Non-Owner Blues

Ten years ago, the Appellate Division of the Supreme Court of the State of New York affirmed Justice Carol Huff’s decision in Zemiles v. Hotel des Artistes Inc. that required the cooperative known as Hotel Des Artistes to refund all of the sublease fees that it had collected from its tenant-shareholders. Justice Huff found that the bylaws and the proprietary lease did not authorize the board of directors to impose a sublet surcharge equal to roughly 33 percent of the monthly maintenance and that the board did not follow available procedures to amend the proprietary lease and bylaws to provide for the imposition of a sublease fee. For these reasons, the cooperative was required to return the fees that it had previously collected and to pay the attorneys’ fees of the successful shareholder in the action.

The proprietary leases of many older cooperatives restrict the power of the cooperative to impose a fee on a sublease. The type of fee allowed by most older proprietary leases and bylaws is one which reimburses the cooperative for its “reasonable fees and expenses” incurred in connection with the sublease application and review process. This type of fee is usually one to compensate management for credit searches, additional administration expenses, and possibly attorney’s fees in connection with the sublease.

The fee was not originally conceived as a revenue device for co-ops. In later years, as cooperative boards attempted to increase revenues from all sources, sublease fees that were designed to add revenue rather than reimburse expenses were imposed. Most were well below the 33 percent fee imposed by the Hotel des Artistes. Sublease fees in an amount as high as 25 percent of monthly maintenance charges have been upheld by courts as being “reasonable.”

Modern bylaws and proprietary leases often explicitly authorize the board to impose a sublease fee as a condition for approval of a proposed sublease.

A bylaw provision granting such authority for sublease fees – and share and proprietary lease transfer and share reallocation fees – can state: “Fees on Subleases, Assignments, or Reallocation of Shares; other conditions, etc. The board of directors shall have authority before an assignment or sublease of a proprietary lease or reallocation of shares takes effect against the corporation to fix a reasonable fee to cover actual expenses and attorneys’ fees of the corporation, the managing agent’s fee, a service fee of the corporation, a transfer fee in the amount of three percent percent of the gross sales price of the shares and lease allocated to the apartment, a sublease fee as may be determined by the board of directors in its sole discretion and such other conditions as it may determine in connection with each such proposed assignment, sublease or reallocation of shares.”

A typical proprietary lease paragraph dealing with subleases can state: “The lessee shall not sublet the whole or any part of the apartment or renew or extend any previously authorized sublease, unless consent thereto shall have been duly authorized by a resolution of the board of directors, or given in writing by a majority of the directors or, if the directors shall have failed or refused to give such consent, then by lessees owning at least 65 percent of the then-issued shares of the lessor. Consent by lessees as provided for herein shall be evidenced by written consent or by affirmative vote taken at a meeting called for such purpose. Any consent to subletting may be subject to such financial and other conditions, limitations and restrictions as the directors or lessees, as the case may be, may in their discretion impose, and such financial conditions may include payment of such sublease fees, application or processing fees, as may be established from time to time in the sole discretion of the directors or lessees, and payment of all related legal fees and disbursements, management fees, and other charges. There shall be no limitation on the right of the directors or lessees to grant or withhold consent, for any reason or for no reason, to a subletting.”

After the board of directors is authorized to implement a fee, the board should determine methods of calculating and collecting it. Most cooperatives impose a fee based on the amount of maintenance being paid by the tenant-shareholder. The type of fee and its method of collection can vary. If the fee is related to the number of shares held by the tenant-shareholder, it may be a flat fee per share or a percentage of the monthly maintenance charge.

Some cooperatives base the fee on the rent being charged by the tenant-shareholder to the subtenant and impose a fee equal to a percentage of the sublease rent or seek to recapture all or a portion of the “profit” by charging all or a portion of the difference between the sublease rent and the monthly maintenance charge. This type of sublease charge may be unenforceable as it imposes a financial obligation on tenant-shareholders that is not based upon the number of shares that they own and may be contrary to the business corporation law’s requirement that “each share shall be equal to every other share of the same class.” For this reason, it is better to adopt a sublease fee based on the number of shares owned by the tenant-shareholder (either a flat fee per share or percentage of monthly maintenance charges) than a fee based on the rent collected.

Can different fees be charged to different shareholders? Some cooperatives are required to or have attempted to collect different sublease fees from their shareholders. For example, most offering plans and proprietary leases exempt the holders of unsold shares from any requirement to pay a sublease fee. If the cooperative wishes to adopt a fee, it may only impose it on tenant-shareholders who are not holders of unsold shares. Courts have approved the special treatment granted to holders of unsold shares in such circumstances.

However, in other situations courts do not look favorably on cooperatives that attempt to impose a different sublease fee upon one class of tenant-shareholders but not on others. For instance, an effort to exempt initial purchasers from payment of a sublease fee and to impose such a fee only on the second and later owners of apartments is likely to fail, as it violates the “fairness” provisions of New York’s business corporation law.

Some cooperatives impose a graduated fee schedule depending upon the length of the sublease, such as a fee equal to 20 percent of monthly maintenance the first year, 30 percent of monthly maintenance the second year, and 50 percent of monthly maintenance the third year. This type of fee is generally adopted by cooperatives that wish to discourage subleasing.

Collection of sublease fees is also not uniform. Some cooperatives collect the entire sublease fee before the start date of the sublease. Others charge the fee over the term of the sublease and invoice it with the monthly maintenance charge. The former discourages subleasing; the latter is less onerous because it is easier for the tenant-shareholder to pay over time.

The economic benefits of obtaining sublease income must be balanced against the potential quality of life change resulting from having a renter, rather than an owner, occupy an apartment. Often, a renter does not take care of the premises or follow the cooperative’s rules as closely as an owner would. In addition, cooperative boards need to be aware of the total number of apartments that are not owner-occupied. Many banks will not lend to a cooperative or make share loans to potential purchasers of apartments in a cooperative that has a large number of subleased units.

When weighing the desire for income against the need to encourage owner-occupancy, most boards adopt sublease policies that preclude subleasing for a period of time after the initial occupancy by the tenant-shareholders (no subleasing permitted for the first three years after closing), that may limit the length of a sublease (no sublease may have a term in excess of two years), or that may preclude sublease renewals or multiple subleases by the same tenant-shareholder within a set period of time (only one sublease for a maximum of two years will be permitted in any five-year period). The policy adopted by the board should be uniformly applied. However, exceptions to uniform rules in cases of extreme hardship should be entertained.

When a tenant-shareholder seeks to sublease an apartment, the cooperative should require an application to be completed by the proposed subtenant, which includes a copy of the proposed sublease. An application fee, which covers administrative and credit check costs, should be obtained together with the application. Should the application receive favorable review, the board should also consider conducting an interview of the proposed subtenant, as it would interview a prospective tenant-purchaser. At the interview, the board can inquire whether there are any payments that the subtenant is obligated to make to the tenant-shareholder that are not reflected on the sublease agreement and have some idea that the proper sublease fee is being charged and collected.

A cooperative may impose and collect a sublease fee when the proper authority exists, when the board believes it is in the best interests of the cooperative to do so, and when the fee imposed complies with law. Since sublease issues can be complicated and depend in part on an interpretation of the cooperative’s bylaws and proprietary lease, it is always prudent to consult with counsel before adopting a sublease fee.