Reformation Reversal

May a co-op board be compelled to reallocate shares among shareholders? Schultz v. 400 Cooperative Corporation suggests that this result is unlikely. The case reversed a lower court decision which had departed from established case law for many years. The ruling revealed a reluctance to change long-standing share allocations for co-op apartments.

This dispute concerned the valuation of a co-op apartment, as reflected by the number of shares of the defendant co-op allocated to the premises. The underlying agreements were all concluded by December 1986 and did not become an obvious point of contention until 1996, when the plaintiffs sought legal redress for the alleged overvaluation of their co-op. Although asserted as an action for reformation of a contract, the matter was ultimately decided on the basis of discriminatory treatment of the co-op shareholders by the defendant's board of directors.

The appellate court said that this issue was introduced at an improper stage of the proceedings and never should have been considered. However, it was apparent from the findings made that the asserted discriminatory treatment, even if it could be established, resulted in no prejudice to plaintiffs and was, therefore, immaterial. The plaintiffs set forth no contractual or equitable basis for the requested relief, which, in any event, was barred by the doctrine of laches. Therefore the complaint was dismissed for failing to state a cause of action.

In September 1985, plaintiffs Carol Schultz and Joyce Haroutunian purchased directly from the co-op the 250 shares allocated to unit 1D, ground-floor professional office space that plaintiffs subsequently utilized for their respective psychotherapy practices. At roughly the end of that same year, the plaintiffs negotiated with the co-op for the elimination of a monthly "professional fee" of $300, which they were required to pay under the terms of the contract of sale. At a meeting held on April 17, 1986, the board of directors approved the allocation of an additional 75 shares to unit 1D in lieu of the payment of the monthly fee. The plaintiffs continued to occupy the premises under the negotiated arrangement for the ensuing decade or more, paying maintenance charges calculated upon the allotment of 325 shares to their unit. Eventually, because of the increase in maintenance over the years, the plaintiffs' total monthly expenditures for the professional unit, under the negotiated arrangement, surpassed what would have been payable under the original allocation of 250 shares plus the monthly professional fee mandated by the contract of sale.

Under the provisions of a letter dated December 29, 1986 from former co-op president Joel Mizerik, the plaintiffs communicated their decision to use their unit for dwelling purposes to the board of directors. According to the complaint, they obtained a revised certificate of occupancy "at great expense" to reflect such residential use and requested that the cooperative board "effect the appropriate downward revision of share allocation relative to apartment No. 1D to reflect that plaintiffs would no longer use the space professionally." This request was refused.

In June 1998, the plaintiffs began this action for declaratory and injunctive relief. (A prior action begun in May 1996 was dismissed as premature.) In substance, the complaint claimed that the original 250-share allocation was "arbitrary and improper" and the professional fee of $300 was "redundant, excessive and arbitrary." Therefore, the plaintiffs suggested that the upward revision was tainted by similar impropriety.

Finally, the complaint asserted that the board's refusal to decrease the allocation of shares to the unit in return for plaintiffs' discontinuance of its use for professional purposes was improper because "there is no longer any basis for allocating a premium number of shares to apartment 1D."

By way of a motion for summary judgment, the plaintiffs sought a declaration reducing the shares allocated to their unit to 100 and injunctive relief, in the nature of mandamus, directing the defendant to accept the plaintiffs' surrender of their stock and to reissue a new stock certificate in the reduced amount. The bulk of the moving affidavit was concerned with avoiding the application of the business judgment rule, alleging unequal treatment between the plaintiffs and the owner of another first-floor unit.

Specifically, it contested the existing allocation of shares to unit No. 1D in view of the 220 shares allocated to unit 1F, owned by Mizerik, the former president. This application was opposed by the defendant, which submitted a cross-motion. However, in the court's view, beyond seeking summary judgment, the moving papers advanced no argument why its application to dismiss the complaint should be granted. The accompanying affidavit said that it "will simply provide the facts, which are entirely undisputed," confining all arguments to the defendant's memorandum of law, which was not part of the record on appeal.

In deciding the parties' motions, the lower court had indicated that it had directed counsel to address, in a fuller way than they had, the "business judgment rule," discussed by the court of appeals in the landmark case of Levandusky v. One Fifth Avenue.

In granting summary judgment to the plaintiffs, the lower court concluded that "the overwhelming, indisputable evidence establishes that Mizerik was given favorable treatment by the Board to the detriment of plaintiffs and as a result they were treated in an economically discriminatory way by the co-op board who violated its duty to them in doing this."

The lower court declared the proper allocation for the plaintiffs' unit to be 200 shares and directed the co-op to issue the appropriate certificate. The court noted that this was an action in equity, seeking to reform a contract freely entered into by plaintiffs, who acquiesced in its performance for over ten years before seeking any relief from its terms. The complaint also cited an action in contract intended to enforce a letter agreement that ostensibly provided for a reallocation of shares to the professional unit upon cessation of its use by the co-op tenants as a professional office.

In analyzing the case, the appellate court treated the matter as an action for breach of the board's fiduciary duty to the tenant-shareowners, concluding that the disparate treatment it perceived did not insulate the board from liability under the business judgment rule.

The court said that the remedy sought in the complaint was clearly equitable, requiring modification of the parties' agreement to afford relief, and the material agreements upon which relief is predicated all date back to no later than December 1986. Before reformation of an instrument may be granted, a party "must establish his right to such relief by clear, positive and convincing evidence."

The court noted that it was axiomatic that the fairness of a bargain is appropriately assessed at the time of its making, not from the perspective of the intervening events that render the performance of its obligations more difficult or more expensive.

A plea for equity does not change this analysis. The circumstances upon which modification was granted must have existed at the time the plaintiff entered into the subject agreement. Said the court: "Equity will not relieve a party of its obligations under a contract merely because subsequently, with the benefit of hindsight, it appears to have been a bad bargain."

It was the plaintiffs who actively sought the modification of which they now complained, and it was not disputed that the negotiated agreement was advantageous to them at its inception and for many years thereafter. As a matter of equity, having acceded to the terms of the bargain for over a decade before seeking judicial intervention, the plaintiffs were forbidden to complain that it was unfair, said the appellate court.

The plaintiffs' reliance on the letter of December 29, 1986 as a ground for relief from the terms of the negotiated agreement was similarly without substance. The letter represents the board's consent to a future change in the use of the premises, expressly providing that a revised certificate of occupancy should be obtained by plaintiffs "at your option and at your sole expense," but making only the affirmative promise that defendant "shall not unreasonably withhold its consent to any physical alterations of the unit required to obtain such amendment and shall execute any documents reasonably required by it in connection with the amendment."

The appellate court states that nothing contained in the letter remotely suggested that any change in the allocation of shares to plaintiffs' unit was contemplated. In short, the letter provided plaintiffs the option to use the premises in a manner inconsistent with its designation as a professional unit; it did not oblige their fellow owners to absorb the financial impact of plaintiffs' exercise of that option by reducing monthly maintenance charges through a downward revision in the shares allocated to their unit.

The issue that preoccupied the lower court — whether the former president of the cooperative was given favorable treatment by the board of directors — was not material to the value placed on the plaintiff's professional apartment, as reflected by the shares allocated to the unit. Nor did the plaintiffs establish the necessary criteria to permit judicial inquiry into the propriety of the board's exercise of its corporate prerogative in determining the number of shares to be assigned to their unit. As the appellate court noted in a case that similarly involved the valuation of a cooperative apartment: there was no allegation of fraud, bad faith, or self-dealing.

The appellate court said that the lower court's foray into the application of the business judgment rule was unwarranted. Under Levandusky, the court observed that courts are generally prohibited from inquiring into the propriety of actions taken by the directors on behalf of the co-op corporation. Although "unequal treatment of shareholders is sufficient to overcome the director's insulation from liability under the business judgment rule, it remains that the disparate treatment alleged to comprise a breach of fiduciary duty must result in some injury to the complaining tenant."

Assuming, for the sake of argument, that Mizerik received the favorable treatment found by the lower court, the appellate court said that the allocation of shares to his unit did not operate to the plaintiffs' prejudice. In comparing the valuation placed upon plaintiffs' unit to that of comparable units, the lower court had found that "these professional units were treated fairly relative to each other." Thus, the supposed "favorable treatment" accorded to Mizerik did not result in disparate treatment of plaintiffs vis-à-vis similarly situated co-op shareowners. Because the board's reallocation of shares did not result in a significant discrepancy in the valuation accorded to comparable apartment units, its action did not deliberately single out plaintiffs for harmful treatment. Therefore, the court held that the business judgment rule insulated the board's exercise of its managerial prerogative from the plaintiffs' indiscriminate attack.

Were the appellate court to consider the merits of the plaintiffs' position and subject the board's action to judicial scrutiny, it said that it would have concluded that its decision to set a significantly lower valuation on the unit occupied by Mizerik was fully justified. The defendant's reply affidavit and the floor plan contained in the record demonstrated that his was an accommodation customarily referred to as a superintendent's apartment, access to which was gained through a four-by-six-foot vestibule, situated next to the freight elevator, at the very end of a long corridor. The window of the apartment looked out onto an air shaft, and the unit was consequently dark. The entrance to the plaintiffs' offices, by contrast, was located immediately beyond the concierge desk, close to a fireplace and not far from the glass entry door to the building. The windows faced south onto 79th Street, and the unit was described as "light and sunny."

In sum, the plaintiffs did not provide "clear, positive, and convincing evidence" of their right to equitable relief. Having failed to show that the agreement they negotiated for removal of the professional fee was unfair at the time they had entered into and having enjoyed the economic advantage of the arrangement for a decade,the plaintiffs established no basis for reformation of the agreement. The court said that the plaintiffs had not been subjected to discriminatory treatment, and they had set forth no other basis warranting departure from the application of the business judgment rule to subject the actions taken by the co-op board to judicial scrutiny. Therefore, the court held that the plaintiffs' motion for summary judgment should have been denied.

While the record did not reflect the basis of the co-op's cross-motion for summary judgment, the court's review of the record compelled the conclusion that dismissal of the complaint was warranted on the ground that it failed to state a cause of action. Accordingly, the order of the lower court entered October 19, 2000, which granted the plaintiffs' motion for summary judgment to the extent of declaring the proper share allocation for their co-op unit to be 200 shares, and which denied the co-op's cross-motion for summary judgment dismissing the complaint, was reversed, on the law, without costs, the motion denied, the cross-motion granted, and the complaint dismissed.

Comment: This reversal of the lower court decision reported earlier last year in Habitat leaves little support for shareholders seeking a reallocation of the shares for a co-op apartment. A different result is difficult because of the frequent passage of considerable time since the alleged improper share allocation was made, the deference given to board decision's under the business judgment rule and the adverse impact on all other shareholders of a co-op if a reduction in a share allocation is granted many years later.