By Keith Turner and Justin Escano
Palm Spings Villas II v. Parth is a another example of what can happen when an HOA board member “goes rogue” and tests the limits of the so-called “business judgment rule,” which HOA board members sometimes naively believe immunizes their conduct from personal liability. The court held that an HOA director can be held personally liable for failing to act with reasonable diligence in the performance of director duties.
This case is important reminder that HOA board members’ authority is also limited by the governing documents, the CC&Rs and by-laws.
In this case, the HOA itself sued Erna Parth, the HOA president and a member of the board of directors, for a number of questionable actions she took on behalf of the HOA:
Parth hired a roofing company to perform roofing repairs, without notice or approval by the Board, after the Board had already approved and hired a different roofing company for the same repairs. She did not confirm whether the company held a roofing license.
Parth signed three promissory notes totaling $1.775 million, secured by HOA assets and property, for a project to repave walkways and other repairs. She did not give notice or obtain approval by the board for obtaining the loans; and she did not review the CC&Rs or Bylaws to determine whether she had authority to execute the promissory notes; but she believed she had the authority to do so. Under the governing documents, a vote of the majority of the members was required to use HOA assets as security for the loans; however, she did not know such a vote was required
Parth hired landscaping company to a 5-year contract; however, under the Bylaws, a majority vote of the members was required to enter into a services contract for longer than a year. She also hired a new management company, even though the existing company had not yet been terminated by the Board, and the Board agreed not to terminate the company until they received bids from other management companies.
Finally, Parth secretly renewed a 1-year contract with their existing security company, even though the Board was actively obtaining bids from other security companies. She did not disclose the 1-year renewal with the new company. When the HOA Board hired a different security company, the existing company sued for breach of contract, which led to the HOA’s cross-complaint against Parth.
At deposition, Perth repeatedly admitted that she had no understanding of what her actual scope of authority was as the HOA President and a board member, and that she never reviewed the governing documents to find out.
Parth’s main defense from personal liability was the business judgment rule. Although the business judgment rule applies generally to all corporations, the California Corporations Code has special sections for volunteer directors of nonprofit organizations. At issue in Palm Springs Villas II, was the section governing volunteer directors and officers of mutual benefit corporations, Corp. Code § 7231.5. Under the business judgment rule, an HOA director will not be held personally liable in the performance of their duties. Even if a director breaks HOA rules, or otherwise makes unsound business decisions, that director will not be personally liable as long as they acted in good faith, in the best interests of the HOA, and based on reasonable inquiry. The business judgment rule is intended to allow board members to make important decisions, including those that may pose some risk to the HOA; without it, directors would be paralyzed by the fear of being held personally liable for acting on behalf of the HOA.
However, the business judgment rule has its limits. It will not protect a director who fails to exercise reasonable diligence, fails to conduct a reasonable investigation, or otherwise acts in bad faith in the performance of director duties.
In Palm Springs Villas II, the court of appeal held that the business judgment rule did not automatically shield Perth from liability, because there were material issues of fact as to whether Perth exercised reasonable diligence and conducted reasonable investigations in the performance of her duties. Parth repeatedly stated at deposition that, before she engaged in these activities, she did not know whether she had the authority to do so. Further, she did not make any efforts to review the governing documents to determine whether her actions needed approval by the Board or by the shareholders. Finally, Parth failed to conduct reasonable investigations and basic inquiries, such as whether the roofing company she hired had a roofing license. According to the court, these failures to investigate amounted to “willful ignorance,” and created an issue of material fact as to whether Parth acted with reasonable diligence. The court even suggested that Parth’s failures could amount to bad faith conduct. As explained by the court, “Permitting directors to remain ignorant and to rely on their uninformed beliefs to obtain summary judgment would gut the reasonable diligence element of the rule and, quite possibly, incentivize directors to remain ignorant.”
Palm Springs Villas II is a good reminder to HOA directors that they have a duty to act exercise diligence when attending to the property’s needs. HOA directors cannot simply hide behind the business judgment rule. The case is good example for disgruntled unit owners to challenge the ineptitude and incompetence of HOA directors, and to remind them to do their duty.