Business Judgment Rule Does Not Protect the Willfully Ignorant

*New Case Law

Volunteer homeowners association (“HOA”) directors are fiduciaries who are held to high standards of conduct when making decisions or taking actions on behalf of the communities they represent. Sometimes those decisions, which may seem reasonable at the time, ultimately lead to problems for the HOA or its members. If volunteer HOA directors were made personally liable for the consequences of their erroneous decisions, it would be virtually impossible for any HOA to recruit individuals to serve on its board. For this reason, HOA directors are afforded several liability protections under California law.  One of those protections is a legal doctrine known as the “Business Judgment Rule.”

The Business Judgment Rule generally shields directors from personal liability that may result from their erroneous decisions, provided that the decision was made (1) with care, (2) in good faith, and (3) was based upon what the director believed to be in the best interest of the HOA. Making a decision “with care” generally requires that directors exercise reasonable diligence to investigate the issues surrounding the decision so that they are able to act on an informed basis.

But how broad are the protections of the Business Judgment Rule? Does it automatically shield a director who chooses to remain willfully ignorant as to the issues surrounding her actions or the scope of her authority? According to the Court of Appeal in the recent case of Palm Springs Villas II Homeowners Association v. Parth (2016) 248 Cal.App.4th 268, that answer appears to be no…

Erna Parth (“Parth”) was the President of the Palm Springs Villas II Homeowners Association (“Association”). During her time as President, Parth took a number of troubling actions on behalf of the Association in her capacity as a director. Those actions included:

• Signing promissory notes on behalf of the Association that were in violation of the Association’s Bylaws, and without first reviewing the Bylaws;
• Executing a five (5) year contract with a landscaper in violation of the Association’s Bylaws;
• Hiring an unlicensed roofing contractor that substantially overcharged the Association, and without first investigating the company or requesting a formal bid;
• Terminating a property management contract despite a prior vote of the Board to table the discussion for a later decision; and
• Executing a contract with a security company without even submitting the proposed contract to the Board, in direct violation of a prior Board resolution to obtain multiple bids from competing companies.

Executing the security contract was what ultimately gave rise to the underlying lawsuit. When the Board learned of the security contract, they refused to ratify the contract or Parth’s decision to execute it. The security company then sued the Association, and the Association then cross-complained against Parth. The Association asserted numerous causes of action against Parth for breach of fiduciary duty, as well as breach of the Association’s CC&Rs and Bylaws. The cause of action for breach of fiduciary duty proceeded through litigation and, after substantial discovery, Parth filed a motion for summary judgment on the grounds that the Association’s claim for breach of fiduciary duty was barred by the Business Judgment Rule.

The trial court then articulated the components of the Business Judgment Rule. It explained how the Business Judgment Rule serves to protect directors from erroneous decisions provided that the directors were: “(1) disinterested and independent; (2) acting in good faith; and (3) reasonably diligent in informing themselves of the facts.” After reviewing the facts at issue, the trial court granted Parth’s motion, holding she had set forth sufficient evidence to indicate that she was “disinterested” and that she had “acted in good faith and without willful or intentional misconduct,” and “upon the basis of such information as she possessed.”

The Court of Appeal reversed the decision, holding that the Business Judgment Rule’s protections require a showing of reasonable diligence on the part of the director:

“When courts say that they will not interfere in matters of business judgment, it is presupposed that judgment—reasonable diligence—has in fact been exercised. A director cannot close his eyes as to what is going on about him in the conduct of the business of the [HOA] and have it said that he is exercising business judgment.”

The Court of Appeal determined that Parth had failed to act with reasonable diligence by failing to investigate the companies she contracted with, ascertain applicable requirements under the Association’s governing documents, or ascertain the extent of her authority as a director of the Association.

Parth’s failure to ascertain the extent of her authority as a director of the Association was central to the Court of Appeal’s holding. Unlike the trial court, the Court of Appeal did not believe it sufficient for Parth to have merely believed she possessed the proper authority to take the actions she did without first making an effort to confirm that she had such authority:

“With respect to Parth’s stated belief that she had the authority to sign the contract, the Association provided evidence in other contexts (e.g., the promissory notes) that Parth failed to understand the scope of her authority; this same evidence suggests that she made no effort to ascertain what authority she did possess to conduct the business of the Association. The business judgment rule would not extend to such willful ignorance.”

Because the Association had produced evidence which called into question whether Parth was acting on an informed basis and with reasonable diligence, summary judgment should not have been granted. In making its decision, the Court of Appeal explained how “[p]ermitting directors to remain ignorant and to rely on their uninformed beliefs to obtain summary judgment would gut the reasonable diligence element of the rule and, quite possibly, incentivize directors to remain ignorant.”

This case touches on a significant issue that many volunteer HOA directors face when making decisions or taking actions. While directors are generally immune from the consequences of their bad decisions, that immunity is intended to apply only when the directors demonstrate that they acted on an informed basis. This underscores how important it is for volunteer HOA directors to examine all issues surrounding their proposed actions, and to utilize qualified professionals (i.e., HOA attorneys, managing agents, etc.) retained by the HOA to assist them in this respect.