– By David M. Peters, Esq. & Simon J. Freedman, Esq. (originally published in July, 1998)

In April of this year, a California Appellate Court decided that an “objective test of reasonableness” should be used to decide whether a homeowners association has properly maintained the common areas. Before this decision, the traditional standard was the “Business Judgment Rule,” which is less stringent.

The Facts

The new standard for common area maintenance was decided in a case called Lamden v. La Jolla Shores Clubdominium Homeowners Ass’n. (“Clubdominium” is not a typo-graphical error). The owner, Lamden, felt that the Association should fumigate an entire building for termites. The Association had an inspection done which concluded that fumigating the entire building was an option, but the inspection report also stated that the building could be spot-treated.

After considering various factors, such as the cost of fumigating the entire building versus spot treating; the cost and inconvenience involved in moving people out of their units for fumigation, and the opinion of experts regarding the extent of the damage, the Association decided to perform spot treatments only. Lamden sued, claiming that the spot treatments were inadequate.

Round One — The Trial Court Decision

The first judge who heard the case used the traditional standard, the “Business Judgment Rule”, to decide the dispute. The “Business Judgment Rule” is a presumption made by the courts that directors’ decisions are based on sound business judgment and, generally, courts will not hold such directors liable for errors or mistakes in judgment, so long as the board members were:

(1) disinterested and independent;

(2) acting in good faith; and

(3) reasonably diligent in informing themselves of the facts.

At trial, the Court ruled the Association acted properly and in accordance with the “Business Judgment Rule.” Lamden appealed.

Round TwoThe Court of Appeal’s Decision

The Court of Appeal agreed with the trial court to a certain extent: the Business Judgment Rule does apply in certain circumstances. However, the appellate court decided that homeowners have a “dual relationship” with their association.

The first part of the dual relationship is the fiduciary relationship directors have with members of the association. This relationship requires directors to exercise their powers in accordance with corporate law (i.e., the Business Judgment Rule). This was the standard that generally had been applied when evaluating directorsÕ decisions. The second part of the dual relationship is the new standard which, as was applied here, is that of landlord and tenant.

In a landlord/tenant relationship, the landlord (the association) has a duty to exercise reasonable care to protect the homeowners’ units from damage. This standard includes the responsibility to use reasonable care in maintaining and repairing the common areas. The court also compared the association’s duties to another legal standard, that of a trustee, which requires prudence, discretion and intelligence in managing its affairs.

Essentially, this new standard makes a board’s decision vulnerable to challenge based on hindsight. The reason is that decisions can now be evaluated under an objective standard of reasonableness, as opposed to the subjective analysis as to whether the board members were acting in good faith.

The Court concluded that a new trial was needed to evaluate whether the particular facts objectively showed whether the Association acted reasonably.

The DecisionHow This Affects Future Decisions

What does this case mean for the future of homeowner associations? Directors are no longer protected by the fact that the board members were disinterested, acted in good faith, and were reasonably diligent in informing themselves of important factors. Now, the analysis will be taken one step further, essentially asking whether the board actually ended up reaching the best conclusion.

For example, many boards use a cost-benefit analysis to make decisions, including when maintenance should be performed. No other analysis was required, because a cost-benefit analysis usually satisfies the Business Judgment Rule. Under the standard held to apply in this case, however, a second analysis must be made. The board is required to determine whether the association’s decision will unduly shift risk or burden to an owner.

Generally, boards should not abandon the cost-benefit approach. However, based on this case, boards cannot categorically choose the most fiscally prudent alternative. Instead, boards must determine whether the most fiscally prudent alternative is also the least likely to expose the owners to unreasonable risk. Any questions regarding whether an associationÕs decision will unduly shift risk or burden to an owner should be referred to legal counsel.