LEGAL CORNER
Bye-Bye Business Judgment Rule?
By Donald A. Frederick
Program Leader for Law,
Policy & Governance;
USDA Rural Development/
Cooperative Programs
donald.frederick@usda.gov
ooperative directors owe a
fiduciary duty to the
membership to exercise
their authority in the best
interests of the association
and all of its members. In lawsuits
claiming directors violated their duty,
courts have routinely applied the “business
judgment rule.”
In its simplest terms, the business
judgment rule provides that a board
action is protected from challenge if
there is a good business justification for
the decision and it isn’t fraudulent or an
abuse of discretion. When the business
judgment rule is applied, the burden of
proof to establish the impropriety of the
decision is on those challenging it.
But in today’s environment of
heightened concern over the diligence
of directors, courts may begin looking
for another standard for measuring
director conduct. In a recent decision
involving a suit against a housing cooperative
and most of its directors, the
appellate court said the trial court
should have applied a “reasonableness”
test, and the burden of proof should be
on the directors to prove their actions
were indeed “reasonable.”
Case facts
In 1974, an apartment building on
Wisconsin Avenue in the District of
Columbia was converted to a housing
cooperative. The cooperative association
financed the purchase with money
borrowed from the developer who had
owned the building, and signed a 30-year mortgage repayment agreement
with the developer. A pro-rata share of
the mortgage obligation was assigned to
each housing unit in the building, based
on the relative value of the units at the
time. Contracts between the cooperative
and its members required the members
to make monthly payments on
their share of the mortgage, which the
cooperative used to pay its monthly
obligation to the lender.
The contracts between the cooperative
and its members permitted the
members — at their option — to prepay
their mortgage obligation. Over the
first 20 years of the mortgage, a small
minority of the members prepaid their
obligation.
By the mid-1990s, the developer was
bankrupt and his assets were controlled
by a bankruptcy trustee. The cooperative
had several unresolved claims
against the developer. The cooperative
had a cash reserve comprised in large
part of payments from members. It
struck a deal with the bankruptcy
trustee to pay off the remaining balance
due on the mortgage, less a negotiated
amount for its claims against the developer.
After this deal was completed, the
directors made two decisions which led
to a lawsuit. First — since the mortgage
that was the basis for the contracts
requiring special monthly payments
from the members no longer existed — the board voted to forgive the amounts
remaining on those notes. Second — since there were no notes to forgive in
the case of the members who prepaid
their obligation — the board deliberated
at length over whether the cooperative
should pay a rebate to those members
on the theory that they had overpaid.
After consulting with legal counsel,
the board determined it had no
equitable basis to justify the rebates and
so voted not to use cooperative funds to
pay the proposed rebates.
Two members who had prepaid their
obligation, including one person who
was a director at the time and had
argued and voted for rebate payments,
sued the cooperative and the other
directors for breach of contract and
breach of fiduciary duty. They asked for
monetary damages equal to the amount
they alleged they would have saved had
they not prepaid their obligation and
been treated the same as the other
members, including the other directors.
Trial court applies
business judgment rule
Both sides of the case moved for
summary judgment, a decision by the
court that they will prevail even if the
facts are interpreted favorably for the
other side. The trial court denied the
motion of the unhappy members and
granted the motion of the cooperative.
First, the court said the unhappy members
hadn’t shown it any provision of
their contract with the cooperative that
could have been violated by the cancellation
of the notes covering the mortgage.
As to breach of fiduciary duty, the
trial court referred to the business judgment
rule and concluded there was no
evidence that the board acted hastily or
irresponsibly. Thus, a jury could not
rationally conclude the board engaged
in any misconduct subjecting the cooperative
to liability.
Appellate court applies
reasonableness test
The District of Columbia Court of
Appeals reversed the lower court decision
and sent the case back to that
court for trial, Willens and Niederman v.
2720 Wisconsin Avenue Cooperative
Association, 844 A.2d 1126 (DC 2004).
The appellate court focused on the fact
that the notes in question were from
the members to the cooperative, not
the developer. It said that the cancellation
of the outstanding notes “...was
conceptually equivalent to the distribution
of corporate assets — the uncollected
future payment on the notes —
to shareholders of the corporation.
Significantly, it was a disproportionate
distribution. ...the minority of members
who had already paid off their own
promissory notes in full did not receive
their proportionate share of the corporate
assets being distributed; they
received nothing, in fact. Meanwhile,
the majority of members whose debts
were still outstanding (including
the...directors other than Willens)
received more than their proportionate
share of the distribution; collectively,
the received all of it....”
The appellate court noted that directors
have a duty of loyalty, which means
they must act in the best interests of all
of the members (court’s emphasis). The
court held that a showing by the unhappy
members that the directors treated
some members, including a majority of
the board, more favorably than other
members was by itself enough to overcome
the cooperative’s motion for summary
judgment. Then the court said
that where the directors have a personal
interest in the decision, the trial court
should not apply the business judgment
rule. It should apply a “reasonableness”
test and shift the burden to the directors
to prove that they fulfilled their fiduciary
duties. The court concluded that it
was not finding that the board acted
unreasonably under the circumstances,
only that it will have to convince a jury
that its actions were reasonable.
The court also held that the cancellation
of the notes may have contradicted
a bylaw provision requiring distributions
of corporate reserves to be in proportion
to the ownership interests. As
bylaws are a contract between the cooperative
and its members, the trial court
also erred in granting summary judgment
on the breach of contract claims.
Conclusions
The court did not question the deliberateness
or the integrity of the directors,
and noted that the board had relied
on the advice of counsel in reaching its
decisions. Nonetheless, the court found
that because a majority of the directors
had an interest in the issue before the
board and voted for a policy that
favored some members, including themselves,
over other members, they forfeited
access to the business judgment rule.
Because member-directors of a cooperative
are users and investors in the
association, they will rarely be voting
on matters in which they are personally
totally disinterested. Under the
approach of this court, even if they
exercise thorough due diligence in
arriving at a decision, they may be
forced to defend and prove that their
decision was reasonable if it favored one
group of members over another. This
may be especially true if they are in the
favored group.
While this may be consistent with
the growing concern about directors
exercising their authority in a responsible
manner, it places a burden on cooperative
directors that often doesn’t apply
to the outside directors who populate
many non-cooperative boards. For
example, a determination to drop a
money-losing line of business or close
an unprofitable facility will likely
impact different groups of members,
and directors, differently.
Cooperative leaders and advisers will
need to be vigilant in making sure both
board and management decisions are as
equitable as possible. And when a decision
that discriminates among the
members is made, the strongest possible
justification for the decision should be
reflected in the minutes and other written
records supporting that decision.
