The Flip Tax that Wasn’t

May a transfer tax (flip tax) be voided by the court if it was not promulgated in strict compliance with the cooperative’s documents? The answer was “yes” according to Pello vs. 425 East 50 Owners Corp.

In August 2004, Joanne Pello purchased the shares of the cooperative allocated to Apartment 2. The cooperative had seven apartments and was located at 425 East 50th Street in Manhattan. In February 2005, the board imposed a transfer fee (flip tax) equal to two months’ maintenance on all unit sales and sublets. The board would not give approval to a sale or sublet unless the fee were paid.

Apparently, Pello and her neighbors had had a contentious relationship for some time. She had been elected treasurer of the co-op in April 2005 but was removed as an officer by the board on October 1, 2005, allegedly for cause after she threatened to sue the co-op. She was removed as a director in November 2005. In September 2006, the board increased the flip tax due on the sale of a unit to 2.5 percent of the selling price. Pello listed her apartment for sale in December 2006 and found a purchaser, but refused to pay the flip tax. The board would not approve the sale.

Pello brought this action against the co-op and its board members seeking to nullify the flip tax on her own behalf and on behalf of all of the shareholders. She argued that the board exceeded its authority in imposing the flip tax and violated Business Corporation Law Section 501(c) because the offering plan, bylaws, and proprietary lease did not authorize the board to impose the fee.

The court explained that transfer fees may be validly adopted, provided that they comply with the requirements of the statute, conform to the proprietary lease, and are authorized by the bylaws, and/or the proprietary lease. The court discussed cases decided by New York’s highest court, the Court of Appeals, which has held that the imposition of a flip tax is not, per se, unreasonable or illegal so long as it is not prohibited by the cooperative’s bylaws or proprietary lease and does not violate the requirements as mandated by Business Corporation Law’s Section 501(c).

In this case, nothing in the original proprietary lease, the bylaws, or the offering plan authorized the board to impose a flip tax. The co-op had language in its governing documents that stated that the “board shall have authority before an assignment or sublet of a Proprietary Lease or reallocation of shares takes effect as against the Corporation as lessor, to fix a reasonable fee to cover actual expenses and attorneys’ fees of the Corporation, a service fee of the Corporation, and such other conditions as it may determine, in connection with each of such proposed assignment.”

This language was not enough to authorize the board to impose a flip tax. The proprietary lease stated that, as a condition to sell, “[a]ll sums due from the Lessee shall have been paid to the Lessor, together with a sum to be fixed by the Directors to cover reasonable legal and other expenses of the Lessor and its managing agent in connection with such assignment and transfer of shares.” This language was also insufficient to allow the board to impose a flip tax.

Furthermore, the court looked at the offering plan which stated: “A fee on the transfer of shares in a cooperative apartment corporation (commonly called a ‘flip tax’) may not be imposed by the corporation’s board of directors, when the bylaws of the corporation authorize the board to impose on such a transfer and assignment only a reasonable fee to cover actual expenses and attorneys’ fees of the Corporation, a service fee of the Corporation and such other conditions as it may determine.”

The co-op claimed that the flip tax was valid because the bylaws were amended twice to impose it. There was a question of whether the co-op was required to amend the proprietary lease or the offering plan, rather than the bylaws; however, the court explained that imposition of a flip tax could, under certain circumstances, be imposed by an amendment to the bylaws. Pello, however, maintained that no such amendment had occurred. The court determined that the important question was whether the co-op documents were validly amended to authorize the board’s imposition of the flip tax.

Each side gave very different versions of relevant events to show how the bylaws were or were not properly amended. The co-op argued that the flip tax was valid because the co-op’s bylaws were specifically and properly amended in 2005 to include a specific provision for a flip tax and that both the 2005 and the 2006 amendments were unanimously voted for by the board. Both amendments were made before Pello entered into her sales contract, and at least one former shareholder paid the flip tax while Pello had been on the board.

The co-op argued that Pello did not object to the flip tax until she tried to sell. Pello insisted that the bylaws had never been amended. She argued that no prior notices were sent by the board to the shareholders and that the board never held a formal vote to amend the bylaws or institute the flip tax. In fact, Pello claimed that she saw the two proposed amendments’submitted by the co-op for the first time in the course of the litigation.

The documents submitted to the court were freshly typed and stood alone on paper rather than on a numbered page of the bylaws or a board resolution. The court said they were not conclusive. The court agreed that the language of both clauses clearly provided for a flip tax; what was at issue was whether the board properly incorporated them into the bylaws.

The procedure for amending the bylaws was described: they “may be amended, enlarged or diminished either (a) at any Shareholders’ meeting by vote of Shareholders owning two-thirds of the amount of the outstanding shares, represented in person or by proxy, provided that the proposed amendment or the substance thereof shall have been inserted in the notice of the meeting or that all of the Shareholders be present in person or by proxy, or (b) at any meeting of the Board by a majority vote, provided that the proposed amendment or the substance thereof shall have been inserted in the notice of the meeting or that all of the Directors shall have waived in writing notice of the meeting; provided, however, that the Board may not repeal a By-law amendment adopted by the Shareholders as provided above.”

The court found that there was no meeting or vote of the shareholders. Sharla Kidder, the board secretary, claimed that she personally spoke to all the shareholders prior to the board’s imposition of the flip tax in 2005 and claimed that all, including Pello, were in favor of it. Even if true, the court explained that this did not constitute the requisite shareholder meeting and approval. Under the bylaws, there was to be an annual meeting of shareholders. In addition, the president, secretary, or majority of the board, or holders of 25 percent of the shares had the right to call a special shareholders’ meeting at any time. Written notice of all meetings had to be given to shareholders between 10 and 40 days prior to the meeting, but such notice could have been waived. No evidence of a waiver or meeting notice – much less a notice of the proposed amendment – was submitted to the court.

The “notice” which Kidder claimed was given to all shareholders in November 2004 was an undated memorandum to the owners from “Sharla Kidder as fellow owner (not as board representative),” which set forth her idea to impose a flip tax and asked the shareholders to “discuss this possible change” by “e-mail[ing] or phon[ing] or slid[ing] a note under [her] door” because “it can be hard to schedule a co-op meeting.”

This was consistent with Pello’s recollection. The court explained that when the governing documents require that the board send notice to the shareholders, failure to provide such notice to all shareholders, even in a small building, would invalidate a vote to institute a flip tax even if it had been approved by more than the requisite number of shares.

Pello also maintained that no prior notice was given to shareholders of the 2006 increase in the flip tax, no formal vote took place, and shareholders learned of the increase in the flip tax only after it had been put in place.

The co-op claimed that the 2005 amendment had been authorized by the bylaws, which allowed the majority of the board to amend them without shareholder approval upon specific prior notice of the board meeting or waiver of the notice of the meeting.

This argument was only partially supported by the evidence. The co-op submitted a waiver of notice of the September 27, 2006, board meeting signed by the three officers who attended it. It also submitted an unsigned loose piece of paper with no authenticating mark purporting to be the minutes of that meeting. It noted that the “Board unanimously voted in favor of increasing the flip tax upon sale of a unit to 2.5 percent of the sale price of the unit. The collecting of the tax was to be the responsibility of the seller of the unit. It was agreed that Sharla [Kidder] would draft a memo to this effect and distribute it immediately.” There was no indication as to how or by whom the actual text of the amendment was to be drafted.

Even assuming that these documents were legitimate and properly amended the flip tax according to the bylaws, the co-op did not show it had the authority to impose a flip tax in the first instance, since documents had not been provided concerning the 2005 amendment, which was the one that had first imposed the fee.

The co-op did not produce a copy of the prior notice to the shareholders or minutes of the board meeting at which the amendment was allegedly authorized. Since the board’s secretary was required by the bylaws to give all required notices and keep minutes of all board and shareholder meetings, the court concluded that either Pello was correct in her contention that the bylaws were never amended or that the officers of the co-op were derelict in their duties so that any action taken by them was meaningless.

In examining the board’s conduct with respect to the flip tax, the court noted that there were only seven units in the building, and that this presented an apparently irresistible temptation for the board to forego adherence to the corporate documents and corporate regularity and instead run the building informally. However, this was not acceptable.

The court explained that if the initial amendment to impose the flip tax in 2005 had been approved by the majority of the shareholders, subsequent amendments to modify the amount of the fee by the board could have been acceptable. However, the court found that, even if both the 2005 and 2006 amendments were validly adopted by the board, such a vote would not have been sufficient to impose an enforceable flip tax.

A co-op board derives its authority to impose a flip from either the co-op bylaws or the proprietary lease. When applied to the actual documents involved in this case, however, there was an apparent contradiction. The bylaws could have been amended by the board, yet an amendment to the proprietary lease had to be in writing and approved by lessees owning at least sixty-six-and-two-thirds percent of the shares.

Accordingly, allowing the amendments to the bylaws purportedly crafted solely by the three members of the board (holders of roughly 40 percent of the shares) to constitute an amendment to the proprietary lease was improper and would have nullified the provisions of the lease.

Although the change to the terms of the proprietary lease may have been executed indirectly through an amendment to the bylaws, the flip tax would not be enforceable, the court said, unless it had been put in place in a way that was consistent with the terms of the proprietary lease. In this case, the court found that it was not. There were instances where a co-op board may amend the bylaws without shareholder approval to impose a flip tax but the court said this was not one of them.

Since neither the original bylaws nor the proprietary lease contained specific authority for the imposition of a flip tax, and since the co-op failed to follow the proper procedures, the flip tax was voided, and all improperly obtained fees were to be returned. Furthermore, since the board acted in excess of its authority in enacting a flip tax without the express consent of the majority of the shareholders, the co-op and its board members were also answerable for damages that the plaintiff could prove she sustained.

Further, the flip tax was the final impediment to Pello’s sale. The court had already ruled that if the board or its members took any action to prevent her from selling her apartment, they could not be said to be acting fairly, impartially, or in the best interest of the building. The court stated that it was clearly in the best interests of all parties to allow her to sell her shares.

Comment: This case teaches us that it is important that boards read both the proprietary lease and the bylaws in order to determine how the building is to be governed. If, after looking at these documents, it should turn out that one imposes a higher burden than the other, then the cooperative may well be required to meet that higher burden.

What this case also teaches is that, even in a small building, the board cannot act informally. Compliance with the corporate documents is necessary in order for the actions of either the board or the shareholders to be deemed legally binding and enforceable. Here, the board did not follow the lease requirements and the outcome was predictable.