Co-ops Lose

Loss of sublet fees, rapid turnover of questionable tenants who have not been reviewed by the board, non-approved renovations – the list goes on and on, but the board is powerless to act since the offending apartment owner is a “holder of unsold shares.” And boards whose buildings still have such owners running roughshod over the co-op’s rules take note: the nightmare isn’t over. It just got worse, thanks to a recent decision by the Court of Appeals of the State of New York.

The case, George Kralik, et al. v. 239 East 79th Street Owners Corp., has opened up a debate that most attorneys and boards thought was resolved years ago. It centers on whether purchasers of co-op apartments owned by an original sponsor are “holders of unsold shares.” If they are, the board has almost no control over the apartments. That can affect revenue and, potentially, sales prices if prospective tenants are wary of buying into a building that is not completely owner-occupied.

“The bottom line is: it is very bad for co-ops,” says Marc Luxemburg, president of the Council of New York Cooperatives & Condominiums, which represents 2,000 co-ops and condos in the state. “This category of holders of unsold shares is not subject to board permission to sell, sublet, or alter their apartments. It’s created a certain element of loss of control – and chaos – in the building.”

Lynn Whiting, director of management at the Argo Corporation, which manages 80 buildings, says she has seen first hand how an investor claiming to be a holder of unsold shares can behave in the worst case scenario. This can involve chronic non-payment of maintenance, loss of sublet fees, rapid turnover of questionable tenants who have not been reviewed by the board, and even non-approved renovations that take place in the middle of the night. Then come the legal fees in dealing with such a person.

“I’m very disappointed,” Whiting says about the Kralik decision. “It’s a matter of control in the building. Holders of unsold shares are strictly investors where the goal of a co-op is to have owners occupy.”

To many people, the problem is a holdover from the past and an issue that should have been resolved as apartments became owner-occupied and moved out of the control of the sponsor. Original sponsors are effectively holders of unsold shares who can operate without the board’s permission when subletting and avoid any sublet fees, sell the apartment to whomever they please without any transfer fee, and even alter the apartment without board approval.

The thinking, of course, had been that the original sponsor would quickly sell the apartments in good faith to people who would then occupy them and be subject to board control and all the applicable provisions of the proprietary lease. That did not happen in all cases, however. There are people who bought shares in a co-op from the sponsor without ever intending to live in the unit, in some instances holding them for years. And therein lies the problem. These people are also exempt from board control.

The Kralik suit is one such case. The Kraliks purchased an apartment in 1985 for investment purposes with the belief, says their attorney Thomas Kerrigan, a partner in Finder Novick Kerrigan, that they were holders of unsold shares and therefore exempt from some of the restrictions. During 12 years they had, at various times, sublet without approval, paid a fee on “threat of exclusion,” and waited out a six-year standoff. They finally acted to resolve the dispute with the board by lawsuit in 1998.

The co-op claimed that the Kraliks were never holders of unsold shares since they had failed to comply with various requirements. The supreme court and the appellate division, which heard the first appeal, agreed. But the order was reversed by the court of appeals and the case remitted back to the supreme court for further proceedings because the controlling documents, including the proprietary lease, which deal with unsold shares, determine whether the plaintiffs are holders. The Kraliks’ status had to be decided by applying the usual rules of contract interpretation to those documents.

“The relationship between the shareholder/lessees of a cooperative corporation and the corporation is determined by the certificate of incorporation, the corporation’s bylaws and the proprietary lease under which a particular apartment is occupied, subject, of course, to applicable statutory and decisional law,” said the court, referring to a preceding case.

Luxemburg estimates there are 500 to 1,000 co-ops that will be affected by the decision where existing shareholders can now claim unsold share status because they bought an apartment from a sponsor and do not occupy it, with another 1,000 to 1,500 co-ops potentially affected because the sponsor holds unsold shares that are available to be sold.

“The courts never really examined the grounding for the rule that we were previously following,” says Kerrigan, the Kraliks’ attorney. “And now that the rule has been struck down by the court of appeals, they may no longer apply that rule.”

What does it mean? “There will be a lot of investors who are going to more freely avail themselves of the privileges of unsold share status,” says Bruce Cholst, a partner in Rosen & Livingston, a firm representing 170 boards in the greater New York area. That means they will not be subject to certain board regulations.

And where, in the past, boards have cited attorney general regulations as a way of asserting control, the Kralik decision has effectively ended that, attorneys say. The court of appeals now supports the view that only the attorney general can apply those regulations and individual co-ops don’t have the right to determine whether those regulations have been followed and what any remedy would be.

A spokesman for the attorney general’s office, which filed a brief in support of the Kraliks’ position, says: “We have no comment on this case except to say that the case was decided along many of the same lines as our brief.”

For the co-ops that were hoping the original decision would be upheld, it’s a new world, says Luxemburg, who asserts that revised interpretations of previous cases will be needed. In terms of day-to-day decisions, “Boards and their professionals will have to more closely scrutinize the language of the original offering plan,” observes Cholst.

Cholst also suggests that boards, faced with a shareholder claiming to be a holder of unsold shares, carefully investigate the history of the apartment in question to see if the shareholder or a member of the family ever occupied it for even a short period of time. This would make that apartment subject to board regulations. “For example, did they ever say to a nephew, ‘Come and use the apartment for the summer’?”

In the interim, 239 East 79th Street Owners Corp. is not admitting defeat, despite the recent ruling. It will probably go to trial again in the fall, predicts attorney David Berkey, a partner at Gallet Dreyer & Berkey, who represents the co-op. “The position of the board is not changing,” he says “The board believes the Kraliks are not holders of unsold shares as provided [for] in the corporate documents and offering plan.”