Right Outcome, but the Court of Appeals is Confused as to the Business Judgment Rule

Right Outcome, but the Court of Appeals is Confused as to the

Business Judgment Rule

 

 

            In a recent decision the Court of Appeals correctly found that it would not second guess the decisions made by a board of directors as to how corporate assets should be applied to remedy existing problems.  At the same time, however, the Court was off base as to what is the Business Judgment Rule, and was off base as to who owes and who is the beneficiary of the fiduciary obligations in a corporation.   Davis v. Innwood Condominium Property Owners Association, Inc., No. 2013-CA-001221-MR, 2014 WL 2938486 (Ky. App. June 27, 2014).

 

            Davis owned a condominium in the Ironwood development, a low and fixed income complex. The property has in recent years faced a number of challenges including the need to expend some $100,000 in brick repairs in order to remedy a code violation, significant repairs to the heating system, and an increase in insurance premiums after a fire.  A special assessment of the owners was made in order to increase reserves.

 

            Davis, who at various times has served on the board of directors, brought suit alleging that the board had failed to satisfy the terms of the master deed as to a number of issues including exterior maintenance, limitations upon occupancy of units and failing to require background checks on occupants.  In addition, he alleged that the board had failed to maintain the property as a “first-class condominium.”  Collectively, he asserted that these failures, characterized as breaches of fiduciary duty, reduced the fair market value of his unit.

 

            After discovery, the trial court dismissed the complaint as being subject to the “business judgment rule”; this appeal followed.

 

            Davis’ argument was that the Master Deed set forth requirements, that even though some issues were being address the board was not requiring full compliance with those requirements, and a breach of fiduciary duty therefore resulted.  The Court of Appeals affirmed the trial court’s determination that the Business Judgment Rule precluded court intervention, it writing:

 

The business judgment rule is “a presumption that in making a business decision, not involving self-interest, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” Allied Ready Mix Co., Inc. ex. rel. Mattingly v. Allen, 994 S.W.2d 4, 8 (Ky.App.1998). The record below indicates that the Board sought guidance from its management company, Prudential Parks, and Weisberg Realtors in making decisions as to how to best address the issues raised by Davis. The record further reflected that the Board did not have all of the necessary funds at its disposal to immediately fix each of the problems raised by Davis. However, the Board, based upon the advice it received, in consideration of the financial status of the tenants and owners at Innwood, did vote to approve a Special Assessment for repairs and maintenance. By considering the economic standing of its residents and the problems at issue and making such a decision, this Court is not persuaded that the Board breached any fiduciary duty in this instance.

 

Finding there to be no assertion of fraud or conflict of interests that precludes the application of the Business Judgment Rule, the trial court’s dismissal of the complaint was upheld.

 

            That said, before the quoted language above the court misidentified the source of the Business Judgment Rule as being in the statutory formulae of the standards imposed upon corporate directors, those being KRS §§ 273.215 and 271B.8-300.  Sorry, but that is not the case.  Those cases recite the standards of performance and the standards of culpability imposed upon directors.  The Business Judgment Rule, in contrast, applies not to corporate directors but rather to the courts called upon to assess the actions taken by the directors, and creates a presumption against judicial review of decisions made by a corporate board.  In no manner is this presumption against judicial review “codified” in the the Kentucky statutes on business and nonprofit corporations.

 

            Another point, this one clearly dicta, in which the Court of Appeals was on less than a sound footing was in finding that there exists a fiduciary duty running from the corporation’s board to the individual owners thereof.  The Court of Appeals acknowledged that this determination is in contrast to that made in the then not final Ballard v. Willow Council of Co–Owners, Inc., 430 S.W.3d 229, 2013 WL 6134150 (Ky. 2013).  A motion for reconsideration in Ballard was denied on June 19, 2014, and that decision is now final. Hence the suggestion in Davis that a fiduciary duty is owed directly to the owners should be treated as moot.

Kentucky Supreme Court Identifies the Beneficiary of a Board’s Fiduciary Obligations

Kentucky Supreme Court Identifies the Beneficiary of a Board’s Fiduciary Obligations

      Last Thursday, the Kentucky Supreme Court issued its long-awaited decision in Ballard v. 1400 Willow Council of Co-Owners, Inc., a dispute that in part revolves around fiduciary duties among the members of the board of directors, the board of directors as a collegial body and the members of a nonprofit corporation.  In that the statute defining the fiduciary obligations of the directors of a nonprofit corporation (KRS § 273.315) uses the same formula as that utilized in the Kentucky Business Corporation Act (KRS § 271B.8-300(1)), this decision has application across both forms of business organization.  Ballard v. 1440 Willow Council of Co-Owners, Inc., 2010-SC-000533-DC (Ky. Nov. 21, 2013). 

      Ballard was the owner of a condominium in the 1400 Willow building.  Consequent to certain problems with exterior masonry, agreed by all to be a common element, the window frames in her condo began to rot out.  There was a dispute as to whether or not the rotting was of such a degree that there was a risk of the glass falling; the condominium board believed there to be an eminent risk, while Ballard’s consultant thought there to not be a problem.  During the pendency of a complaint for declaratory relief, workers employed by the condominium association (a/k/a the “Council”) entered the condominium and replaced the windows at a total cost of $65,000.  The Council as well filed a lis pendens on the title to the condominium as security for the amount it had expended.  Slip op. at 3.  Thereafter Ballard amended her complaint to claim damages for breach of contract, breach of fiduciary duty, promissory estoppel and punitive damages.  Some two years later she would again amend her complaint to assert that the lis pendens filed by the Council as well as a similar document filed with the Jefferson County Clerk constituted slander of title.

      At a trial that took place in September, 2007, the jury determined that the windows did need to be replaced and that the need for replacement was caused by the masonry problem.  The jury also found that (a) the Council failed to exercise “good faith and loyalty” to the condo owners including Ballard, (b) that she should be made whole on $54,000 of condo fees paid, and (c) that the lis pendens was a knowing and malicious false statement as to the title of her condo for which $75,000 would compensate her.  The jury declined to award punitive damages.

      The jury’s decision was appealed to the Court of Appeals, which reversed and remanded for a new trial.  The Supreme Court then granted discretionary review.

       Before going to what I find interesting in this decision, namely the discussion of fiduciary duties and contract law, it should be noted that this decision has important points on real property law.  First, the Supreme Court held that the statute of limitations on a claim of slander of title would be five years (KRS § 413.120) and in so doing reversed a prior decision holding it to be one year.  See slip op. at 11.  Turning to the actuality (or not) of the slander of title claim, while the Court reviewed a good deal of foreign law holding that the filing of a lis pendens has an absolute privilege, it ultimately held that the filing of a lis pendens has only a qualified privilege.  Slip op. at 16.  From there, in reliance upon the jury’s determination that the lis pendens was “false and knowingly and maliciously made,” the Court held that the qualified privilege was not available to the Council.

      The broader issue addressed by the Court is the nature of fiduciary duties, specifically who owes them and to whom they are owed.  While Ballard’s theory of the case appears to have changed over time, she ultimately asserted not a derivative action on the corporation’s behalf charging the directors with a breach of duty owed the entity but rather “she sued the [Council] as an entity for breach of its contractual obligations and common law fiduciary duties to her, individually.”  Slip op. at 20.  That attempted parsing of her claim ultimately failed as she relied upon a non-existent fiduciary duty.

[W]e cannot say that the Council had a fiduciary duty to the individual owners.  Ballard has not cited any Kentucky authority which provides that a nonprofit corporation has a fiduciary duty.  Rather, we believe it is the officers and directors that have a fiduciary duty, and that duty is to the nonprofit corporation.  See KRS 273.215.

Slip op. at 20.

      The Court continued its analysis of the point, making express that the duty is to the entity and not the individual members:

[T]he directors in this case only owed a fiduciary duty to the corporation.  Specifically, KRS 273.215 provides that a director shall discharge his duties “(a) In good faith; (b) On an informed basis; and (c) In a manner he honestly believes to be in the best interests of the corporation.”  (Emphasis added).  As correctly noted by the Court of Appeals, this is a reasonable interpretation because the co-owners in this case could have competing agendas, which may not be in the best interests of the Council.  Thus, the board of directors had a fiduciary duty to the Council as a whole and not to the individual unit owners, such as Ballard.

Slip op. at 21.  On that basis the jury’s award of $54,000 for breach of fiduciary duty was for breach of a non-existent duty, the Court of Appeal’s reversal thereof was upheld.

      Justice Noble, joined by Justice Scott, dissented as to the reversal of the finding of a breach of fiduciary duty.  Essentially, Justice Noble argued that the jury’s determination that the Council filed to “exercise good faith and loyalty” (slip op. at 27) equated to a breach of fiduciary duty.  The problem with this assessment was identified (but apparently not recognized) by Justice Noble when she noted the source of Ballard’s rights as a condo owner as to her particular unit, namely the “contractual rights and expectations” set forth in her deed and the Master Deed.  The failure was in not recognizing that contractual obligations are not fiduciary obligations, and that the obligation of “good faith and fair dealing” is contractual in nature.  See slip op. at 31 (“thus violating the general fiduciary duty – that ‘of good faith and fair dealing’ – contained in all contracts.”).

      Fortunately the majority opinion addressed this point, recognizing that “we cannot say that the jury’s find of a breach of fiduciary duty is equivalent to a finding of failing to act in good faith” (slip op. at 22), thereby properly separating the status-based gap filler that is the law of fiduciary duties from the contractual interpretation principle that is good faith and fair dealing.

Membership in a Nonprofit Corporation

The Kentucky Court of Appeals Again Addresses

Membership in a Nonprofit Corporation

          The Court of Appeals has again addressed the questions of membership in a nonprofit corporation and obligations owed to the members.  Fenley v. Kamp Kaintuck, Inc., 2011 WL 5443440 (Ky. App. Nov. 10, 2011) (Not to be Published).  This decision follows upon, in various aspects, 1400 Willow Council of Co-Owners, Inc. v. Ballard (reviewed here on September 29) and Tinsley v. Wildwood Country Club (reviewed here on October 4).

        The Fenleys were members of Kamp Kaintuck, Inc., a Kentucky nonprofit corporation.  Under KKI’s bylaws, all active members were required to attend once every three years.  There was no dispute that the plaintiffs did not do so.  On that basis, KKI’s Board of Directors terminated the plaintiffs’ memberships.  They in turn sued for wrongful termination of membership status, made allegations of breach of fiduciary duty, sought an accounting of KKI’s assets and as well its liquidation.

        As to the first complaint, namely that the Fenleys were wrongfully terminated from member status, the Court easily dismissed that count.  They were terminated for violation of the bylaw requirement that they attend the camp at least once every three years.  In support of this conclusion, the Court cited 14A C.J.S. Clubs § 14 (2011).  While no doubt this authority supports the proposition for what it was cited, it is curious that the Audubon County Club decision (785 S.W.2d 501 (Ky. App. 1990)), it having been relied upon by the Wildwood County Club court, was not cited.

          As to the count for breach of fiduciary duty, and consistently with the decision rendered in 1400 Willow v. Ballard, the Court stated that the fiduciary duties run to the corporation and the shareholders/members as a whole.  “Hence, a Board member or officer owes no common-law fiduciary duty directly to an individual shareholder/member,” citing 18B Am.Jur.2d Corporations § 1462 (2011).  From this position, the Court determined that any action for enforcement of those fiduciary duties, whether existing at common law or based upon statute, must be brought in the form of a derivative, rather than a direct, action.  To the extent that the plaintiffs sought to bring a derivative action, in that their membership status had already been terminated, the Court held that they lacked standing to do so.  With respect thereto, the Court cited Bacigalupo v. Kohlhapp, 240 S.W.3d 155, 157 (Ky. App. 2007) for the continuous ownership standard that is applicable in the context of a business corporation.  See also KRS § 271B.7-400(1).  Purely as an aside, why do courts, in addressing statutory requirements, cite cases that talk about the statute rather than directly citing to the statute?  The Court set forth its position that, in any derivative action involving a nonprofit corporation, a similar requirement would be applied, but specifically sidestepped the question as to whether derivative actions exist in nonprofit corporations.  2011 WL 5443440, *3, note 2.

           With respect to the claims for an accounting and for judicial dissolution, the Court held that, as the Plaintiffs were no longer members of KKI, they lacked standing to seek either of those remedies.

Expulsion from a Non-Profit Corporation - Tinsley v. Wildwood County Club, Inc.

Expulsion from a Non-Profit Corporation -

Tinsley v. Wildwood County Club, Inc.

In Tinsley v. Wildwood County Club, Inc., No. 1010-CA-001295-MR (Ky. App. 2011), the Court addressed (a) whether a member had been afforded the “procedural due process” provided for in the bylaws and (b) whether the expelled member was entitled to a refund of his $25,000 membership fee.

In response to allegations of inappropriate conduct including harassment of female employees, the Wildwood Board met and made a preliminary determination that Tinsley would be expelled.  By letter, in furtherance of a bylaw affording a member the opportunity to be heard as to expulsion, Tinsley was invited to meet with the Board.  Notwithstanding an objection that the hearing would be “moot,” he did appear and through counsel objected to alleged procedural errors on the Board’s behalf – he did not respond as to the merits of the charges.  The prior decision to expel Tinsley was affirmed, and a suit followed.  The appeal followed the trial court’s denial of summary judgment to Tinsley as to certain points, holding that Wildwood did not violate its bylaws, and a grant of summary judgment to Wildwood on all other matters.

As to the procedural points, relying upon Hartung v. Audubon Country Club, 785 S.W.2d 501 (Ky. App. 1990), the court noted “that judicial review of a club’s actions concerning membership is limited only to enforcement of the club’s own rules.”  Slip op. at 11.  The Court of Appeals found that the process employed, namely a board vote to expel with an opportunity to be heard and for that vote to be reconsidered, met the requirements of the bylaws.  It as well cited Kirk v. Jefferson County Medical Society, 577 S.W.2d 419, 422 (Ky. App. 1978) for the proposition that it is “sufficient that the constitution and bylaws are substantially observed.”  Slip op. at 13, n. 11.

As to the right to a refund of his $25,000 (and as to this point there was a dissent), the Court of Appeals determined that the bylaws and related documents provided for three treatments:  (i) expulsion for cause with a refund of the fee; (ii) expulsion not for cause with a refund of the fee; and (iii) expulsion for cause with the opportunity for a hearing to challenge the expulsion, but no refund if the expulsion is upheld.  Slip op. at 16.  Finding Tinsley fell into the third category, he was not entitled to a refund of his $25,000.