Sponsor Control: A Brilliant Idea

Barbara Taylor knew things were getting bad when she heard reports that male prostitutes were wandering the floors of her co-op apartment building on West 181st Street in Manhattan. It wasn’t what she had envisioned when she moved in to the 125-unit, two-building cooperative named The West Gate in January 1986. Back then, what had first struck her was the immense size of her unit – 2,000 square feet – and the glorious views of the Hudson River. What she should have noted but didn’t (being “completely naive about co-ops”) was a crucial fact hidden in the fine print of her closing papers: the sponsor still owned 51 percent of the cooperative’s shares.

What Taylor’s co-op did to deal with that issue was, in one attorney’s view, “a brilliant idea” – a groundbreaking use of the rulings in two landmark court cases to wrest control from a sponsor who wouldn’t give it up. And it’s something every cooperative facing a similar situation can do.

The sponsor in this case, a family concern named Edelstein, had owned the two buildings at 360 and 370 West 181st Street for years. When the property was converted in 1984, the Edelsteins began charging free market rental prices for any apartments that they owned that became vacant. The sponsor was also the managing agent, had selected the accountant, ran the laundry room, and held three seats on the five-member board.

Few of the residents in the buildings – a cross-section of first-time owners, retirees, and families – saw reason to complain, however. Over the years, the Edelsteins kept the maintenance low and seemed to be a steadying influence on the property. But some now insist that the relationship was not that benign, with the sponsor warning anyone who asked that hiring a new management firm – or any change in the status quo, for that matter – would cause the maintenance to go up and the value of the owner’s equity to sink.

“They approached many retirees and single women with the warning, ‘This is only way it’ll be personally viable for you and good for the co-op,’ recalls Taylor, currently West Gate’s president. “They used scare tactics.”

The last sale, says Taylor, had been in January 1986. After that, the Edelsteins freely stated at a shareholders’ meeting that they had no intention of selling any more units but would simply rent. “That, of course, struck a chord with people who intended to sell,” Taylor notes. “Potential buyers, and those who wanted to refinance, or those who were getting home equity loans, were having a terrible time as long as the sponsor controlled so many of the shares.” But the resident-shareholders, in the minority, were powerless.

So the property cruised along, with low maintenance and an increasing number of deferred capital problems, including leaks from an aging roof and more and more frequent electrical and plumbing problems. “One of the great benefits we had was very, very low maintenance,” recalls Woody Howard, a long-time board member, “but we fell behind on our physical maintenance, and we began to realize that we had leaks in the roof, our elevators were beginning to get a little shaky, and the laundry room was a mess. It started to occur to us, ‘Why aren’t we fixing these things?’ And it became increasingly clear that they [the sponsor] were awfully intransigent about investing real money in the building.”

There were also still increasing problems with the transient population of the rental units owned by the Edelsteins. Says Taylor: “Among the 66 sponsor-owned apartments, there was and is a tremendous amount of turnover. There was an alleged male prostitute ring operating out of one of the units.”

The situation changed when the board’s size was increased from 5 to 9. The motion was presented by shareholders who felt the two buildings were under-represented, and the Edelsteins, apparently confident that the board was docile, let it pass. “They didn’t see us as causing any trouble,” recalls Howard. “The relationship was very friendly.” (The Edelsteins, through their lawyer, did not return phone calls for comment.)

That left four sponsor representatives and five resident-shareholder reps. The tenants were suddenly in charge. As the first order of business, the majority terminated the laundry operator’s lease because, says Howard, “it occurred to us that the laundry room was kind of yucky. We found that the Edelsteins took the laundry room on as a kind of fiefdom; they never did any competitive bidding, and the co-op was getting $200 a month [rent]. We said, ‘Wait a minute, there are people who want to do our laundry room and we can maybe get better rent.’ We asked them about it and they got very defensive.”

After the new majority flexed its muscles with the laundry room operator, it hired a new managing agent, Siren Management; a new accountant; and a new attorney. “It wasn’t that we came in with this big agenda; it just occurred to us that we could do this,” Howard says. “[Our professionals] had just been such a monopoly before; it was very paternalistic,” Howard says. “In the Edelsteins’ minds, it was really their building. We actually told the Edelsteins that they could bid on the job [as manager]. They did but we didn’t go with them because we started to feel our strength as a co-op.”

The Edelsteins then attempted to increase their representation on the board by reducing the number of seats held by “independent” directors – i.e. non-sponsor-controlled seats. To do that, they accused board member Woody Howard of self-dealing and demanded that he be removed from the board.

The charges were weak. According to Taylor, when Howard had wanted to make some primarily cosmetic alterations in his apartment, he submitted the proper paperwork – insurance certificates, hold harmless agreements, etc. – and paid a fee to Siren Management, which then said everything was in order and that board approval was not needed. When the Edelsteins made it an issue, though, Howard pointed out that similar requests had been routinely approved by the Edelsteins when they had acted as manager.

After a special meeting of the shareholders refused to remove Howard, the Edelsteins began a lawsuit. The co-op’s attorney suggested the board seek out an experienced litigator (he wasn’t one) to advise them in their defense. At the suggestion of a number of other co-ops with which the board talked, the directors turned to James Samson, a partner at Bangser Klein Rocca & Blum.

Although the Edelsteins had deep pockets and made a lot of threatening noises, Samson seemed unperturbed. And no wonder: he played smart offense instead of defense, devising a legal strategy that fellow attorney Stuart Saft, a partner at Wolf Haldenstein Freeman & Herz, calls “brilliant.” In it, he combined ideas from two different court cases, 511 West 232nd Owners Corp. v. Jennifer Realty Co. and 40 West 67th Street Owners Corp. v. Pullman to combat the sponsor’s refusal to sell his rental units. The first case argued that a sponsor had to sell if his actions prevented the co-op’s viability, while the second allowed a board to cancel an owner’s shares for conduct it deemed objectionable.

Samson’s concept was deadly in its logical simplicity. “We were concerned because you get a sponsor with incredibly deep pockets, making $800,000 a year off his rental apartments and, even if he has to spend $100,000 a year litigating the issue, it’s economically worth doing,” explains Samson. “He could drag it on, so I tried to find a short cut and thought we ought to terminate the sponsor for objectionable conduct. The theory was that the conduct of renting the apartments had prevented the building from becoming a viable co-op under Jennifer. We had quality-of-life issues, what with the rental tenants creating real problems. There were the prostitutes and the board had no control over who was moving in or out and no control over who had the keys. And shareholders tried to get loans and couldn’t because the sponsor owned 51 percent of the units, so we had those grounds too.”

Ironically, Samson had been considering the strategy before the Pullman decision was announced. After it came down, he knew he was on solid ground. “My partner, John Fink, thought I was absolutely crazy for trying to pull this off. Then, out comes Pullman, and it looks really viable,” says Samson. “Pullman says the board’s decision is not even reviewable. The only possible problem we had was that it wasn’t the entire board voting for it; we had the five independent [resident] directors vote unanimously for the objectionable conduct.”

Nonetheless, as soon as a few apartments became vacant, Samson sent the Edelsteins an objectionable conduct warning notice, saying that if they rented any of those apartments the board would view that as objectionable because it violated the sponsor’s obligation to sell them, as defined by the Jennifer decision. The sponsor defied the notice and rented the units; the board terminated the shares. With an auction scheduled to sell off the apartments, the Edelsteins went to court and obtained an injunction to delay the cancellation and the auction until the court ruled.

When the court decision came down, the Edelsteins lost. Their case was not helped by a statement from the Edelstein camp during the deposition that “if we knew we would have to sell all the units, we never would have converted the building.” Says Samson: “That was a breathtaking admission. That was a statement on which you could hang a fraud claim.”

The state Supreme Court lifted the injunction and, Samson notes, the sponsor has appealed the decision twice — the Edelsteins lost the first appeal, 5-0, and the second one is pending — and Samson is optimistic. “So now they have 18 vacant apartments and my guess is that, under Jennifer and Pullman, they’ll probably have to sell.”

Samson feels the rulings are good news for boards plagued by sponsors who refuse to sell. “It’s a shortcut to the Jennifer situation. If, instead of starting lawsuits, the board simply declares the sponsor’s conduct objectionable due to the diminution of the quality of life and can demonstrate that, the building has a way to force the sponsor to sell without going to court. It is a non-curable default. If you send out the proper notice, the act of renting terminates the lease.”

“It was an absolutely brilliant strategy,” says fellow attorney Stuart Saft. “We’ve been looking for a mechanism for sponsors to sell unsold apartments for years and we haven’t been able to come up with one. Jim took the Pullman argument, which is that the board gets to decide what objectionable conduct is, and combined it with Jennifer’s concept of what makes a viable co-op, and the court said that there’s a legitimate argument there. And it’s [a technique] that can be repeated in every one of these instances. If anything, it will put more pressure on sponsors to sell unsold apartments.”

The board, which has been meeting without the Edelsteins in special executive sessions to get the essential day-to-day decision-making done, is looking forward to a resolution. “It’s been awful,” says Taylor. “We’ve had the most fractious board meetings imaginable.”

Adds Howard: “It’s very tense right now. Our managing agent and our accountant are doing a great job of holding everything together, but as far as making quality-of-life improvements during the lawsuit, that was impossible because we can’t really have a real board meeting. A lot of folks have been very dubious that anything could happen because the Edelsteins have impressed everyone with their deep pockets, their bulldog attitude — ‘This is gong to be our building for our grandchildren’ — but Barbara [Taylor] has been like a bulldog herself and hung on. It makes sense that this is the way it should go. If you live in a co-op, you should be able to run it. ”