Guide to the Procedures & Decisions of the Commission on Common Ownership Communities
Appendix A: The Business Judgment Rules
 

In disputes between associations and their members, the legal issue most often involved is the “business judgment” rule.

Arguably, there are at least 3 related but distinct legal principles that can be called the "business judgment rule", and they will be described separately in this Appendix.

Defined in very general terms, the business judgment rule says that the decisions of the governing body of an association and its members—usually the board of directors—are assumed to be correct, and the courts will therefore uphold them unless certain conditions are met.

Or, put another way, when a dispute over the validity of a decision of the board is brought before a court, the court will not substitute its own judgment of what is best for the association in place of the judgment of the board of directors, so long as the board acted properly.

The business judgment rule is derived from the law of corporations, and it is applied to common ownership communities because most of them are also corporations, and even when they do not have corporate charters they are governed much like corporations. In all common ownership communities, as in corporations, the members share the ownership of the association’s property, and they delegate their rights to manage the association’s affairs and to control its assets to an elected board of directors.

The Commission currently registers well over one thousand common ownership communities. There are probably tens, if not hundreds, of thousands of corporations of all kinds doing business in Montgomery County alone, from multinational defense corporations to auto repair shops and nonprofit charities. It would be impossible for the courts to supervise every decision of these corporations, nor would we probably want to substitute the opinions of judges for those of the stockholders and managers in the day-to-day operations of these organizations. For practical reasons, and because the courts lack the expertise to run such varied and often complex entities, the courts have developed a set of rules that limits their ability to review the decisions of private enterprises to those in which the organization acted improperly, arbitrarily, or in bad faith. This means that if the only issue is the wisdom of a decision—whether to adopt a rule or raise an employee’s pay or to increase the assessments—then the court will uphold the decision.

As noted at the beginning of this Appendix, there is no single business judgment rule. There are at least 3 distinct business judgment rules recognized by Maryland law. The facts of the dispute will determine which rule applies, and it is possible that a single case can involve all three of the rules.

The Protection of Individual Members of the Governing Body (“the Right to be Wrong”)

State law (Real Property Article, Section 14-118, Courts & Judicial Proceedings Section 5-422), says that individual members of a board of directors cannot be held personally liable for their decisions, and in fact cannot even be named as defendants in a lawsuit against an association, unless there is evidence to show they engaged in serious misconduct. In Reiner v. Avenel Community Association {see Appendix B], a trial court not only dismissed a complaints made against the individual members of a board of directors, but went on the order the homeowner to pay the association’s legal fees to defend them, as a penalty for violating Section 14-118.

Note that under these laws, the only reasons for which board members can be sued are acting outside the scope of their duties, or in bad faith, or in a "reckless, wanton, or grossly negligent manner." ("Gross negligence" is generally defined as the deliberate or reckless failure to exercise ordinary care.) Mistakes, negligence, and bad judgment are not reasons for which a board member can be held personally liable.

In other words, board members are protected from individual liability if they make a decision that is later found to be a bad one, or even if it is later held to be in violation of some association rule or even in violation of some law. Thus, for example, a board might adopt an assessment increase that under its rules should have been adopted by a vote of the general membership, or perhaps the board made a decision in a closed meeting that should have been made in an open meeting and which thus was made in violation of State law. Nonetheless, as long as they were acting in good faith, the individual members of the board cannot be sued merely because they made a mistake in interpreting or applying a rule or a law. For the exception to apply, it must be shown that the board members acted recklessly or with gross negligence, or that they intentionally violated their governing documents or a relevant law. Similarly, the board might place some of its funds in an investment account that later loses value. So long as the board acted in good faith and with due care, its members cannot be sued for the association’s financial losses.

Because of this protection, this aspect of the business judgment rule can be called “the right to be wrong.” There are good reasons for such protection. Common ownership communities depend heavily on the efforts of volunteer boards of directors, and usually the volunteers have had no previous experience in managing complex organizations and large sums of money. If board members knew they could be sued personally for every mistake they might make, it would probably be impossible for our communities to fill their boards and manage their own affairs. In this way, the business judgment rule provides a great benefit for our associations.

This legal principle is built into the County Code as well. Section 10B-8 defines a “dispute” as a disagreement over “the authority of the governing body” to do, or to fail to do, something. The Commission interprets this to mean that all disputes must involve the decisions of the board or of the council of unit owners. The decisions and conduct of the individual members of the board or of the individual members of the council of unit owners do not represent the decisions of the board or council of unit owners as a group. Consequently, the Commission has never accepted jurisdiction over complaints against individual members of the governing body of an association, but only against the governing body itself.

The Protection of the Board’s Business Judgments

The legal protections granted to the individual members of the board of directors and of the governing body do not necessarily protect the decisions of the board or the governing body. A board’s decisions can be overturned even if the board’s members can’t be sued for making those decisions.

When members challenge the decisions of a governing body, they can be successful not only if they can prove bad faith or fraud, but also if they can prove that the governing body did not have the legal authority to do what it did. For example, in Ridgely Condominium Association v. Smyrnioudis (see Appendix B, below), the Court held that the decision of the governing body was invalid because it conflicted with the association’s own Declaration of Covenants. The Commission applied a similar reasoning in Stalbaum v. Ashley Place at Tanglewood, #26-14, when it invalidated a rule allowing the board to revoke the parking privileges of a member who was delinquent in his assessment payments when the HOA’s own covenants only stated that it had the right to deny access to recreational facilities. In Voorhees v. Decoverly I HOA, #05-11, the panel held that the association must refund $1000 to its members that it used to clean up a tract of land that it did not own, because the governing documents stated that the community’s funds could only be used to maintain the community’s property. And a condominium’s decision to spend money on a study to add a new common element was declared invalid when the board failed to obtain a majority vote of the membership for such a project when required by the association’s bylaws in Glenn v. Park Bradford Condominium, #29-11.

Conversely, in the recent decision on a Montgomery County dispute, Reiner v. Avenel Community Association, Inc. [see Appendix B], the court upheld a board’s decision to enforce a rule banning the use of asphalt roof materials when the homeowner could not produce any evidence that the rule violated the County Fire Code or that the rule was not properly adopted.

Consequently, a governing body’s decision can be overturned, even if made in good faith and without fraud, if the decision was not made in compliance with an association’s own governing documents or in compliance with a relevant law. They can also be reversed if they are “arbitrary or capricious,’ meaning that they cannot be rationally justified.

The law and the Commission require the member intending to challenge a decision that is protected by the business judgment rule to allege, and provide evidence of, bad faith, fraud, arbitrariness or of a lack of legal authority. It is not sufficient simply to claim fraud, bad faith, arbitrariness or lack of authority. There must be a showing of some supporting facts or of a specific law or rule that has been violated. Without such a showing, the Commission will often simply refuse even to accept a complaint for a hearing. See, for example, the Commission’s extended discussion of the business judgment rule in #66-09, Simons v. Fair Hill Farm HOA, in which it held that a member filing a complaint challenging the board’s business judgment had the burden of proof of alleging, and documenting, bad faith, fraud, or lack of authority, or else the complaint could be dismissed for lack of jurisdiction.

The business judgment rule protects the governing body’s decisions, whether those decisions are 98 board’s FAILURE to make any decision at all. This is implicit in the title of the rule: it protects judgments, otherwise defined as “the exercise of discretion,” consequently, it does not apply to inaction. This point was emphasized by the leading commentator on the law when he wrote:

Consider the breadth of the enumerated powers that this example of [the typical bylaws] presents. First, the members of the board have an obligation to act. This means that the board must make a decision when confronted with a germane issue; the board may not refuse to consider the issue and thus refuse to meet its duty. Not taking action is just as much an affirmative decision as taking action. . . . 
A board should have sufficient information to make an “informed’ decision, and must actually make a decision. The board must deliberate and decide, not procrastinate or equivocate, allowing inaction to produce a consequence called a “decision.” 
W. Hyatt, CONDOMINIUM AND HOMEOWNER ASSOCIATION PRACTICE: COMMUNITY ASSOCIATION LAW at 83, 99 (3d edition 2007).

The Court of Appeals applied this exception in the recent case of Greenstein v. Council of Unit Owners of Avalon Court Six Condominium Association (see Appendix B, below). In that case, the board of directors was aware for several years that the new condominium had extensive water leaks. Although aware, the board failed to take any action for several years. When it finally voted to sue the condominium’s builder for breach of warranty, its case was thrown out by the trial court because the Statute of Limitations had run out before the case was filed. The members of the association then sued the association for damages and the Court of Appeals ruled that they could do so and that the business judgment rule did not protect the association. Although this case is well-known because of the Court’s holding that members can sue associations for negligence, it is worth noting that the negligence here was not that the board decided not to sue, but rather that the board did not make any decisions at all until it was too late. The board negligently lost its rights to sue the developer and thus negligently lost the members’ legal rights. If the board, knowing of the water leaks, had made a timely decision not to sue, it might well have avoided liability under the business judgment rule. (Note also that this lawsuit was against the association, not against the individual members of the board of directors.)

(The Commission has also upheld a claim against an association by one of its members for negligence in Prentice v. Sierra Landing Condominium Association, #15-08. In that case, the Commission ruled that an association that failed to make timely and effective repairs to prevent an ongoing water leak into a unit was liable to repair all the damages to the unit, even those that were not otherwise covered by the condominium’s master insurance.)

The business judgment rule is incorporated into, and defined by, Section 10B-8 of the County Code. The specific definitions are important:

4. Dispute means any disagreement between 2 or more parties that involves: 
   2. the failure of the governing body, when required by law or an association document, to: 
      8. exercise its judgment in good faith concerning the enforcement of 99 the association documents against any person that is subject to those documents. 
5. Dispute does not include any disagreement that only involves: 
   5. the exercise of a governing body's judgment or discretion in taking or deciding not to take any legally authorized action. (Emphasis added.)

What Section 10B-8 requires the governing body to do is to "exercise its judgment". It recognizes the right of the governing body to decide to do something, or to refuse to do something. But the board must make a decision when required to do so, and its decision must be within the scope of its legal authority and made in good faith.

The business judgment rule also extends to the board’s interpretations of it governing documents. When rule or section is vague, or can be interpreted in more than one way, the courts must uphold and apply the board’s interpretation if it is a reasonable one, even if other reasonable interpretations are also possible. See, Tackney v. U.S. Naval Academy Graduates Alumni Association, but see also South Kaywood Community Association v. Long, Appendix B, below.

This latitude especially applies to the board’s exercise of its authority to preserve the overall architectural scheme of the community. When the governing documents are vague concerning a specific architectural item or change, the board’s determination of what is consistent with the overall design of the community is given great weight, and it will not be reversed by a court simply because the relevant rule is vague. The board has the right to interpret vague rules. See the case of Markey v. Wolf in Appendix B, below.

The Commission gave an excellent example of how the business judgment rule should be applied in Prue v. Manor Spring HOA, #39-09, where, among other matters, the Commission upheld the board’s interpretation of the clause “the rear wall of the house” when it was not clear how that clause applied to the particular house design in question.

The Protection of the Board’s Decisions to Enforce Its Rules

When the board of directors wishes to take an action that restricts a member's or resident's rights to use his property as he sees fit, or to penalize a member or resident, the business judgment rule requires it to meet a higher standard than that required by good faith. In addition to acting within its authority and in good faith, the board must have a reasonable basis for its decision, and that reason must be related to the overall purposes of the association.

The case usually referred to for this principle is Kirkley v. Seipelt (see Appendix B, below). In Kirkley, an HOA member had installed, without permission, a metal awning of the front of his house and the HOA board told him to remove it. He challenged that decision in court, arguing that the governing documents did not mention awnings at all, that two other lots had awnings on the fronts of their houses, and that other homes had awnings on the rears of the houses. The Court of Appeals rejected all his arguments. The Court held that the HOA had not waived 100 enforcement of its rules simply because 2 other homes, out of hundreds, had awnings on them; and there was a big difference between installing awnings on the rear of a home and on the front of the home where they were more obvious. Most importantly, the Court held that the board had the right to interpret and decide how to apply its governing documents, so long as it did so in a way that was consistent with its overall purposes. In this case, although the documents did not specifically prohibit or regulate awnings, the community had been constructed without awnings, and the board's decision not to permit awnings was consistent with the overall architectural design of the community. The Court set the standard that is still followed today in rule enforcement cases:

We hold that any refusal to approve the external design or location by [the association] would have to be based upon a reason that bears some relation to the other buildings or the general plan of development; and that this refusal would have to be a reasonable determination made in good faith, and not high-handed, whimsical or captious in manner.

In the important case of Simons v. Fair Hill Farm HOA, #66-09, the Commission discussed the meaning of Kirkley v. Seipelt in the overall context of rule enforcement. The Simons panel held that in rule enforcement cases, as well as in cases where the association imposes penalties on its members, the burden is not on the member to prove that the board acted in bad faith in order to prevail. Rather, the burden is on the association to show that it had a good reason for its decision. In Simons, the board could not show any evidence on which it based its decision that the member had damaged the association's trees and therefore the panel overturned the board's decision.

It should also be noted that not only must the association show that it has a reasonable basis for its decision, but that the reason must be related to one of the overall purposes of the community as specified in its governing documents. Most such documents allow the association to regulate parking, architectural changes, and how the lots may be used.

In Reiner v. Avenel Community Association, Inc., the Court seems to say that a board’s decision to limit a member’s right to install the roof shingles of his choice is a “business judgment” that can only be reversed if the member shows fraud or bad faith by the board, and that the “reasonableness” standard is not applicable. However, that must be taken in the context of the court’s statement that even if the “reasonableness” standard did apply, the homeowner failed to produce any evidence that the decision conflicted with any law, or that the board did not have the legal authority to make the decision, or that the board’s decision was unreasonable. On the contrary, the court stated that the rule and the board’s decision reflected a reasonable effort to comply with the standards in the HOA’s governing documents and to preserve the appearance of the community as it was.

The Commission generally takes the position that "disputes" involving the board's rule enforcement decisions are not covered by the business judgment rule of Section 2 of this Appendix. The reason is that Section 10B-8(5)(E) states that the word "dispute" does not include any disagreement that "only" involves the exercise of the governing body's judgment or discretion in taking or deciding not to take any legally-authorized action." In the Commission's view, a dispute over a rule enforcement action involves not only good faith and whether the board had the authority to enforce a rule, but it also involves, as per Kirkley v. Seipelt, the factual issue of 101 whether the board had a good reason for its decision; and the Commission expects the governing body to prove, with competent evidence, that it had a proper reason.

If the association can show that its decision to enforce a rule is within its authority and that it has a reasonable basis that is related to the purposes of its governing documents, then the Commission will usually respect and uphold the association's decision, and not substitute its own judgment for what constitutes the proper appearance of the community or how its lots can be used.

The Commission treats rule enforcement disputes much differently when the party to the case is the member or resident against whom the association is enforcing a rule, than when the party is trying to force the association to enforce a rule against someone else. In the former case, the party is directly affected by the association's action. In the latter case, not only is the party not directly affected but also wants the association to directly affect someone who is not a party. The Commission does apply the business judgment rule of Section 2, above, to such cases because Section 10B-8(4)(B)(viii) only grants the Commission authority over "disputes" to the extent that they involve "the failure of the governing body, when required by law or an association document, to exercise its judgment in good faith concerning the enforcement of the association's documents against any person that is subject to those documents." Thus, so long as the board makes a decision about whether another person has violated a rule or not, and has done so in good faith, the Commission has no jurisdiction over complaints that seek to make the board take action against another person. Therefore, it is the burden of the complainant to show either that the board failed to make a decision ("exercise its judgment") or that the board did make a decision but that it was motivated by bad faith. If the board decided not to enforce a rule against another person, and complainant does not allege and document the existence of bad faith in connection with that decision, the Commission will usually refuse to accept jurisdiction of the complaint.

There are several reasons for this policy, but the simplest one to understand is this: the governing documents almost always require the board to enforce the governing documents, but they almost never say how or to what extent the board must do so in particular cases. They do not say, for example, that the board must issue fines or assess penalties or file suit, although they might allow the board to do so. Nor do they say that the board must find a member to be in violation simply because another member complains about him or her. In effect, they give the board the discretion to decide how to deal with such issues. See the cases of Markey v. Wolf and Black v. Fox Hills North Community Association in Appendix B, below.

The Meaning of “Fraud or Bad Faith”

The protection given by the law to individual board members and to the board’s decisions does not apply when the members make a decision fraudulently or in bad faith.

As suggested above, the courts assume that the governing body acts in good faith. The party wishing to dispute the decision must therefore prove with evidence that it acted in bad faith.

Most members equate “bad faith” with “conflict of interest,” and assume that any conflict of interest renders the board’s decision invalid and the members responsible personally liable. The law is more complicated than that.

Section 2-419 of the Corporations and Associations Article specifically permits a board member to vote on a matter in which he has a possible conflict. To do so properly, he must first of all disclose the existence of the conflict to the rest of the board, so that it has full knowledge of all the facts. Secondly, the board member can vote on the issue so long as he does not cast the deciding ballot.

In this context, we should distinguish between actual and potential conflicts of interest. The real issue should be whether the association benefits from the decision and how much it benefits. For example, a board member may run a landscaping company. If the contract he offers for his services to his own association is for a lower price than his competitors can offer, then is there a real conflict of interest? If both parties benefit from a transaction, are their interests the same? Whenever there is the possibility of a conflict of interest, the parties should try to look behind the label to determine whether the decision makers knew about the possible conflict, and the extent to which the decision was intended to assist the association as a whole.

In an important case involving claims of conflict of interest and bad faith—although not a case involving a community association—the Court of Special Appeals wrote that the test was this:

If the [trial] court finds that the transaction was, on the whole, motivated by a legitimate corporate purpose, it should declare the sale to be valid; if it finds to the contrary—that the purpose of the transaction was primarily one of management’s self-perpetuation and that that purpose outweighed any other legitimate business purpose—it should declare the sale to be invalid.

Thus, even a real conflict of interest will not necessarily invalidate a decision if the primary purpose of the decision is to benefit the corporation as a whole. (Mountain Manor Realty Inc. v. Buccheri, see Appendix B, below.)

Conflicts of interest are not the only example of bad faith, however. Maryland’s courts have defined “bad faith” to include much more than conflicts of interest. In recent decisions, they have stated it in various ways:

The business judgment rule insulates business decisions from judicial review absent a showing that the officers acted fraudulently or in bad faith. (NAACP v. Golding.)

Courts will not second-guess the actions of directors unless it appears that they are the result of fraud, dishonesty, or incompetence.

[T]he courts cannot be invoked to review [the decisions of a board of directors] coming properly before them, except in cases of fraud— which would include action unsupported by facts or otherwise arbitrary.” (Black v. Fox Hills North Community Association.)

Thus, “fraud or bad faith” can include not only conflicts of interest but also "dishonesty," "incompetence," "arbitrariness," and decisions "not supported by facts".

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While the business judgment rule provides great protection to the decisions of an association's governing body, it requires associations and their board members to act in good faith and with reasonable care. The law presumes they have done so. Therefore, it also requires anyone challenging the decision to show that the decision was either made for the wrong reasons (fraud, bad faith), for no good reason at all (arbitrariness, lack of any factual basis), or in violation of the association’s own governing documents or of the law.

If the member is able to demonstrate that the association’s decision is tainted by the violation of one of these duties, then the Court or the CCOC is able to review the merits of the board’s decision and make its own judgment whether the decision serves the best interests of the community.