Business Judgment Rule

New Case Limits Protections of Business Judgment Rule for Conflicted Directors

It’s a Thursday night, you just got off of work, and you are ready to crack open a cold one with your favorite show—wrong, you are a volunteer board member for your homeowners association and have a three-hour long Board meeting to attend where you may or may not be greeted by disgruntled association members.

For the overwhelming majority, individuals that serve on the boards of directors for HOA’s are volunteers who serve the best interests of their communities and receive far less credit than they deserve. On the other hand, there are sometimes directors who serve their own personal interests, financial gain or otherwise. This was the case in Coley v. Eskaton (2020) 51 Cal.App.5th 943, involving an HOA with a five-member board, of which three of the five members were employees of corporate entities that developed and managed the community (collectively, “Eskaton Entities”).  The plaintiff, a homeowner, sued the HOA, the Eskaton Entities and two of the directors employed by the Eskaton Entities (“Director Defendants”), alleging that the Director Defendants ran the association for the benefit of the Eskaton Entities, rather than the association and its members.

The Eskaton Entities owned more than half of the units in the community, establishing majority vote in every association election and the power to consistently elect a controlling majority of the board. The salaries earned by the Director Defendants from the Eskaton Entities were dependent on the performance of the properties managed by the Eskaton Entities.

The plaintiff alleged that every decision made by the Director Defendants on behalf of the association was, in reality, made in the best interests of the Eskaton Entities and the Director Defendants’ own financial interests, all at the expense of other association members. For example, the Director Defendants voted to approve certain assessment increases against “patio-type” units and decrease assessments against “lodge-type” units for the payment of security services—you guessed it, the Eskaton Entities owned only lodge-type units.

Furthermore, the Director Defendants shared privileged communication between the association and its counsel with their own personal counsel for their defense in the action, among other lawsuits brought against them by association members. The court found the Director Defendants’ actions to be in breach of their fiduciary duties, and moreover, found the Director Defendants personally liable for their actions. The court opined that such “conclusion is inescapable” and that the Director Defendants’ roles as board members and as employees of the Eskaton Entities “left the directors in an irreconcilable conflict of interest.”

Generally, board members are shielded from personal liability through provisions of the CC&Rs, D&O insurance, and California law, including but not limited to, Corporations Code section 7231, more commonly known as the business judgment rule (“BJR”). In short, the BJR shields board members from personal liability so long as they: (1) act in good faith, (2) act in the best interests of the association, and (3) act with such care, including reasonable inquiry, as an ordinarily prudent person.

The court in Coley v. Eskaton found the BJR to be inapplicable because the Director Defendants were acting under a material conflict of interest and abused their positions on the board for their own financial gain at the expense of the association membership. Without the protection of the BJR, the Director Defendants were held personally liable for breaching their fiduciary duties.

Board members are held to a high standard in their services as fiduciaries to the HOA, regardless of whether or not such members are appointed by the developer of the association or elected by association members. Any act or omission by a board member that serves his or her interests over those of the HOA constitutes a conflict of interest and breach of fiduciary duty, stripping him or her of protections from personal liability, whether it be from the business judgment rule or elsewhere.

Accordingly, it is of utmost importance that any individual who intends to serve on the board take the position seriously, act in good faith, and act in the best interest of the HOA while avoiding conflicts of interest. This calls on board members to make reasonable inquiries, rely on expert opinions and reports, and exclude oneself from board decisions that may potentially create a conflict of interest.  Board members who serve conflicting interests will not be protected from personal liability by the BJR.

Republished from OC View Magazine with permission.