Risky Business

Community service should be a fulfilling activity in which one's contributions can be measured through self-appraisal and sometimes even recognized by others. The dark side to serving on a co-op or condo board is the threat of liability.

What kind of liability should a board be concerned about? The areas include negligence, discrimination (either in employment or housing decisions), defamation, and financial matters (liens and inadequate reserves, perhaps leading to assessments), architectural matters, and criminal activities (forgery, embezzlement, and outright theft).

It can't happen to you? Guess again. Here are case studies of some of the issues:

Discrimination. A number of association members lodged complaints against the association's longtime custodian. The board took action and fired the custodian. The custodian sued the association for age discrimination, and the case was settled out of court for $145,000.

Defamation. A security company alleged that a manager made false and slanderous remarks about it to the association's board. The company further claimed that the manager attempted to persuade the board to transfer the association's security business to another vendor. Although the claimant's suit failed, the manager's defense expenses exceeded $10,000.

Criminal Activities. An association's former treasurer had check-signing responsibility as well as access to the association's payroll checking account. The lack of internal controls within the accounting system allowed the treasurer to perpetrate an elaborate scheme in which she set up a fictitious company that allegedly provided services to the association. The loss wasn't discovered until after the treasurer had moved away. A thorough investigation determined that she had taken $200,000.

Another source reported these cases: a board spent $1 million defending itself against a resident who alleged that a special assessment was too high and inequitably distributed; an association resident paid $15,000 in attorney and court costs arguing over a $500 set of drapes; and a homeowner lost a court dispute over a fence which cost him $40,000 in legal fees. The
community association's legal tab was $61,000.

The Business Judgment Rule has created a presumption under law, when applied to a community association, that its directors act in good faith and are fully informed in order to act in the association's best interests. While about anyone can sue, in order to prevail, a unit-owner would have to demonstrate that the director did not act in good faith.

There is a wide body of case law testing this rule. One case involved unit-owners who had objected to an assessment for building repairs that had been approved by their board. The court held the propriety of the assessment in that the board, before authorizing the assessment, had sought and listened to professional opinions of engineers, auditors, and legal counsel, using its business judgment.

Still, you should not be lax in setting safeguards. What steps, short of insurance, can a board take to prevent claims from arising and then protect itself once claims are filed?

Policy Adoption. Execute and enforce an employee policy manual clearly spelling out board policy against any type of discrimination or harassment. A similar policy should be adopted in respect to dealing with prospective unit-owners or shareholders. These policies should then clearly be disseminated to all concerned, followed up by periodic orientation sessions. Further, every allegation should be logged in and disposed of properly, including termination of violators.

Structural or Aesthetic Changes. Seek the services of outside experts, such as architects and engineers and then be guided by their professional opinions.

Breach of Fiduciary Duty. Adopt and strictly enforce regulations prohibiting self-dealing. Ensure that each director fully knows his/her obligations and responsibilities. Err on the side of caution by soliciting counsel's opinion on any proposed action of any significance.

Insurance Coverage. Get insurance. The basic policy is a Directors & Officers (D&O) liability and should be supplemented by an Employment Practices Liability (EPL) and Employee Dishonesty (crime policy). While some insurers offer a single policy embracing all three coverages, problems may arise if they share a single aggregate limit. There have been cases where a successful EPL suit significantly eroded the limit left for any D&O liability action.

Broad coverage is available for D&O liability, EPL, and crime, separately or all in one policy. The details:

D&O Liability Coverage insures board members against having to pay out-of-pocket compensatory damages, attorney fees, and other legal costs associated with suits alleging mismanagement, self-dealing, conflict-of-interest, housing discrimination, acts beyond authority granted by covenants, conditions, and restrictions, violation of certain federal and state laws, breach of contract, and breach of fiduciary duties.

Employment Practices Liability Coverage protects board members and the association against settlements and damages resulting from charges of discrimination, sexual harassment, and wrongful termination.

Crime Coverage protects the association from losses resulting from employee theft, disappearance of money and securities, forgery, funds transfer fraud, credit card fraud, and other criminal acts.

Broad Definition of Insured Persons includes past and present directors, officers, trustees, employees, and committee members, as well as property managers and their employees. "Second generation" claims arising from property damage (other than those related to a construction defect or specified perils) are covered. Coverage is also available for property manager wrongful acts, including acts, errors, and misstatements made while providing real estate property management services at the direction of the association board. Protection for Community Association Leaders, D&O liability insurance, and employment practices liability insurance are written on a claims-made basis. Crime insurance is written on a loss-sustained basis.

Duty-to-Defend Coverage means that your insurance carrier will appoint experienced counsel to defend the insured should it be sued.

In the end, insurance protection is available from several sources, but it should be considered the last line of defense. Sound, businesslike practices will go a long way in terms of preventing claims.

Herbert H. Feldman is president and CEO of Alpha Risk Management, a 29-year-old risk management consulting firm.