Directors Failure To Investigate

The business judgment rule protects directors from personal liability provided they conduct a reasonable investigation (due diligence) before making a decision.

In a recently published case, the Court of Appeal found that board president Edna Parth was subject to personal liability for failing to investigate matters before taking action. The court was disturbed that, among other things, she:

1. Hired a roofing company without soliciting bids, checking references or licensing, without verifying insurance, or consulting management or legal counsel. The company proceeded to perform defective work that required additional repairs.

2. Signed promissory notes for $900,000, $325,000 and $550,000, secured by the association’s assets, receivables and property. Parth later testified that she had not reviewed the CC&Rs or bylaws and did not know whether she had authority to sign the notes and was not aware they needed membership approval.

3. Signed a five-year contract with a landscape company and later admitted she did not know if she had authority to sign it. She testified that her understanding of her authority under the bylaws was “none.”

The court noted that the failure of a director to conduct due diligence is a breach of their fiduciary duty. In addition, conduct contrary to the governing documents may fall outside the business judgement rule. The court commented that directors cannot close their eyes to matters as basic as the provisions of the CC&Rs and bylaws and at the same time claim they exercised business judgment.

RECOMMENDATION: Board members should make sure their minutes reflect that they investigated and deliberated on issues before making a decision. In addition, they should consult legal counsel, management, and consultants as may be appropriate. Finally, they should have a working knowledge of their governing documents (and then follow them). To read the case, see Palm Springs Villas II HOA v. Parth

Thanks to the Davis-Stirling.com electronic newsletter for this information.