The Business Judgment Rule

The single most important decision affecting cooperatives and condominiums rendered by a New York court was the unanimous decision of the court of appeals (New York’s highest court) in Levandusky v. One Fifth Avenue Apartment Corp. It was written by Judge Kaye, now chief judge of the court, in 1990. In Levandusky, the court held that actions taken by the boards of directors of cooperatives and the boards of managers of condominiums would not be based on whether the decisions were reasonable but would be subject to the business judgment rule. Accordingly, board decisions would not be subject to judicial second-guessing unless the board acted beyond its authority or acted in bad faith or in a discriminatory manner.

Levandusky involved a declaratory judgment action brought by Dr. Ronald Levandusky, a member of the board of directors of One Fifth Avenue Apartment Corp. and a former president, to have the court order the lifting of a stop-work order issued by the board. That order prevented Levandusky from proceeding with the alteration of the kitchen of his apartment unless he restored a two-inch steam pipe to its original position and removed the jog he had installed in the pipe that enabled him to enlarge his kitchen.

The change in the steam pipe was not included in the plans that Levandusky had submitted to the board and its architect, although Levandusky claimed that he had discussed it with the building’s architect, who had voiced no objection. In response, the architect reported that he had had a general discussion with Levandusky and had not been commenting on any specific situation. The other interesting fact was that Levandusky was one of the authors of the co-op’s own renovation guidelines, which he was now ignoring.

Initially, the supreme court held that the board had acted unreasonably since the building’s engineer had indicated that it was feasible that the steam pipe could be moved without adversely affecting the building’s heating system – although he also advised against doing it. The court held the board to a reasonableness standard. After re-argument, the supreme court changed its position and ruled that the work could be stopped until the steam pipe was restored. Levandusky then appealed the decision. The appellate division was divided, with a majority agreeing with the supreme court’s original decision that the board’s action was unreasonable and therefore should be reversed.

The case then went to the court of appeals. It reviewed the standard that should be applied in judicial review of a challenge to decisions made by co-op or condo boards. The court, in examining this area of the law, noted: “As courts and commentators have noted, the cooperative or condominium association is a quasi-government – ‘a little democratic sub-society of necessity’...The proprietary lessees or condominium owners consent to be governed, in certain respects, by the decisions of a board. Like a municipal government, such governing boards are responsible for running the day-to-day affairs of the cooperative and to that end, often have broad powers in areas that range from financial decisionmaking to promulgating regulations regarding pets and parking spaces...

“The stability offered by community control, through a board, has its own economic and social benefits, and purchase of a cooperative apartment represents a voluntary choice to cede certain of the privileges of single ownership to a governing body, often made up of fellow tenants who volunteer their time, without compensation. The board, in return, takes on the burden of managing the property for the benefit of the proprietary lessees.”

Having analyzed the nature of the ownership of a cooperative or a condominium, the court then went on to fashion the level of judicial review appropriate for this form of home ownership, rejected the reasonableness standard, and provided a comprehensive explanation of its reasoning: “So long as the board acts for the purposes of the cooperative, within the scope of its authority and in good faith, courts will not substitute their judgment for the board’s. Stated somewhat differently, unless a resident challenging the board’s action is able to demonstrate a breach of this duty, judicial review is not available.

“In reaching this conclusion, we reject the test seemingly applied by the Appellate Division majority and explicitly applied by Supreme Court in its initial decision. That inquiry was directed at the reasonableness of the board’s decision.... The difference between the reasonableness test and the rule we adopt is twofold. First – unlike the business judgment rule, which places on the owner seeking review the burden to demonstrate a breach of the board’s fiduciary duty – reasonableness review requires the board to demonstrate that its decision was reasonable. Second, although in practice a certain amount of deference appears to be accorded to board decisions, reasonableness review permits – indeed, in theory requires – the court itself to evaluate the merits or wisdom of the board’s decision...just as the Appellate Division did in the present case.

“The more limited judicial review embodied in the business judgment rule is preferable... Even if decisions of a cooperative board do not generally involve expertise beyond the usual ken of the judiciary, at the least board members will possess experience of the peculiar needs of their building and its residents not shared by the court.

“Several related concerns persuade us that such a rule should apply here. As this case exemplifies, board decisions concerning what residents may or may not do with their living space may be highly charged and emotional. A cooperative or condominium is by nature a myriad of often competing views regarding personal living space, and decisions taken to benefit the collective interest may be unpalatable to one resident or another, creating the prospect that board decisions will be subjected to undue court involvement and judicial second-guessing. Allowing an owner who is simply dissatisfied with particular board action a second opportunity to reopen the matter completely before a court, which – generally without knowing the property – may or may not agree with the reasonableness of the board’s determination, threatens the stability of the common living arrangement.

“Moreover, the prospect that each board decision may be subjected to full judicial review hampers the effectiveness of the board’s managing authority. The business judgment rule protects the board’s business decisions and managerial authority from indiscriminate attack. At the same time, it permits review of improper decisions, as when the challenge demonstrates that the board’s action has no legitimate relationship to the welfare of the cooperative deliberately, singles out individuals for harmful treatment, is taken without notice or consideration of the relevant facts, or is beyond the scope of the board’s authority.”

In the almost 15 years since the court of appeals decided Levandusky, there have been many instances where the courts have been called on to examine actions taken by cooperative and condominium boards and the cases decided against the boards have been few. And those usually involve examples of extreme situations where the board was clearly acting beyond the scope of its authority or in bad faith or was discriminating.

On the other hand, the court has been very expansive in applying the business judgment rule to the actions of boards, thereby avoiding any second-guessing of the boards. What makes it so difficult for the shareholders or unit-owners to succeed in such cases is that the shareholder or unit-owner must demonstrate that the board breached its fiduciary duty by acting in bad faith, or by taking discriminatory acts, or acting outside of its authority. The burden of proof is on the shareholder or unit-owner challenging the board to establish that the board acted improperly. Otherwise, the court will not review the specific action of the board that is the subject of the complaint. To confirm the board’s authority, the courts carefully examine the law, as well as the proprietary lease and bylaws in a cooperative and the declaration and bylaws in a condominium.

If the court of appeals had acted differently in 1990 and agreed with the appellate division that the correct standard for boards should be whether they acted “reasonably,” then virtually every decision made by a board would be subject to judicial review and the boards would hesitate to act out of fears of potential litigation. The Levandusky decision has enabled cooperatives and condominiums to survive in difficult economic times and prosper in good times because the boards do not have to worry about being second-guessed. Moreover, the court of appeals decision in Levandusky is the basis for most of the subsequent decisions reported in this issue of Habitat.