Board Policy: The Post-Enron Model, Part II

In the June issue of Habitat, I said: “In the wake of the scandals of the past few years that have rocked the boardrooms of Enron, Worldcom, Tyco, and, now, AIG, the code of corporate ethics has been rewritten both as a matter of law (the Sarbanes-Oxley bill) and practice, which now often goes beyond what is legally required to a policy of zero tolerance. Although such legislation is not applicable to co-ops or condos, given the changed regulatory climate it is probably only a matter of time before their practices, too, come under judicial, legislative, and public scrutiny.

“There is a need for fundamental reevaluation of the underlying system. Where else in corporate America do you find unpaid and untutored boards in charge of enterprises with multi-million-dollar budgets and assets in the many hundreds of millions? Every company I know, at least in theory, has a chief executive officer who is paid for his or her expertise, an in-house management team to help define and implement policy, a professional board (of inside and more objective outside directors) to exercise oversight, and a shareholder constituency which itself, or through its representatives, trains its sight on performance.”

In that column, I advocated the need for reform in the governance of co-ops and condos, including creation of a position for a functional CEO: an expert, objective outsider able to advise the board, carry out its mandate, and oversee the managing agent. I remain convinced of the necessity to professionalize the manner in which these real estate enterprises (that double as homes) are run so as to more closely approximate the standards now demanded by the rest of corporate America. Although co-ops and condos are non-profit ventures, like business corporations, they have significant underlying assets, budgets, cash flows, and expenses that require similar management discipline. Such systematic overhaul may take time to accomplish but, in the interim, there are steps boards can take to rationalize the ethics of co-op and condo governance, improve performance, and pave the way for more fundamental changes.

An essential prerequisite for any successful board is that its members understand their fiduciary responsibilities. That means putting the interests of their constituents above their own, and to treat all owners fairly and equally. This concept does not always come naturally, especially to non-professional directors who may want to accommodate the wishes of individual shareholders not realizing that such well-intentioned action can spell disaster. (“What’s wrong with the resident real estate broker being the board president?” they ask. Or: “Why can’t we let that shareholder install a washer-dryer even though we turned down another’s request?”) If the governance of co-ops and condos is to become truly professional, this kind of mindset needs to be changed through education: the appointment of a knowledgeable, objective outsider, as previously recommended, would help facilitate this transformation.

A corollary to this concept is that boards must enforce provisions of proprietary leases and bylaws – or change them. Nothing is more likely to test director resolve than sublease restrictions from which shareholders seek personal exemptions, or boards that look the other way depending on circumstances. “We approve subleases of shareholders we like,” one director advised me. “Sure, our proprietary lease contains leasing restrictions, but don’t worry about them,” said another. If market conditions or shareholder sentiment has sufficiently changed over time, amend the provision. But such selective enforcement will only foster a perception of an insular board that considers itself above the law, making it difficult to govern in an even-handed fashion and exposing the corporation to potential legal challenge.

The dynamic among board members also should be addressed. Too often a small minority of directors bears a majority of the burden, a situation that can foster fractious relations among directors and impede proper functioning of the building’s business. Confronting non-performing members (who are also neighbors) – especially when there may not be candidates waiting in the wings – is a difficult, but unavoidable, challenge. And if the problem persists, it may be appropriate and necessary to advise shareholders of the need to step up to the plate, or failing that, to amend the bylaws to reduce the number of directors to a level that both assures adequate representation of owners and a fully engaged board.

The interaction between boards and management companies needs to be more clearly defined so that there are adequate checks and balances, and each party understands and carries out its respective role. Although, in theory, boards oversee the acts of their managing agents, in practice many directors lack adequate knowledge to do so, leaving sometimes less-than-expert managers to proceed without guidance or supervision.

There is room for improvement on both sides. Management companies need to begin upgrading the level and depth of their personnel to reflect the greater complexities facing buildings, including the introduction of in-house counsel. Given the trend toward consolidation in the management industry, more such companies should have client bases sufficient to sustain these necessary additions at modest additional cost. It is more difficult, though not impossible, to set performance standards for unpaid volunteer board members, a reality that is an inherent flaw in the present system.

The casual manner in which business is conducted in many co-ops and condos needs to give way to standardized practice. Tales of serial lobby renovations strike at the heart of a larger problem. The purchase of goods and services, including capital projects, is another prime example of the lax attitude that prevails in many transactions. Since the kickback scandals of a decade ago, boards generally have been vigilant in following stringent bidding practices.

But that’s just the first step; they also need to fully understand and negotiate both the business and legal terms of such transactions, which can have significant consequences for their buildings. Because management companies often lack the level of personnel to adequately advise on such matters, and the use of outside counsel is not perceived as cost-effective (particularly in projects of relatively modest scale), unless there is a skilled professional on the board, proposals submitted by vendors, contractors, and others may be accepted as offered, not effectively bargained for – a lapse that may not be discovered until trouble looms. It turns out the board has agreed to pay too much upfront, leaving it without any leverage to get the job done. Or the project’s construction cost is spiraling out of control, taking along with it the engineer’s fee, which is linked to such cost and has not been capped. The result is that many of the ordinary safeguards taken for granted in everyday business transactions are lacking in the context of co-ops and condos. Recognition of the problem by boards is the first step toward developing mechanisms to upgrade the manner in which business is conducted.

In addition to revamping the strategies for their own buildings, boards need to begin exploring united action with their counterparts at other buildings in order that their more powerful communal voice is brought to bear on matters of common interest. Real estate taxes are a major example. Although some accommodation for the disparities among classes of properties has been achieved by the real estate tax abatement law, the lack of transparency in the system makes it difficult for boards to effectively anticipate or challenge the rapid and sometimes erratic rise in assessments, a reality that can play havoc with building budgets.

In the business arena, some economies of scale have been achieved on behalf of buildings by a relatively few management companies that make group purchases of umbrella insurance. But boards need to pressure such companies to more effectively pursue these opportunities of scale. In addition, they should consider acting in cooperative fashion with other buildings to purchase commodities (such as fuel oil), to negotiate union contracts, and (together with appropriate officials) to address important issues in the insurance marketplace, including the virtual lack of competitive pricing in a field dominated by less than a handful of providers.

In the wake of the changed circumstances confronting co-ops and condos, boards would do well to take the necessary preventive (and/or corrective) measures to assure the well-being of their buildings.