Who’s the Boss? Fighting the Sponsor.

What you can and cannot do when dealing with investors.

It’s the annual meeting of co-op shareholders and a new board of seven directors is about to be elected. The sponsor, who is the former landlord of the building, shows up and nominates himself, his wife, and adult son as his three nominees. There are five candidates for the board who live in the building and they have been effective tenant leaders over the years. Suddenly, an individual who had bought two occupied apartments as an investor from the sponsor nominates himself as a candidate. The sponsor votes his shares for this investor’s candidate – who is elected because of the sponsor’s votes. Only three resident- shareholders are elected. At the first meeting of the board, the sponsor is named president of the co-op, the long-planned lobby renovation project is put off, and the board votes to hire the sponsor’s management company as the new agent and the sponsor’s lawyer as the new co-op attorney and transfer agent. All votes are 4 to 3 in favor. The sponsor, his wife, son, and the investor-shareholder cast the four votes. The shareholders want to know: was this legal?

There is probably no greater area of conflict between resident co-op owners and sponsors than determining the extent of the sponsor’s rights to vote for members of the board (successors to the sponsor who have been labeled “holders of unsold shares” will be discussed as “sponsors”). The resident-shareholders want a board of directors committed to the quality-of-life interests of those who maintain their homes in the building, while sponsors seek to protect their investments, often by adopting a more landlord-like attitude to protect cash flow by limiting expenses, such as maintenance increases.

The Business Corporation Law of New York, which governs most cooperatives, generally favors the concept that “every shareholder…shall be entitled… to one vote for every share [owned].” In drafting the regulations applicable to co-op conversions, the attorney general’s office tried to force sponsors to agree not to fully exercise that right. Virtually all plans contain a statement such as this: “The Sponsor or the Holder of Unsold Shares will not control the Board of Directors beyond five years from the date of Closing or after the sale of 50 percent of the shares of stock offered hereby, whichever comes first.”

Unfortunately, that language has created as many problems as it has solved. The courts and the attorney general’s office have accepted a narrow definition of the word “control” and have only been willing to prevent sponsors from designating or nominating “related parties” to fill a majority of board seats, while allowing sponsors to vote all of their shares in the election of “unrelated” candidates.

Similarly, the courts have accepted a narrow definition of “related parties” and have limited that term to the sponsor’s relatives and employees, or persons with whom the sponsor has a direct financial relationship. Voting for a slate that includes a minority group of sponsor affiliates plus sponsor-friendly “unrelated” people, even including other non-resident investor-owners is not legally considered an exercise of “sponsor control.”

Many attorneys representing tenant groups in the conversion process have understood the inadequacy of the AG’s regulations and court interpretation of those regulations, and, in their initial negotiations with the sponsor, have obtained stronger “anti-control” language in the offering plans and co-op bylaws. Typically, those negotiated provisions provide that the sponsor “may only vote its shares for one less than a majority of the Board of Directors” or “may not elect a majority of the Board,” as two decisions phrased it. The courts will generally enforce those negotiated provisions by limiting the sponsor’s ability to vote in a manner that would allow the sponsor to play a role in the election of a majority of the board members. With these provisions in the co-op’s bylaws or plan, there is no need to allege that the other candidates are affiliates of the sponsor; the sponsor may be forbidden from casting any votes in the election for the majority block of directors (three directors in a five-person board; four directors in a seven-person one, and so on).

Based on this history, the first step in determining the right to limit the sponsor’s votes in a co-op election is to review the bylaws and offering plan of the co-op. With only the AG’s standard language in the plan, the resident-shareholders may only focus on the relationship between the sponsor and the candidates who receive sponsor votes. The sponsor may be blocked from voting for a board whose majority would consist of sponsor employees, relatives, and persons with whom the sponsor has economic relationships. Allegations of such a relationship will not be sufficient to block a candidate’s election – the resident group must be able to prove the relationship. With the broader language directly limiting its right to “vote” or “elect,” the sponsor can be prevented from creating a “working majority” of sponsor-friendly directors.

A board may be able to limit sponsor participation in voting for directors by negotiating with the sponsor after the cooperative conversion is completed. A sponsor may face a future situation in which it will have no seats on the board if the co-op does not have a bylaw provision providing for designation of a sponsor board representative when the sponsor owns a minimum number of apartments; or does not have cumulative voting enabling the sponsor to elect a proportional number of directors.

If those provisions are not present, it may be possible for a co-op to trade an amendment to the bylaws guaranteeing a sponsor seat as long as the sponsor owns a minimum number of shares in exchange for an agreement from the sponsor to refrain from voting for any other directors. There may be other issues that may be traded for the sponsor’s agreement not to vote. For instance, one co-op agreed to hire a management company acceptable to both the co-op and the sponsor in exchange for the sponsor’s agreement not to vote.

There are other techniques that may be used to limit sponsor control: many boards and sponsors are not aware that directors may not use “proxies” to appear or vote at a board meeting. As fiduciaries, a board member must appear in person to participate at a meeting. Often, all of the sponsor designees do not show up at board meetings. This may give the resident members of the board practical control. Further, in the absence of sponsor designees, it may be possible to amend the co-op’s bylaws to increase the number of directors. Because of the fiduciary nature of board service, and the possible personal liability of board members who may vote the sponsor’s instead of the co-op’s interests, it may be difficult for a sponsor to obtain sufficient warm bodies to maintain a “friendly” majority when the sponsor needs five of a nine-person board.

Finally, resident-shareholders may take steps to limit the ability of a sponsor who does not own 50 percent or more of the co-op’s shares to be the critical “swing vote” in elections of board members. It is lawful for the residents to have an informational meeting at which informal elections are held and all resident-owners agree to vote as a block for those candidates who win the informal election. Similarly, where cumulative voting exists, residents may agree to vote as a block only for a “control group” of candidates (a majority of the board to be elected), based on the results of an informal election of the residents. These steps prevent the spreading of resident votes among too many candidates, thereby allowing a sponsor to cast votes in a way to direct the outcome of the election.

Arthur Weinstein is an attorney in private practice.