Sponsor's board owes a fiduciary duty to condo.

When a rental building is converted to condominium or cooperative ownership, or when a condominium or cooperative development is being constructed, it is common practice for the sponsor of the project to create the cooperative corporation or the condominium association which will take title to the property when the building is ready.

The sponsor also designates the board of directors of the cooperative corporation or the board of managers of the condominium association, as the case may be. The board members frequently are partners or employees of the sponsor.

The Court of Appeals of the State of New York ruled 40 years ago in the case of Northridge Cooperative Section No. 1 v. 32nd Ave. Constr. Corp., 2 N.Y.2nd 514, that there is a fiduciary duty on the part of the initial board of directors of a cooperative, not to the sponsor who appointed the board, but rather to the cooperative corporation itself.

The question raised in the 1993 case of Board of Managers of the Fairways at North Hills Condominium v. Fairway at North Hills, 603 N.Y. 2d 867, is whether this rule also applies to the members of a condominium's initial board of managers appointed by the sponsor.

The Fairways at North Hill Condominium, which is located in the incorporated village of North Hills in Nassau County, New York was being developed by the sponsor of the condominium, who selected three individuals to be the initial board of managers of the condominium.

The current board of managers of the condominium, elected by the unit owners, instituted a lawsuit against the sponsor-designated members personally, for damages to the condominium resulting from alleged breach of their fiduciary duty to the condominium by their failure to correct deficient construction and for their failure to properly estimate common charges.

The sponsor-designated members claimed that since they were appointed by the sponsor even before any condominium unit was sold, their duties and loyalty were owed to the sponsor who appointed them and that they had no fiduciary duty to the condominium or to the unit owners. As a consequence, they claimed they should not be held personally liable for any alleged failure to concern themselves with construction or common charge matters during the time that a large number of condominium units were unsold, causing the sponsor to be liable for a considerable proportion of the repair and reconstruction assessments which might have been warranted at that time.

The Appellate Division of the Supreme Court, Second Department unanimously held there is a fiduciary duty on the part of the initial board of managers to the condominium association and to the unit owners from the time of the sale of the first condominium unit. The members of the board of managers are in a fiduciary relationship with the unit owners because they transact business which is not theirs and is not for their own benefit, but for the benefit of other persons (the unit owners).

A board of managers of a condominium has the same fiduciary duty as a board of directors has to a cooperative, namely, that the members of the initial board of managers of a condominium must perform their duties in good faith and with that degree of care which an ordinary prudent person in a like position would use under similar circumstances.

While on the one hand, the initial board of managers of the condominium is often linked with the sponsor's legitimate pursuit of lawful profits, on the other hand it is entrusted with a great deal of power over the proprietary interest of unit owners. This creates a great potential for conflicts of interests. As such, a very high standard of duty must be imposed upon the board of managers to ensure that board members do not gear their decisions to the benefit of the sponsor at the expense of the condominium association or the unit owners.

The court found additional support in the offering plan and the by-laws of the condominium association, which provided that the sponsor could designate the board managers who would be in control of the condominium for the first two years or until 51 percent of the condominium units were sold. Further, these documents disclose that the board of managers was charged with governing all of the affairs of the condominium on behalf of the homeowners, including the power to determine and levy common charges, to make special assessments and to expend those assessments for the maintenance, care and preservation of the units, the buildings and other common areas of the condominium association.

Consistent with New York law, the by-laws also provided that the board members would be free of liability to the unit owners for honest errors of business judgment, while at the same time, they would remain liable to unit owners for willful misconduct or bad faith. Thus, by the very terms of the by-laws of the condominium, a fiduciary duty was imposed upon the sponsor-appointed managers which would make them liable if, indeed, they were found to have had self-dealing and exercised bad faith.

The court concluded that the fiduciary duty of a condominium's initial, sponsor-appointed board of managers owed to the unit owners are clearly analogous to the fiduciary duty which the courts have already determined to exist on the part of the initial sponsor-appointed board of directors of a cooperative to its shareholders. Although neither the New York Condominium's Act nor New York case law has squarely addressed the issue of whether a condominium's first board of managers owes the condominium and its unit owners a fiduciary duty, this court said that it does.

The court, in so ruling, also recognized that as a practical matter, unit owners who are damaged by bad faith depredations of unscrupulous boards may find themselves without realistic recourse in the event the sponsor's assets become unavailable due to corporate dissolution or involuntary liquidation. Holding these board members individually responsible will provide an additional remedy to these unit owners.

(Edward L. Schiff if the senior partner of the New York City law firm of Schiff, Turek, Kirschenbaum, O'Connell, LLP.)