Bye-Bye Business Judgment Rule?

By Frederick, Donald A. | Rural Cooperatives, January-February 2006 | Go to article overview

Bye-Bye Business Judgment Rule?


Frederick, Donald A., Rural Cooperatives


Cooperative 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. …

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