Community associations of any size are similar to big businesses in many ways. Most community associations are confronted with various maintenance and operational tasks. Typically, a community association’s business is conducted by a board of directors. These boards of directors may be responsible for six and seven figure annual budgets. They determine the characteristics of their communities and are charged with protecting and enhancing the value of the real property in which more and more of us invest and make our homes.
Even the casual consideration of the role of community association directors compels the conclusion that their role is so important that capable persons must be attracted to be directors. The period of developer control is critical to the initial health of a community association, consequently, developers must be able to attract good candidates for appointment to the boards of their communities. Unless, after transition, associations attract capable owners to be directors, the community association businesses are at risk of failure. While Armageddon is not yet upon us, there are problems that dissuade developer-appointees and owners from serving as directors.
Too often lately, service on the board of directors of a community association is a good way to lose sleep, lose friends and get sued. Over the last several years, in community after community, the relationships between directors and their members have become adversarial. Whether because of the economy, their personal circumstances, or due to the manner in which homes and investments are being managed, owners are angry. This anger is being manifested in disrupted board meetings, personal confrontations with officers, and lawsuits naming directors as defendants.
In this hostile environment, it is more important than ever to recruit good candidates to boards of directors. Regrettably, it is far more difficult to attract thoughtful individuals to serve. A major concern preventing more qualified candidates from serving is that they will be exposed to claims and, in particular, to tort claims. One way to address this concern is to educate potential directors on how to protect themselves from tort liability. This article will discuss the types of tort claims most frequently asserted against community association directors and offer suggestions on how directors can best protect themselves from such claims.
Our courts will allow claims only for breaches of duty. Therefore, in considering how directors can protect themselves from claims, the starting point is a review of the duties owed by directors.
Duty of Care – Directors of community associations are recognized to have the same duties as those of a business operation. That is, they must give the business of the association the same degree of care and diligence that prudent persons would exercise in their own affairs in similar circumstances. Generally, this is a responsibility owed to the association and to its members collectively, but not to the world at large. If a director fails to satisfy this duty in any particular case and, as a result, a person to whom the director owes a duty is damaged, that person can assert a claim against the director, personally. The Duty of Care requires a director (1) to act prudently with the care of an ordinary prudent person; (2) to act in the best interests of the association; and (3) to do so in good faith.
Each of the responsibilities outlined below requires the efficient allocation of time by the director. Although we cannot say any one of these responsibilities is essential (i.e., that a failure to complete the particular function automatically demonstrates a failure of care) substantial compliance with these elements of care is commonly expected of the director and may be required by law. To discharge the Duty of Care the director must monitor the association’s activities. This includes such things as:
- Attending Meetings. Regular attendance at meetings of the board of directors is a basic element of prudent performance as a director.
All directors must remember they act as a group, and therefore attendance at board meetings is urged. Continuous or repeated absence may expose the director to the risk of not satisfying the Duty of Care. Sporadic board attendance by some directors reduces the morale of those who do attend. It should be understood directors cannot vote or participate by appointing another person, even another director, as a proxy. All directors should understand the reasons for this rule. First of all, whatever reasons the members may have had for choosing the director, that choice was the selection of one person to perform a duty, not the grant of a transferable privilege. Secondly, all the other directors are entitled to demand the duly elected or appointed director’s wisdom and judgment, not that of such surrogate as the director may choose. Thirdly, such deference and accommodation the directors themselves may give to each other in the course of their work cannot, as a practical matter, be transferred to purely personal appointees.
- Independent Judgment. Each director, no matter how selected, shares in all the responsibilities and powers of the directors. Each director should exercise her or his independent judgment on all association decisions.
The law views a board of directors as an entity, each member of which sharing the same rights and duties, and each member being accountable to the same constituency. Even if other parties may regard the director as representing a particular group or interest, these considerations do not affect his or her duties as a director which are to the entire association and the responsibilities will be the same as those of any other director. If the board decides to delegate a task to a particular director, that is a decision of the board, not of the constituency or body which selected or suggested the director.
- Information. To function effectively a director needs to be informed.
To function effectively, a director needs to have an adequate source of information flow. This information is often supplied by the manager or executive director. To the extent that it is not adequate, a board or an individual director will have to determine what additional information is needed. Needless to say, the director should read the information with which he or she is supplied, even when a director has total and justified confidence in the individual supplying the information. In general, the board may rely on information supplied by the manager, but if for any reason any member of the board thinks it is inadequate in any respect, he or she should not hesitate to request further information.
A director exercising good faith judgment will usually be protected from liability to the association or to its membership under the Business Judgment Rule. This legal concept is well established in the case law applying to business corporations. It has also been recognized as applicable to the directors of nonprofit corporations such as homeowner associations. The Rule states a court, in an action brought by the association or its members, will not re-examine the actions of a director in authorizing or permitting an association action if such director’s action was undertaken in good faith, in a manner reasonably believed to be in the best interests of the association, and with an independent and informed judgment. The doctrine basically is a statement by the courts that it is inappropriate for them to “second guess” the decisions of a board, including those which have proven to be unwise or unsuccessful. The Business Judgment Rule will not be applied in situations where basic breaches of duty by the director (such as criminal activity, fraud, bad faith, willful and wanton misconduct) are present.
Duty of Undivided Loyalty – Directors of community associations, like their counterparts in for-profit corporations, have a duty to the association and its members to act only for the association’s benefit, with an eye to its best interests, and without regard for any personal interest the directors may have. Courts take this duty very seriously, often using expressions such as “utmost good faith” and placing the burden on the director to demonstrate the fairness of any transaction in which the director is personally involved if the transaction is challenged.
The Duty of Loyalty requires directors to exercise their powers in the interest of the association not in their own interest or the interest of another entity or person. By assuming office, the director acknowledges with regard to any association activity, the best interests of the association must prevail over the director’s individual interests or particular interests of the members who elected him or her. The basic legal principle to be observed here is a negative one: the director shall not use his or her association position for individual personal advantage. The Duty of Loyalty primarily relates to:
- Conflicts of Interest
- Corporate Opportunity
Directors of nonprofit corporations may have interests in conflict with those of a for-profit corporation. The Duty of Loyalty requires a director be conscious of the potential for such conflicts and act with candor and care in dealing with such situations. Conflicts of interest involving a director are not inherently illegal nor are they to be regarded as a reflection on the integrity of the board or of the director. It is the manner in which the director and the board deal with a disclosed conflict which determines the propriety of the transaction.
A conflict of interest exists whenever any contract, decision, or other action taken by or on behalf of a the board would financially benefit: (1) a director; (2) a parent, grandparent, spouse, child, or sibling of the director; (3) a parent or spouse of any persons named in (2); or (4) an entity in which a director is a director or officer or has a financial interest. As this definition reveals, this interest can occur either directly or indirectly. The director may be personally involved with the transaction, or may have an employment or investment relationship with an entity with which the association is dealing, or it may arise from some family relationship. A conflict of interest may result from a director performing services for the association (e.g., a landscape contractor, banker, insurance agent, attorney or real estate broker). The board should not assume a conflict cannot exist for a director who receives no monetary or other tangible benefit from a transaction with the association. For example, access to information which could be used for individual profit might put the director in conflict with the association.
The law recognizes these problems, not by treating conflict as inherently a moral or legal offense, but rather by prescribing the process whereby a board of directors and the individual directors should disclose conflicts and how they should proceed in the face of such situations. In general, a director’s conflict will be cleared of any consequence by, first, full disclosure and, second, approval or ratification of the subject by a disinterested majority of directors. When a director has an interest in a transaction being considered by the board of directors, the director must disclose the conflict before the board of directors takes action on the matter. The duty of disclosure of an interest exists without regard to whether the proposed transaction is fair, or whether the director urges or opposes the transaction, or whether the director is present during discussion of the transaction, or is counted or not counted in establishing a quorum at any meeting where the transaction is discussed. Upon disclosure by the director, the board should provide a disinterested review of the matter.
Disclosure enables the other members of the board to evaluate the proposed transaction not merely in terms of fairness, but also for its impact on the public image of the association. Generally, the disclosure should include the existence of such interest and its nature (e.g., those arising from financial or family relationships, or professional or business affiliations, etc.) and should be made before any action is taken by the board concerning the matter. The director, although not legally required, may consider it prudent to be absent from the part of the meeting when the matter is being discussed except when her or his information may be needed. A director having a conflict should record his or her absence from discussion and abstention from any vote relating to the subject of the conflict. However, in Colorado, a director, even if interested, may be counted for the purpose of determining the presence of a quorum.
In some cases a director may have an interest in a transaction but be unable, because of duties running to others, to disclose the nature of the interest. In such a case, the director should at least state such interest exists, consider leaving the meeting, or at least abstain from the discussion and not vote thereon. In the rare instance, where the conflicting interest presents so difficult a problem that even the above measures are impossible, the director should consider resigning.
Any contract entered into without disclosure of a conflict and abstention of voting by the interested director is void and unenforceable. In such event, the board, at the next meeting of the board, should vote again on the contract, decision or other action taken. As a practical matter, a non-disclosing director exposes him or herself and the board to substantial risks in such an undisclosed conflict. In the event of litigation, the non-disclosing director, and, in some instances, even the disinterested directors who supported the transaction will have the burden of proving fairness. While the law affords protection to directors whose decisions were made in the ordinary course of business and in good faith, however unfortunate the decisions may turn out to be, this doctrine (the Business Judgment Rule, described above) will not extend to shield the non-disclosing director or the unreasonably uninformed director from liability.
A board of directors which discovers that it has acted upon a proposal in ignorance of an undisclosed interest therein should promptly reexamine the issue, with an appropriate record of such scrutiny. In some cases a board may legitimately choose to deal with an inside supplier of goods and services because of greater familiarity with the supplier’s reliability. Although such association with a director providing services may result in extra benefits for the association, the association records must show the best interests of the association were the overriding consideration in deciding to use such a supplier. Before a director engages in a transaction which he or she reasonably should know may be of interest to the association, the director should disclose the transaction to the board of directors in sufficient detail and adequate time to enable the board to act or decline to act with regard to such transaction.
A director should not, in the regular course of business, disclose information about the association’s legitimate activities unless they are already known by the members or are part of the association’s records. In the normal course of business, a director should treat as confidential all matters involving the association until there has been general public disclosure or unless the information is a matter of public record (i.e., reported in the minutes) or common knowledge. The individual director is not a spokesperson for the association and thus disclosure to the public of association activities should be made only through the association’s designated spokesperson, usually the President or property manager. This presumption of confidential treatment should apply to all current information about legitimate board or association activities.
Duty to Act within the Scope of Authority – Directors owe a duty to their associations and to their members to perform their duties in accordance with the authority granted to them by statute and in their governing documents. If directors exceed this authority, and damage results, the directors may be personally liable for their unauthorized actions.
Technically, the three duties described above are creatures of corporate law rather than tort law. However, claims premised on asserted breaches of these duties are so common that directors and prospective directors should consider how claims based on them can be avoided. Of course, traditional tort law duties must also be considered. Broadly, these include the duty to avoid doing damage to the person or property of another through negligence and the duty not to intentionally damage the person or the property of another.
THE RANGE OF CLAIMS
The human imagination, of course, knows no bounds. Thus, the potential claims against community association directors may be limitless. Nevertheless, it is possible to list the principal types of claims that have been asserted against directors to date. Setting out the list will help to focus the discussion of available protection that follows.
The claims owner-elected directors most frequently face are listed below. The length of the list offers a clear indication of how prevalent claims against directors have become.
- Failure to maintain and repair the common property.
- Failure to adequately gauge and fund reserves.
- Improper investment of reserves.
- Improper budget management.
- Failure to collect assessments.
- Negligent hiring and supervision.
- Failure to file requires reports and returns.
- Premises liability.
- Selective enforcement of governing documents.
- Wrongful towing.
- Wrongful filing of assessment liens.
- Failure to correct conditions that violate environmental laws.
- Slander, libel or defamation of character.
- Interference with contract.
- Breach of duty of undivided loyalty.
- Failure to provide adequate safety measures.
- Failure to protect funds.
- Conflict of interest.
- Failure to follow Business Judgment Rule.
THE GENERAL RULE
Before turning to a discussion of the range of protection available to protect directors from the avalanche of potential claims they face, it is important to point to the general rule concerning the personal liability of directors. Failure to do so will create a false impression. The fact is, while directors have become attractive targets, they are not often found personally liable. This is because, as a general rule, a director does not incur personal liability for an association’s torts. In order for directors to become personally liable for the association’s wrongful actions, they must have participated in the action, approved the action in advance or have ratified the action after it has occurred. An understanding of this rule, coupled with a solid understanding of the three principal corporate law duties of directors set out above, are the foundation of the protection available to directors.
THE RANGE OF PROTECTION AVAILABLE
Essentially, there are four methods of personal protection for directors.
- Indemnification/limitation of liability in governing documents;
- Legislative reform;
- Directors and officers insurance/fidelity bond; and
- Careful practices/risk management program.
Any individual who considers service on a board of directors for a community association owes a duty to himself/herself to understand these methods of protection and to be certain each is as fully available as the law of the jurisdiction will permit. In that way, a director can safely serve his association without putting his personal wealth at risk.
Indemnification – Indemnification is the agreement or duty of one party to protect another from loss or damage. In the case of directors, this agreement can be either express or inferred.
Directors are viewed as agents for their principal, the association. Under the general law of principals and agents, an agent is entitled to be indemnified by its principal for claims arising out of the agent’s acts within the scope of its duties. This protection includes the responsibility of the principal to furnish the agent a defense against claims asserted against the agent by third parties. As an agent of an association, a director is entitled to have the association pay any successful claims asserted against him/her for authorized acts within the scope of his/her authority as a director, and to have the association furnish him/her a defense against the claim.
Legislation exists requiring corporations and associations to protect their directors against claims asserted against them for acts taken in the discharge of their duties as directors. The statute in most instances codifies the case law that existed before the statutes were adopted.
Finally, it is common for association governing documents (typically bylaws) to include express language requiring the association to indemnify its officers and directors from both claims and the cost of defending claims against them arising from their actions as directors. Frequently, such documents will exclude from indemnification protection, claims arising from deliberate wrongdoing, gross negligence and fraud. Likewise, reimbursement is often limited to the extent there are insurance proceeds.
Legislative Reform – The state legislature has created protection from or limitations upon the liability of directors of community associations. These limitations take the form of immunity from liability for certain conduct. The limitations also vary depending upon whether directors are developer-appointed or owner-elected.
Directors and Officers Insurance – This insurance protects the individuals who serve as directors or officers from a number of types of claims asserted against them arising from their actions as directors or officers. Such insurance is an important part of a director’s means of protection because it will pay the costs to defend against such claims. The cost of defending claims, even groundless claims, can be prohibitive if it must be borne by a community association or an individual director.
In considering this form of protection for directors, it is essential to recognize there is no uniform contract of insurance as there are for other types of coverage. As a result, the format and the coverage will vary dramatically from policy to policy.
In order to appreciate the value of any particular directors and officers insurance policy (“D&O policy”), one has to study it carefully. For example, it is generally necessary to study both the definitions section and the exclusions section of a policy to fully appreciate the protection the policy offers. Some policies will protect and defend only against claims for “negligent acts.” This leaves unprotected any claims for intentional acts. Other, broader policies will cover against claims of “wrongful acts.”
Generally, there are two types of coverage available in directors and officers insurance policies. Most policies will only cover claims or furnish a defense when the claim asserted is for money damages. Under these policies, no defense will be furnished when the claim is for equitable relief. One or two carriers offer coverage that will defend directors from any claims, without regard to whether money damages are sought.
Among other important considerations in review D&O policies are the following:
- No currently available D&O policy will cover claims for punitive damages.
- Most D&O policies do not cover slander, libel or defamation, although such coverage may be offered as an endorsement to the policy.
- All D&O policies exclude claims for pollution, leaving claims against the directors related to environmental issues unprotected unless picked up by other insurance.
- Umbrella policies do not usually fit over D&O policies. Thus, low limits of D&O coverage may be dangerous.
- With two exceptions, D&O insurance carriers will not insure any directors on a board that includes developer-appointed members.
Careful Practices/Risk Management Program – The value of being thoughtful and careful as a director as a means of self-protection will continue undiminished so long as the nature of the Business Judgment Rule continues unchanged.
In reviewing the conduct of directors in response to a claim by their association or its members, the Business Judgment Rule examines the steps directors took in arriving at business decisions. The Business Judgment Rule protects directors against any liability based on the outcome if the decisions were reached through appropriate steps. The substantive reasonableness of any particular decision is not questioned by the court. That is, even if a particular action of a corporation or association is, in 20/20 hindsight, negligent, so long as the directors exercised the same care and attention as a prudent person would in their investigation leading to the decision, the directors will not be personally liable.
In reviewing the conduct of directors in the face of tort claims by third parties, directors will generally not be found liable unless they intentionally act wrongfully or unless they ratify acts they know to be wrong. Careful practices, thus, will work equally well to avoid risks based on tort law theories.
Careful practices will similarly serve to warn directors of potential conflicts of interest and help them to avoid circumstances in which their undivided loyalty can be called into question. For developer-appointed directors, particularly, those practices that will help the red flags to go up are central to avoiding claims of breach of fiduciary duty.
Every association should put into place a risk management program. Risk management is the affirmative action taken by an association to minimize exposure to liability and reduce expenditures for damages, costs and attorney fees. Through a risk management program, an association’s exposure to liability is minimized by the proper use of insurance (general liability, casualty, D&O, worker’s compensation, etc.), risk transfer methods (contracts, licenses, releases, indemnifications, etc.), and risk avoidance procedures (on-site inspections, proper rules and enforcement procedures, etc.).
ADVICE FOR ALL DIRECTORS
Specific advice for community association directors can be compiled from the foregoing review of the duties of directors, typical claims against directors, the general rule protecting directors, and the four forms of protection for directors. Our short list of advice for all association directors reads as follows:
- Do not be a director unless you will spend the time it takes to do the job. Your community association is not a social club; it is a business that requires professionalism of its board of directors. Central to such an approach is spending the time it takes to do the job properly.
- Understand the association and its operations. This means knowing and understanding the association’s authority and responsibilities as defined in its governing documents and by practice, its finances, its management, and its relationship with its members. Responsible decisions are most possible when directors understand the community they serve.
- Be alert and critical in reviewing the information furnished to you concerning the operations of the association. Early reaction to major trouble is often the greatest service a director can do. Lethargy in the face of such trouble promises loss to the association and claims against directors.
- Be an active director. Most associations require its boards of directors to meet regularly and, absent special circumstances, to make their decisions in meetings. This is based on the valid conclusion that the process of listening, asking, and speaking leads to better decisions. In order to be able to be active, get informed. Ask for information about decisions that are to be made and then study what you are given in advance of the meeting at which the decision is to be made.
- Select and then support good management. As volunteers, most community association directors cannot and should not become involved in the detailed management of an association. Rather, the directors must employ good management and evaluate regularly its performance. So long as assessment of management is positive, support and rely on it to help you in making informed decisions.
- Seek the advice of professionals and then listen to that advice. Good directors recognize they are generalists who often need the advice of specialists in order to be well informed. Directors should seek the advice of community association managers, accountants, lawyers, engineers, contractors, and the like, as circumstances require. However, professionals may not always be right and it may be a good decision to reject their advice in that particular case. Keep in mind, prudence requires business decisions be based upon available expertise. If the advice of experts is rejected, there should be good reasons for the rejection.
- Do not make a decision solely because it is popular or merely to quiet dissension. Later, when hindsight is sharpest, this rationale will do nothing to protect a director who has made a decision that cannot be defended by the Business Judgment Rule.
- Do not accept special treatment. Altruism in its most rigorous form should control your decision to be a director and should characterize your service. Even the most inconsequential compensation or special consideration will prove indefensible when raised at an annual meeting or during a deposition.
- As a director, be reluctant to do business with the association. Any transaction with the association should be at arm’s length and for the association’s benefit, not yours. Every such transaction should be fully disclosed and memorialized. Be sure to follow the association’s governing documents and policies and be sure that other directors do likewise.
- Make sure the minutes reflect the process that was followed and the advice received for all major decisions.
- Do not serve without broad indemnification and a limitation of liability in the governing documents or without broad D&O insurance protection and a fidelity bond.
- Attend a presentation by association’s legal counsel on fiduciary duties of directors and applicable statutes.
- Adopt a comprehensive risk management program designed to minimize liability and reduce damages in the event of liability.
The growing contentiousness of disputes between members of community associations and those who manage the affairs of these associations requires directors of a community association to recognize they face the same exposures as business corporation directors. Those of us who provide professional advice and services to these associations need to stress this advice, routine as it may be, and the consequences of casually or unmindfully undertaking and serving as a director of a community association. Only by receiving and acting on this advice can directors safely serve their communities. In it is not too extreme to suggest that if directors cannot serve relatively free from claims, the community association as a form of real estate development and ownership will be at risk.