Director Qualifications

May a co-op board require that directors be shareholders and residents of the co-op? The answer was “yes” in the Realty Enterprise LLC vs. Hyde Park Owners Corp. where the board had the power to amend the bylaws.

Hyde Park Gardens was a 746-unit cooperative apartment complex located north of Jewel Avenue and west of 138th Street in Flushing, New York. Realty Enterprise was a limited liability company whose principals own and manage more than 3,000 apartments in the metropolitan area. As of December 19, 2002, New York Realty took by assignment a loan on which the cooperative owed $18,770,168 in principal and more than $6 million in accrued interest.

On June 4, 2003, New York Realty acquired 54 units in the cooperative from an investor who occupied a seat on the board of directors through a designee. New York Realty allegedly reached an understanding with the board that its designee would become a director. New York Realty never received its seat. On June 2, 2003, the board had allegedly passed a secret resolution that amended the co-op bylaws to require that directors be residents.

New York Realty complained that the present board had acted illegally. In May 2000, the board of directors amended the bylaws to require that all directors be shareholders of the co-op. On June 2, 2003, the board imposed the requirement of residency on directors. According to New York Realty, the amended bylaw concerning residency deprived shareholders who are non-residents from participating. On the other hand, Ruth Farrago, the president of the board, alleged that in 2003, in order to ensure that the co-op was run by people committed to the long-term maintenance of the property and not by investors looking for quick profits, the board amended the bylaws to require that directors be residents of the co-op. She denied that the board intended to discriminate against New York Realty. Over the years, six directors who had moved out of their apartments had been asked to resign and they did so.

New York Realty objected to a plan by the present board to borrow $8 million for what the board claimed were short- and long-term capital needs. According to Leon Goldberg, one of New York Realty’s managing members, “At prevailing interest rates, the practical effect would be that the $8 million loan would cost the co-op $16 million over its term, with a balloon payment of more than $7.5 million looming at its maturity. The co-op’s per unit debt would be $29,600, more than double the $14,131 figure of just four years ago.”

On the other hand, Farrago alleged that the additional financing was needed for maintenance projects such as roof repairs and sewer upgrades and that the financing would only result in a modest increase in maintenance costs. She contended that New York Realty, an investor in, but not a resident of, Hyde Park, was not concerned about the quality of life at the co-op, but rather had as its concern low maintenance costs that facilitate the sale of units.

The court noted initially that New York Realty had brought a hybrid Article 78 proceeding and action for declaratory and injunctive relief. While an Article 78 petition can be given summary treatment if there is no issue of fact, a party can ordinarily obtain summary relief in an action for a declaratory judgment and a permanent injunction by bringing an appropriate motion. However, in the case at bar, the parties have “charted their own procedural course,” and the court said that it would reach the merits of the causes of action, as the parties themselves had done.

The first cause of action sought a judgment declaring invalid the amendments to the bylaws that required directors to be shareholders and co-op residents. The court said that the first cause of action lacked merit. The Business Corporation Law (BCL) says that “the business of a corporation shall be managed under the direction of its board of directors, each of whom shall be at least eighteen years of age. The certificate of incorporation or the bylaws may prescribe other qualifications for directors.”

In this case, the determination of the board of directors to require directors to be both shareholders and co-op residents was not only supported by the BCL, but was also shielded from judicial interference by the business judgment rule. The court noted: “[T]he business judgment rule prohibits judicial inquiry into actions of corporate directors ‘taken in good faith and in the exercise of honest judgment in the lawful and legitimate furtherance of corporate purposes.’”

The second cause of action sought a judgment declaring that the amendments to the bylaws that required directors to be shareholders and residents of the co-op were invalid on the ground that the requirements violated the Business Corporation Law. The statute provides that “each share shall be equal to every other share of the same class.” However, the court held that the board could impose qualifications for directors without violating the law, since stock ownership alone did not create a “vested right to become a director.” Even if stock ownership alone created rights concerning corporate directorships, in the court’s view, the board could limit such rights under the BCL without violating the principle that shares within a class are equal.

The third cause of action alleged that the board had not held an annual meeting of shareholders for the election of directors since December 2003. New York Realty sought an order directing that the board schedule a shareholders’ meeting for the election of directors. The BCL provides that: “A meeting of shareholders shall be held annually for the election of directors and the transaction of other business on a date fixed by or under the bylaws.”

In this case, the corporate bylaws required that the annual meeting be held before May 1, and New York Realty alleged that the last shareholders’ meeting occurred on December 15, 2003. New York Realty relied on the BCL, which authorized shareholders holding 10 percent of the votes entitled to elect directors, to demand in writing the call of a special meeting for the election of directors. New York Realty submitted such a demand purportedly signed by individuals holding more than the necessary amount of shares. However, the co-op alleged that the demand for a special meeting to be held on September 29 was invalid because the co-op received it on August 25, 2005, only 35 days previously. The BCL requires that the date specified for the special meeting be not less than 60 days from the date of the written demand.

The third cause of action lacked merit because of New York Realty’s failure to establish that it complied with the statutory mechanism for demanding a special meeting for the election of directors. In any event, the court noted that the respondents had stated that the board had no objection to calling an annual meeting and had scheduled one for November 15, 2005.

The fourth cause of action sought an order prohibiting the board from entering into new “material transaction[s]” on behalf of the co-op, such as the $8 million loan, until a shareholders’ meeting is held for the election of board members. The court said that: “In order to state a cause of action, a complaint seeking a permanent injunction must show: (1) the violation of a right presently occurring, or threatened and imminent; (2) that the plaintiff has no adequate remedy at law; (3) that serious and irreparable injury will result if the injunction is not granted; and (4) that the equities are balanced in the plaintiff’s favor.”

In the court’s view, New York Realty had adequately pleaded these elements and, moreover, had established these elements as a matter of law. The co-op had failed to raise any genuine issues of fact that would preclude summary treatment of the fourth cause of action. New York Realty had a right to elect corporate directors on an annual basis for the management of the co-op and a right to have the co-op governed by directors who hold office as provided by statute and corporate bylaws.

Permitting the present members of the board to undertake major financing on behalf of the co-op before a new election would amount to a violation of New York Realty’s rights as a shareholder and could result in serious injury to it. Moreover, the equities were balanced in New York Realty’s favor since the respondents alleged that an election for a new board would be held just days away on November 15, 2005. Under these circumstances, the court concluded that New York Realty was entitled to a permanent injunction prohibiting the board from undertaking new financing of behalf of the co-op until a new election for board members was held.

In its fifth cause of action, New York Realty sought an order directing the board to provide photocopies of a list of shareholders, including addresses and telephone numbers, the minutes and notices of meetings of the board in 2005, and documents pertaining to the proposed second mortgage. The court said that, here, New York Realty had established a clear legal right to the inspection of the list of shareholders, including their addresses, though not their telephone numbers. The court said that New York Realty’s request was otherwise overly broad.

Accordingly, the petition/complaint was granted to the following extent: New York Realty was granted summary judgment on its fourth cause of action. The board was prohibited from undertaking new financing on behalf of the co-op until a new election for members of the board of directors was held. New York Realty was granted judgment on the fifth cause of action in the petition/complaint to the extent that the respondents would make available for New York Realty’s inspection a list of shareholders, including their addresses. The petition/complaint was otherwise dismissed.

Comment: This case reaffirms several established guidelines for co-op governance dealing with qualifications for the service of directors, holding annual meetings of shareholders and enabling shareholders to communicate with other shareholders to solicit proxies in advance of a shareholder meeting. Significantly, in this case, the board was able to restrict board service to shareholders and residents of the co-op. This is not always the best policy and in many co-ops a board would be unable to amend the bylaws to accomplish this policy without shareholder approval.