Understanding Breach of Fiduciary Duty by Developer-Appointed Directors in Condominium Associations
Many co-owners volunteer to serve on the board of directors because they believe that they can lead their condominium association in a positive direction. This belief is essentially what it means to fulfill their duty as a fiduciary: to act in good faith, loyally to the association, and avoiding self-dealing. If the association believes that a co-owner director has not fulfilled their fiduciary duty, then a simple remedy is to vote to remove the director from the board or simply not re-elect that director when their term expires. But what recourse does a condominium association have that is still under developer control where the developer is entitled to appoint at least one, if not more, director to the board? This article examines the issues surrounding the fiduciary duties owed by a developer-appointed director to the association.
What is a Fiduciary Duty?
A fiduciary acts from a position of trust and authority to the entity they serve. In the context of a condominium association, a director acts on behalf of the association. As such, each director owes a fiduciary duty to the association’s members, the co-owners. A fiduciary duty generally requires one to ‘act for someone else’s benefit, while subordinating one’s personal interests to that of the other person.’ ” Baughman v W Golf & Country Club, Inc, unpublished per curiam opinion of the Court of Appeals, issued June 9, 2009 (Docket No. 279425), quoting Wallad v Access BIDCO, Inc, 236 Mich App 303, 307; 600 NW2d 664 (1999). Michigan courts have imposed the specific fiduciary duties of good faith, loyalty, and avoidance of self-dealing. Prentis Family Foundation v Barbara Ann Karmanos Cancer Institute, 266 Mich App 39, 49; 698 NW2d 900 (2005).
In addition to a director’s fiduciary duty, the Michigan Nonprofit Corporation Act provides the standard of care for directors and officers of a nonprofit corporation (nearly all condominium associations are incorporated as nonprofit corporations):
(1) A director or officer shall discharge his or her duties as a director or officer including his or her duties as a member of a committee in the following manner:
(a) In good faith.
(b) With the care an ordinarily prudent person in a like position would exercise under similar circumstances.
(c) In a manner he or she reasonably believes is in the best interests of the corporation.
MCL 450.2541(1). The standards of care identified in MCL 450.2541(1) are also referred to as the business judgment rule.
A California court held that the owner of the developer corporation and his wife who were directors of the association owed a fiduciary duty to the association and its members:
Of particular significance is the conflict of interest presented where, as here, the owner of the Developer and his wife and major co-owner, are also directors of the Association in its infancy, along with the Developer’s employees. We note that the duty of undivided loyalty (see Scott, The Fiduciary Principle, 37 Cal.L.Rev. 539) applies when the board of directors of the Association considers maintenance and repair contracts, the operating budget, creation of reserve and operating accounts, etc. Thus, a developer and his agents and employees who also serve as directors of an association, like the instant one, may not make decisions for the Association that benefit their own interests at the expense of the association and its members.
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We think that here, the failure of the initial Association directors to exercise supervision which permits mismanagement or non-management is an independent ground for the breach of fiduciary duty by the Developer during the initial period of the Association, when the Developer and its employees controlled the Association.
Raven’s Cove Townhomes, Inc v Knuppe Dev Co, 114 Cal App 3d 783, 799-800; 171 Cal Rptr 334, 343 (1981). Accordingly, every director of a condominium association, whether elected by the co-owners or appointed by the developer, have a fiduciary duty to act in the best interest of the association.
How Many Developer-Appointed Directors Are On The Board?
During the development of a condominium, the developer has a right under the Michigan Condominium Act, MCL 559.152, to appoint directors to the board and also identifies when co-owners are entitled to elect nondeveloper co-owners to the board. A prior article, MCL 559.152: When Do the Co-owners Elect Directors After Developer Control?, addresses the process and formula for electing nondeveloper co-owners to the board. For the purposes of this article, it is sufficient to understand that a developer has the right to appoint at least one director to the board until there are less than 10% of the units that may be created offered for sale.
For purposes of establishing a breach of a fiduciary duty, the developer-appointed director must have some culpability in causing the breach. In Sunnyside Resort, the Court discussed the issue of causation in relation to a developer appointee levying assessments and stated as follows:
Although the complaint does not include an allegation that Beckman also breached a duty during his time as a director for the SRCA’s board of directors, the SRCA made that argument at trial and now on appeal. Once again, however, the district court properly determined that the SRCA has not provided sufficient proof of causation. As just discussed, the four-member board of directors establishes a budget and issues assessments based on the percentages in the master deed. It is undisputed that at all times that Beckman served on the board, the vote to approve the budget was unanimous.
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Consequently, the SRCA could not possibly prove that Beckman’s vote, as a sole director, was a cause-in-fact of the alleged injuries suffered by the SRCA. Even if Beckman had voted as the SRCA alleges that he should have voted, the SRCA still would have suffered the same damages.
Assume that there are three board members. Any action of the board of directors must be approved by a majority of the directors, in this case two directors. The board is considering a matter. If there are two developer-appointed directors and both vote to take action on the matter in a way that is not in the best interest of the association, then the board will take an action that is not in the best interest of the association. Accordingly, the developer-appointed directors potentially breached their fiduciary duties because they caused the association to suffer damage by taking action not in the best interest of the association.
Now consider the flip side, where there is only one developer-appointed director. If only the one developer-appointed director votes to take action on the matter that is not in the best interest of the association (the two other directors voted to take action in the best interest of the association), then the board will take action on the matter in the best interest of the association. Accordingly, the developer-appointed director likely did not breach their fiduciary duty because their vote, although not in the best interest of the association, did not cause damage to the association.
Examples of When a Developer-Appointed Director May Breach Their Fiduciary Duty
There are many circumstances where a director may breach their fiduciary duty to the association. Below are examples of such circumstances.
1. Engaging Contractors that the Developer-Appointed Director has an Interest
The board of directors for a condominium association has the general authority and power to act on behalf of the association to maintain the common elements that are assigned as the association’s responsibility under the master deed. The board of directors should engage a qualified contractor to perform any necessary maintenance, repair, or replacement of the common elements that the association is responsible for. It is not unusual for a board of directors to engage a contractor that one or more board members are already familiar with. But when one or more directors have a personal or financial interest in the contractor, such as when a director(s) owns the company, the facts underlying the transaction may establish that engaging the contractor is not in the best interest of the association.
Entering into a transaction in which a director has an interest is not in and of itself improper. Instead, the terms of the transaction need to be reviewed for fairness. See Kern v Kern-Koskela, 320 Mich App 212, 236-238; 905 NW2d 453 (2017) (holding that demonstrating self-dealing is not enough, a transaction must also be unfair to the corporation). The Michigan Nonprofit Corporation Act provides the following as guidance when a condominium association enters into a transaction in which a director or officer has an interest:
(1) A transaction in which a director or officer is determined to have an interest shall not be enjoined, set aside, or give rise to an award of damages or other sanctions because of the interest, in a proceeding by a shareholder, a member, or a director of a corporation that is organized on a directorship basis or by or in the right of the corporation, if the person interested in the transaction establishes any of the following:
(a) The transaction was fair to the corporation at the time it was entered into.
(b) The material facts of the transaction and the director’s or officer’s interest were disclosed or known to the board or an executive committee of the board and the board or executive committee authorized, approved, or ratified the transaction.
(c) The material facts of the transaction and the director’s or officer’s interest were disclosed or known to the shareholders or members who are entitled to vote and they authorized, approved, or ratified the transaction.
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(4) Satisfying the requirements of subsection (1) does not preclude other claims relating to a transaction in which a director or officer is determined to have an interest. Those claims shall be evaluated under principles applicable to a transaction in which a director or officer does not have an interest. (emphasis added).
Consistent with MCL 450.2545a, the Michigan Supreme Court has held as follows with respect to establishing whether a transaction was “fair” to the corporation:
…‘(o)fficers of a corporation may deal with it only in good faith. Such contracts must be fair and in the interest of the corporation and all of the material facts must be made known to the directors. Any unfair advantage taken by an officer or director may be the basis for an attack upon the validity of the contract….“When the validity of any such contract is questioned, the burden of proving the fairness to the contracting parties of any such contract shall be upon such director, partnership, other group or association, or corporation who shall be asserting the validity of such contract.”
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Given an instance of alleged director enrichment at corporate expense such as in this case, the burden to establish fairness resting on the director requires not only a showing of ‘fair price’ but also a showing of the fairness of the bargain to the interests of the corporation. Only when a convincing showing is made in both respects can ‘fairness’ under the statute be said to have been established. We are inclined to agree with Fill Buildings’ position that that corporation was entitled to make a profit on its lease and that a ‘fair price’ for the leasehold agreement was established.
Let’s return to the example of a board of directors that has a majority of developer-appointed directors. Now assume that the developer always uses the same company for landscaping, snow removal, and other maintenance services. And it just so happens that the company is owned by individuals employed by the developer, who also just so happen to be the same individuals who have been appointed to the board of directors by the developer. Do those facts establish that the developer-appointed directors breached their fiduciary duties by hiring the company? Perhaps, but the facts underlying the transaction will tell the story.
Did the board solicit quotes from other companies for the same work or did the board choose to hire the company without getting other quotes? Is the contract price similar to the quotes of other companies? Will the chosen company provide the same level of services as other companies? If there is evidence that shows the transaction with the company is not fair to the association, such as when the contract price is substantially higher than other quotes, then that may show that the developer-appointed directors entered into a transaction that was unfair to the association and are personally benefitting from the transaction, and therefore, breached their fiduciary duties by taking action that was not in good faith or in the best interest of the association.
2. Failing to Make Necessary Repairs to Defective Construction
In circumstances where there is damage to a common element that the association is responsible for repairing or replacing under the master deed and that arises from defective construction, developer-appointed directors may breach their fiduciary duties by failing to require the developer make the necessary repairs.
The Michigan Court of Appeals has held that:
…implied warranties are created when a developer-vendor transfers common areas to an Association. In Smith v. Foerster-Bolser Construction, Inc., 269 Mich.App. 424, 431, 711 N.W.2d 421 (2006), this Court held that an implied warranty of habitability is created when a developer-vendor transfers a new home to a purchaser. In Plymouth Pointe Condominium Ass’n v. Delcor Homes-Plymouth Pointe, Ltd, unpublished opinion of the Court of Appeals, issued October 28, 2003 (Docket No 233847), this Court noted that other jurisdictions have held that the same warranty of habitability also applies to the development and purchase of new condominiums and the accompanying common areas (see Berish v. Bornstein, 437 Mass. 252, 770 N.E.2d 961 (Mass, 2002). Such a rule is logical and necessary.
Heritage in the Hills Homeowners Ass’n v Heritage of Auburn Hills, LLC, unpublished per curiam opinion of the Court of Appeals, issued February, 2, 2010 (Docket No. 286074) p 11 (emphasis added). Accordingly, when the developer sells a unit to a co-owner, there is an implied warranty that the unit will be habitable. If the unit is not habitable due to construction defects, then the board may have a fiduciary duty to pursue the developer to repair the defects. A board led by a majority of developer-appointed directors may decline to pursue the repairs, which would likely be at the cost of the developer, and therefore may breach their fiduciary duties of acting in good faith, loyalty to the association, and avoiding self-dealing.
3. Financial Matters
Although finances may be at the heart of various matters implicating fiduciary duties, two areas that are (mostly) purely financial are properly funding a reserve fund and assessment amounts.
MCL 559.205 requires that each condominium association maintain “a reserve fund for major repairs and replacement of common elements . . .” The administrative rules to the Condominium Act provide additional requirements for the reserve fund, including that it have a minimum of “10% of the association’s current annual budget on a noncumulative basis” and that such amount must be set aside when the developer transitions control of the association to the co-owners. Mich. Admin. R. 559.511(1) and (3). A board of directors potentially breaches their fiduciary duties if the reserve fund is not properly funded or requiring the developer to fully fund the reserve fund at the time of transitional control, although such claims may be also brought as a failure to comply with the Michigan Condominium Act or the condominium bylaws.
Developer-appointed directors may also breach their fiduciary duties by purposefully “lowballing” the amount of assessments. A South Carolina court found that a developer breached its fiduciary duty by under assessing the co-owners and stated as follows:
While the evidence shows the Developer provided some maintenance of the common areas at its own expense until it belatedly organized the Association, there is evidence that the common areas were substandard at the time the Developer turned them over to the Association. There is also some evidence the Developer seized the opportunity in 1987 to “unload” the common areas on the Association without a plan to establish a reserve or a plan to fund the Association until such time as assessments were adequate to cover maintenance expenses. It seems unfair to the villa owners for the Developer to burden them with substandard or deteriorated common areas that required an immediate expenditure of funds to bring them up to standard without a plan or a reserve fund to cover the expenditures. See Orange Grove Terrace Owners Ass’n v. Bryant Properties, Inc., 176 Cal.App.3d 1217, 222 Cal.Rptr. 523 (Ct.App.1986); see also Richard Gill Co. v. Jackson’s Landing Owners’ Ass’n, 758 S.W.2d 921 (Tex.App.1988) (fiduciary relationship established between condominium developer and condominium association because developer assumed responsibility for managing condominium until owners’ association could be formed). (emphasis added).
Goddard v Fairways Dev Gen Pship, 310 SC 408, 415; 426 SE2d 828 (1993). Whether a developer or board led by developer-appointed directors intentionally lowballed assessments is a fact-intensive issue that will likely require expert review to establish that maintenance of the common elements should have been performed and what an adequate assessment amount would have been to perform such maintenance.
4. Limitations on a Developer-Appointed Director’s Liability
Even if a developer-appointed director breaches their fiduciary duty to the association, the director may be able to rely on certain defenses that preclude liability.
Under MCL 450.2541(7), a claim against a director or officer of a condominium association must be brought “within 3 years after the cause of action accrued, or within 2 years after the time when the cause of action is discovered or should reasonably have been discovered, by the complainant, whichever occurs first.”
A claim of breach of fiduciary duty or breach of trust accrues when the beneficiary knew or should have known of the breach. The ‘knew or should have known’ language indicates that when a claim accrues is subject to an objective standard. A plaintiff is deemed to be aware of a possible cause of action when he becomes aware of an injury and its possible cause.
Prentis Family Foundation, 266 Mich App at 47-48. Accordingly, an association should be diligent about pursuing a claim that a developer-appointed director breached their fiduciary duty, otherwise the claim will be barred.
A condominium association’s articles of incorporation and bylaws also may limit director and officer liability. Under MCL 450.2209(1)(c), an association’s articles of incorporation may contain the following:
A provision that eliminates or limits a director’s or volunteer officer’s liability to the corporation, its shareholders, or its members for money damages for any action taken or any failure to take any action as a director or volunteer officer, except liability for any of the following:
(i) The amount of a financial benefit received by a director or volunteer officer to which he or she is not entitled.
(ii) Intentional infliction of harm on the corporation, its shareholders, or members.
(iii) A violation of section 551.
(iv) An intentional criminal act.
(v) A liability imposed under section 497(a).
A final common defense available to directors is the business judgment rule identified in MCL 450.2541(1). A director who acts in good faith, with the care an ordinarily prudent person would exercise in similar circumstances, and in a manner they reasonable believe is in the best interests of the association may be able to avoid liability. Although the business judgment rule and fiduciary duties are distinct concepts, they typically go hand-in-hand where a director who appropriately exercises their business judgment usually has not breached a fiduciary duty.
Conclusion
All directors of a condominium association, whether a co-owner director or developer-appointed director, owe a fiduciary duty to the co-owners of the association. A generalized statement of a fiduciary duty is to act for the benefit of the association instead of their own personal benefit. Michigan courts have identified a director’s fiduciary duties as acting with good faith, loyalty, and avoidance of self-dealing. Condominium associations who have a concern that a developer-appointed director has breached their fiduciary duties to the association should contact an experienced community association attorney to discuss the underlying facts and whether the director can raise a valid defense to limit their liability.
Michael T. Pereira, Esq., is an Attorney with Hirzel Law, PLC and focuses his practice on general counsel matters and document amendments. Mr. Pereira graduated from the University of Detroit Mercy School of Law in 2018, where he graduated magna cum laude and second in his class. Following graduation from Detroit Mercy, Mr. Pereira spent nearly three years with the Michigan Court of Appeals as a research attorney and as a law clerk to Judge Patrick M. Meter and Judge Anica Letica. Best Lawyers: “Ones to Watch” recognized Mr. Pereira in 2024 for professional excellence in real estate law. He may be reached at (248) 478-1800 or mpereira@hirzellaw.com.
