owner must state factual allegations that establish one of these reasons for judicial intervention. Under the rule of reasonableness, the unit owner does not bear this burden with respect to the second basis for judicial intervention. Rather, the association must establish both that the action is for a legitimate purpose and that it is reasonably related to accomplishing such purpose.
The New York Court of Appeals has embraced a business judgment rule and therefore has preferred to be most deferential to board decisions. Not all courts and commentators agree, however. The Restatement of Property rejects the business judgment rule because it provides unit owners with too little protection. Restatement (Third) of Property (Servitudes) ' 6.13, cmt. b.
Uncertainty and Confusion in the Law
Court decisions considering the amount of deference to be accorded board decisions at times generate uncertainty or confusion. One example of court-generated uncertainty consists of decisions that use the term "reasonableness" or "business judgment" but do not explain whether they are embracing the full scope of each rule, including requirements regarding burden of proof. Some decisions actually use both phrases.
Several appellate decisions in the Florida courts illustrate this problem. After the two Hidden Harbour decisions, several appellate cases in Florida stated that "the business judgment rule" will protect a corporation's board of directors. See Cedar Cove Efficiency Condominium Ass'n v. Cedar Cove Properties, Inc., 558 So. 2d 475, 479-480 (Fla. Dist. Ct. App. 1990); Farrington v. Casa Salana Condominium Ass'n, 517 So. 2d 70, 71 (Fla. Dist. Ct. App. 1987); Tiffany Plaza Condominium Ass'n v. Spencer, 416 So. 2d 823, 826 (Fla. Dist. Ct. App. 1982). Nevertheless, those courts went on to state that this was true if the board acted in a "reasonable" manner.
The Hidden Harbour decisions involved restrictions in the condominium declaration and rules enacted by the board. The later decisions involved discretionary operating decisions. Were these later cases embracing a business judgment rule for board decisions other than rule-making? Unfortunately, none of the decisions discusses whether the unit owner or the board bears the burden of challenging or justifying the purpose behind the action taken. Therefore, it is not clear what rule the courts intended to apply.
A second example of court-generated uncertainty or confusion consists of opinions that state that they adopt a rule of reasonableness but do not impose on the board the burden of proving that its actions serve legitimate objectives and are reasonably related to serving such objectives. Thus, they are not adopting a true rule of reasonableness. One must look beyond the phrases employed by the courts and examine who bears the burden of proof.
The Restatement of Property adds to this confusion. The Restatement rejects the business judgment rule as the standard to guide judicial deference. It admits that there seems to be no difference between the business judgment rule and the rule of reasonableness on the substantive bases for judicial intervention. It then adopts the position that the unit owner has the duty of proving a breach of duty, which allows judicial intervention, including the duty to act reasonably. That is not a true rule of reasonableness. It is the business judgment rule.
In planned unit developments, unit owners subject themselves to rules and other decisions made by duly elected board members. Courts have been very deferential to such decisions, recognizing the need for rules and for a degree of management discretion. Legal principles employed to help determine when a court should interfere with management discretion include the rule of reasonableness and the business judgment rule. Although these two rules seem straightforward, lawyers arguing their cases and courts writing their opinions should be more precise when employing one standard or the other, thus establishing a clearer path for those that follow.
Vincent Di Lorenzo is a professor of law at St. John's University in Jamaica, New York. He is a member of the Real Property Division's CLE (A-1), Development, Operation and Management of Community Associations (H-1) and Homeowners and Community Associations (Including Cooperatives) (H-6) Committees.