Crash Course

As the Wall Street meltdown continues and the New York economy cools, the housing glut that has affected much of the country for the last two years will undoubtedly also have an adverse impact on New York. In all likelihood the contractions among the lenders and the slowing of sales may make it difficult for sponsors to meet their obligations under their offering plans. Although it will not have the dire consequences of the sponsor defaults of the late 1980s, when co-op sponsors owned 70 to 80 percent and more of partially converted buildings containing rent-stabilized and rent-controlled tenants, who were paying below market rents, condominium boards must be prepared to step in and deal with sponsor defaults in order to preserve their owners’ quality of life and the value of the investment in their homes.

A sponsor’s default creates numerous problems. The most significant of which is the sudden shortfall in the building’s cash flow. That requires the non-defaulting owners to make up the difference in common charges until the default ends. When the sponsor owns 75 percent of the units, this means that each non-defaulting unit-owner must pay four times the common charges paid before the default to have sufficient funds to operate the building. Such a situation would be unacceptable, if not impossible, for the unit-owners.

A default caused by a sponsor may be dealt with by a means that is quick, effective, efficient, and relatively inexpensive. In New York, the sale of the cooperative or condominium interests are subject to the jurisdiction of the attorney general (AG). Therefore, one way of dealing with the problem, prior to the sponsor’s default triggering a general default and the loss of all of the unit-owners’ equity in their homes, would be a complaint filed with the attorney general. The problem however is that the AG cannot force the sponsoring entity to find funds to meet the sponsor’s obligations and usually, by the time the unit-owners and the AG learn of the situation, the sponsor’s lenders have taken over the sponsor’s interests in the unsold units.

Although the condominium is, in many ways, better off than a cooperative sponsor defaulting – because there is no mortgage on the building and everyone pays his or her own real estate taxes – the problem exists that the lender does not have to complete the building according to the plan, does not have to sell the unsold units, and does not have to pay common charges until it actually takes ownership of the units. It is therefore incumbent on the board to act quickly and decisively.

The condo sponsor does not have to pay the common charges because, unlike the situation in a cooperative, the lien for unpaid common charges by the condo’s board of managers is inferior to the lien of the first mortgage on a unit. Therefore, the holder of the mortgage on the unit is not required to pay until the foreclosure auction eliminates the sponsor’s interest and transfers the unit.

Before the condominium receives any of its common charges, the lender must receive its principal, interest, and expenses. The problem, then, is what the non-defaulting unit-owners must do in the event the sponsor or another unit-owner fails to pay common charges, and the holder of the mortgage on the unit fails to take any action.

The condominium would then not have the money with which to meet its operating expenses, and that could further reduce the value of the units on which the mortgagee has a lien. The lender should pay the common charges – just as it would the real estate taxes – to avoid a situation where the asset’s value is reduced significantly. That would make it more difficult to sell the unit, especially in a soft market. However, in an economic downturn, logic does not always prevail.

The condominium should place a common charge lien against the unsold condominium units to protect its interests in the event the mortgagee does foreclose its mortgage. In this way the condominium would be in the second position and would be reimbursed from the proceeds of the foreclosure sale after the mortgagee has been paid in full (presuming there would be excess proceeds).

Another alternative for the condominium, which would work if the lien was not in excess of the property’s value, is for the condominium’s board of managers to proceed to foreclose the lien and sell the apartment, subject to the mortgage. In either event, the condominium board should proceed expeditiously to place the lien against the apartments owned by the sponsor in which common charges are not paid and force the lender to act as quickly as possible, since the lender’s foreclosing its lien will cause the common charges to be paid again by a purchaser.

Notwithstanding this, if the lender’s lien is significantly greater than the value of the unit, the board should begin a lien foreclosure action and seek to have a receiver appointed to rent the unit or collect use and occupancy charges from a non-paying occupant and pay the common charges to the board. Although the lender may complain that the rent should go to the lender, it is likely that a court will require that the common charges be paid in order to enable the board to preserve the value of the unit.

A board should never proceed with a foreclosure of its common charge lien if the lender has begun a foreclosure or, for that matter, if the lender is doing nothing. The board will always come behind the lender and will not receive any money until the bank is fully paid. Since a foreclosure in New York involves 13 separate motions and is a very expensive task, the board could be spending tens of thousands of dollars with no hope of recovery.

As for the completion of the building, the board could start a lawsuit against the sponsor, but that could also result in spending hundreds of thousands of dollars with little chance of recovery for several reasons. The first and foremost reason is that the sponsoring entity may have no assets since the sponsor’s principals used an entity to shield the sponsor from personal liability.

The second is that only the unit-owners who purchased their units directly from the sponsor have a claim against the sponsor for breach of contract. The second-generation buyer does not have a claim because he or she purchased from someone else. That means that if a board starts a lawsuit against a sponsor and, by the time the suit is settled or a judgment granted, only half of the original buyers remain, the court can limit the recovery to only half.

Moreover, the board will not be able to recover its legal fees. The board can start a lawsuit to pressure the sponsor but, before committing to spend hundreds of thousands of dollars, it should make certain that it has a strategy that makes sense. The best bet is to file a complaint with the enforcement bureau of the attorney general’s office, which is headed by Lewis Polishook. Because there is no private right of action under the Martin Act, New York State’s securities law, the AG has far more power to get the sponsor to perform than a judge in a litigation.

Finally, open discussions with the lender to convince it to finish the building and sell the unsold units, which will be worth more if the building is completed and operating. Threatening the lender is not a good way to open that negotiation. Alternatively, if the building is finished, the board could also negotiate to buy the unsold units from the lender at a discount and then rent them until the market improves.

However, regardless of the approach you decide to pursue, let your owners know what you are doing, maintain open lines of communication, and seek their advice. This is a very difficult situation and you having a fight with your residents while attempting to deal with the overall situation is not a good idea. The board needs to focus on solving the problem and not antagonizing the unit-owners. Good advice, by the way, in any situation.