Legal Lessons: Capital Work

Legal Lessons

Choosing an attorney for your building requires a series of steps. First is taking the task at hand and figuring out what legal skills are required to solve your problem. Then comes the hunt, often through word of mouth, for the lawyer possessing those skills. In the past, many boards have used Habitat’s annual attorney survey to identify potential firms and lawyers. This year, to make that resource more valuable, we have increased the scope of what we asked participating lawyers to provide. Besides the basics (fees, size, areas served, etc.), we asked them to write about typical issues or cases they have encountered and then to offer advice and comment. In doing this, we hoped to capture each lawyer’s unique thinking and tone. And we took some additional steps, too, visiting every attorney’s office and taking photos of him or her so you could see who was telling the legal tale. Digesting the advice and legal cautions will take some time, but for board directors who monitor the legal lines, it’s a good investment.

Filing a Claim on Time

Borah Goldstein Altschuler
Nahins & Goidel

ISSUE How should board members approach and handle disputes with contractors, vendors, or shareholders?

BACKSTORY An apartment corporation, undergoing a major balcony restoration project, received advice from its engineer that the contractor was not properly performing the work. Following an opportunity to cure, and a failure to do so, the American Institute of Architects contract was terminated for cause. Pending a determination of the expense for another contractor to complete the work, the apartment corporation withheld payment for work already performed by the contractor. The contractor filed a mechanic’s lien, which was bonded by the apartment corporation. Legal action was not immediately begun by the contractor, as negotiations were ongoing between my law firm and the contractor’s law firm. Somewhere in the process, the board president, an attorney, and another board member, who worked in the construction industry, chose to meet with the contractor and the contractor’s attorney, without the presence of a representative from my firm. Negotiations broke down, and approximately two years after the filing of the mechanic’s lien, the contractor sued the apartment corporation for unpaid sums. He also sued the two board members seeking damages for “tortious interference with contractual relations” and for acting without authorization from their fellow board members.

Upon receiving the summons, the co-op immediately notified the apartment corporation’s director’s and officer’s liability insurance carrier. However, the carrier denied coverage on the basis of claimed late notice, alleging that it should have been made aware of the earlier mechanic’s lien filing. The apartment corporation started a declaratory judgment action in New York State Supreme Court seeking a declaration that the carrier could not disclaim coverage. The carrier removed the case to federal court based upon diversity of jurisdiction. The insurance carrier moved to dismiss the declaratory judgment case, and a federal court magistrate found that a issue of fact to review at trial existed: whether the board of directors, at the time that only a mechanic’s lien was filed, could reasonably have expected the eventual start of a lawsuit against individual board members. The contractor’s claims in his lawsuit were successfully defeated and the apartment corporation actually recovered money damages from the contractor. Given that the case with the contractor was over, the insurance carrier made a business decision to elect to pay the apartment corporation’s legal expenses and avoid a potential adverse decision from the magistrate.

COMMENT There are a number of lessons that can be learned from this story. Most significantly, it is easy for what appears to be a simple dispute to quickly spiral out of control. More specifically however, are the following:

Board members should always avoid becoming personally embroiled in any matter and should utilize the services and good advice of their experts (attorneys, engineers, accountants, managing agents, and the like) to obtain the full benefit of the Business Judgment Rule, and to potentially protect them against personal liability.

Board members who effectively use their professionals as shields, and if necessary, swords, will give themselves the greatest possible insulation from personal suits, and thus, personal liability.

Individual board members should never represent that they are speaking for the entire board of directors, and thus, the apartment corporation, when they have not, by a vote of the board of directors, been given the authority to do so.

While all claims do not have to ripen into insurance claims, they may. Insurance carriers are legally and contractually entitled to be given notice by the insured at the earliest possible date that a claim arises. A corporation cannot act like the boy who cried wolf and notify a carrier of every little burp, since that could affect premiums and, possibly, future coverage. Deciding when to file notice of a potential claim must be made on a case-by-case basis after consultation with the corporation’s attorney and managing agent.

—Eric M. Goidel

Contract Review

Law offices of C. Jaye Berger

ISSUE Should the board show a proposed contract to its attorney, even if it has lawyers on the board?

BACKSTORY The board of directors in a co-op building I represent was embarking on a large capital improvement project. The board had several attorneys on it who had each reviewed the proposed contract with the architect, in anticipation of this project. It had been drafted by the architect. After their review, they decided to “run it by me” at the last minute before they signed it. Knowing construction contracts as I do, I immediately noticed several important things. First, I could tell by the name of the company that it was not set up as an architectural firm. Architectural firms cannot be regular corporations, so their business names cannot end in “Inc.” or “Co.” Most architectural firms are “PLLCs” or “P.C.s,” so the name you would expect would be something more like Smith Architects, PLLC.”

As it turns out, the firm was set up to be a construction consulting company and not an architectural firm. However, the owner was a licensed architect and he stamped drawings. The owner was practicing architecture, as well as “consulting” on construction projects like a construction manager. This told me that the firm probably did not have the errors and omissions insurance that an architectural company would be expected to have. It turned out that it only had general liability insurance. My raising this issue caused the company to check into its insurance coverage and correct it. In addition, there was a provision in the contract limiting the firm’s liability to the amount of its fees. In other words, if the architects made a mistake in the design or their administration of the contract, their liability could be limited to $30,000 or some such minimal amount. I found this provision “embedded” in an arbitration provision, of all places. None of the board attorneys noticed it, because they had just assumed the contract contained a standard arbitration provision. They weren’t looking for it. This provision was deleted.

COMMENT As an attorney who frequently handles building construction and renovation issues involving co-ops and condominiums, I am accustomed to hearing people say, “We just signed the contract the contractor gave us. We didn’t want to spend a lot of money.” Or. “It’s all just boilerplate.” However, whatever money the building will be spending on the work is significant and time must be spent having knowledgeable legal counsel draft documents which protect the building. I believe contracts for the work and the process of negotiating them are a crucial part of ensuring that the project is a success. When you isolate important issues from a proposed contract and begin to discuss them, you will quickly see where there may be potential problems and disagreements in the future and you can improve upon them. The other aspect is having good project management. In other words, once the contract is signed, it must be followed and enforced. If it requires waivers of mechanic’s liens each time the contractor is paid, then someone must be responsible for ensuring that this is followed. If there are insurance requirements required the naming of additional insureds, then that must be followed. Adhering to all of these requirements will make it more likely that the project will be a success.

— C. Jaye Berger

Coping with Construction Disputes

Himmelfarb & Sher

ISSUE How does a board avoid a construction dispute regarding the performance of a major capital improvement project. The short answer: due diligence.

BACKSTORY The board selected an engineer to prepare specifications and perform oversight for a major capital improvement project, He was. unfortunately, unfamiliar with municipal requirements and/or local guidelines mandating certain approvals for the performance of the project from both the Department of Buildings (DOB) and the Board of Health (BOH). The project had to be stopped midway through for the submission of revised plans and approvals since the original specifications failed to properly address BOH requirements (though it was DOB code compliant). To obtain BOH approval, the building needed large-scale corrective remedial repairs. The process incurred unnecessary expenses that resulted in extensive delays. The contractor claimed not to be at fault since he followed the engineer’s specifications, and received payment approvals; the engineer asserted that the corrective repairs were simply added value items required for the project and the board would have incurred these expenses if the specifications had been correct. The board threatened litigation against the engineer and contractor and negotiated significant reductions in both the engineering fee and the cost of the repairs.

COMMENT First, the board needs to perform due diligence with its manager in identifying the specific scope of work, establishing a budget, and engaging a construction expert, either an engineer or architect, for preparing specifications for the major capital improvement project. This should be done in conjunction with the selection of a contractor. Just as there are doctors and attorneys with designated medical specialties or areas of legal concentration, the same is true for engineers and architects. These are the professionals who have an expertise and/or area of specialization; who are more familiar with the particular construction problem, [such as the heating plant, masonry facade, electrical upgrade, or swimming pool], and/or who have more experience or knowledge with the requirements of the municipality or DOB.

Therefore, the board needs to choose wisely and conduct interviews with both the prospective experts and contractors, as well as check references and experience. The scope of work designated in the specifications is critical to the success and performance of the major capital improvement project, including the scheduling time of start and finish; progress payments, retainage and penalty provision; amount of insurance, workers compensation, umbrella coverage and deductible limit; and the type and length of guaranty/warranty.

The use of the standard American Institute of Architects (AIA) construction agreement presents certain isues since the AIA General Conditions require significant revisions in order to properly protect the owner building. Accordingly, it is recommended that the attorney revise same and/or prepare a rider or an entire separate agreement that does not incorporate the general conditions, which are not necessarily owner-friendly. The utilization of the expert and/or the manager to perform oversight and supervision of critical stages of the project and approve payments is both necessary and essential to the success of a Project, since it enables the expert to confirm compliance by the contractor with the specifications and adherence with manufacturer’s requirements, in conjunction with the issuance of the manufacturer’s warranty. The lesson: proper, prior preparation prevents poor performance.

—Ronald A. Sher

Increasing the Tax Basis

Miller & Miller

ISSUE Is it correct that a shareholder in a cooperative housing corporation is entitled to increase his or her tax basis in his or her shares as and when the corporation makes a capital expenditure?

BACKSTORY I had a call from the treasurer of a fairly large cooperative housing corporation. She told me that the corporation had borrowed $2 million by increasing the mortgage on its building and had then immediately spent the money to pay for a replacement roof for the building, which she knew was a capital improvement as opposed to a deductible ordinary repair. Her question was whether it was true that each shareholder’s tax basis in his or her shares had gone up by his or her proportionate share of the $2 million expenditure. Would the tax basis of a three-percent shareholder, for example, have gone up by $60,000? She understood very well that a shareholder selling at a gain would really like for that to have happened. She told me that she believed that she had read, in a seemingly authoritative publication, that a cooperative corporation’s shareholders’ tax bases went up whenever the corporation made a capital expenditure. However, she wasn’t 100 percent sure that she remembered it correctly, and, before she advised her shareholders, she wanted me to confirm the accuracy of what she thought she remembered.

The treasurer was somewhat startled – and noticeably chagrined – when I told her that, although she probably had read that the mere expenditure by a cooperative housing corporation for a capital purpose would cause each shareholder’s tax basis to increase (because a lot of people do believe that to be the rule), that is not the law. Rather, I told her, a shareholder’s tax basis goes up only as and when he or she pays money into the corporation as a capital contribution.

I went on to refer to the two common instances in which a shareholder makes a capital contribution, namely (1) when an amount is collected from him or her and earmarked for a capital expenditure to be made in the future (in which case it is usually set aside in a separate fund) and (2) when an amount is collected from him or her for the express purpose of paying down a corporate debt (as typically happens when a portion of maintenance is required to be used to amortize a mortgage on the corporation’s building).

I pointed out that applying the incorrect rule does not always produce an incorrect result. If, for example, nothing relevant occurred between the time that the capital contribution was made and the time that the money was spent for the designated purpose – whichever happened first – applying the incorrect rule would do no harm.

COMMENT But it does not always happen that way. Suppose that shareholder John Jones in a hypothetical housing cooperative had made capital contributions totalling $100,000 for his share of the cost of a capital item and had sold his shares before the corporation spent the money. Applying the incorrect rule (under which he would have no tax basis increase) might cause him to pay income tax on an extra $100,000.

Of course, applying the incorrect rule might work the other way around – i.e., it might cause a selling shareholder to underestimate his or her income-tax exposure, possibly to his or her ultimate great regret. Suppose that a different hypothetical housing cooperative had borrowed a large amount that it had used for a capital improvement. Suppose, too, that the proportionate share of shareholder Mary Smith, who owned her apartment as an investment, was $150,000, and that, before she had made any contributions to pay down the debt, she had an opportunity to sell her apartment for $200,000 more than her pre-expenditure tax basis. If she were to be misled by believing in the incorrect rule, she might sell the apartment thinking that she would have only $50,000 of taxable gain, rather than the $200,000 of taxable gain that she would actually have. If she would not have sold had she known her actual income-tax cost, she might turn out to be a very unhappy camper.

Finally, I pointed out to my questioner that, in her cooperative’s situation, even a shareholder who (unlike Mary Smith) did in fact sell only after the loan had been repaid could be detrimentally misled. If that shareholder relied on the incorrect rule, he or she might believe himself or herself entitled to double dip – i.e., first claim a tax basis increase when the corporation spent the money and then claim another increase when a portion of his or her maintenance was used to repay the loan. An unexpectedly large income-tax bill might be the result.

— Joel E. Miller

Lien on Me

Wagner Davis

ISSUE Can a contractor file a $1.8 million lien against a cooperative for work done in a tenant-shareholder’s apartment?

BACKSTORY As cooperatives and condominiums take advantage of a down economy and low interest rates to perform façade and roof repairs, penthouse terrace issues seem to be making a comeback. After spending millions on a penthouse, the last thing the penthouse owners want is for their terraces to be ripped up and then to receive a bill from the cooperative for a portion of the work. My firm has several cases pending and at least one reported case has made it to the front page of the New York Law Journal.

However, the most interesting co-op case my firm has handled in the last year relates to two tenant-shareholders, a husband and wife, who purchased and renovated two combined apartments (with the board’s approval), and then were unable to pay the general contractor. The contractor filed mechanics’ liens against the cooperative’s building (as distinguished from the tenant-shareholders’ apartment) for the whopping amount of $1.8 million! This was by far the largest lien ever filed against one of my cooperative clients for work performed by a tenant-shareholder. In order to pressure the tenant-shareholder to pay, the contractor threatened to start foreclosure proceedings.

The cooperative sent notices terminating the tenant-shareholde began a summary eviction proceeding in housing court. Still, the cooperative tried to resolve the dispute. An amended lien was filed by the contractor restating the amount of the lien at $1.15 million and, as part of an overall settlement, the tenant-shareholder requested that the board sign a recognition agreement for an additional $650,000 in financing on the apartment, the proceeds of which were going to be used to pay down the amount owed to the contractor and to reduce the mechanics’ lien. The tenant-shareholders claimed that they had given a “bag of diamonds” to the contractor that was worth $500,000 as security for the balance of the amount due. The contractor confirmed that a bag of stones had been delivered, but could not say what they were or how much they were worth. Terms were proposed for the tenant-shareholders to pay the balance of the amount due the contractor and the lien was going to be removed. This would give the tenant-shareholder time to sell the apartment and pay the balance of the amounts owed to the contractor. All parties concerned, including the cooperative’s mortgagee, were prepared to wait for the sale of the apartment. Papers were drawn and things seemed to be simmering down when the cooperative learned that the tenant-shareholders’ bank had loaned an additional $650,000 before the tenant shareholders signed the settlement agreement (and apparently without a signed recognition agreement) and that the attorney for the tenant-shareholders had been fired. As an aside, it always fascinates me how a bank decides to loan money to tenant-shareholders who have already had their proprietary leases terminated and yet other lenders were balking at making loans to qualified buyers of apartments in the building because of the large mechanics’ lien that had been filed in this case. I was not surprised when the bank that loaned the additional $650,000 wound up as one of institutions that was caught up in the credit crisis over the past year. The cooperative subsequently discovered that this lender closed the $650,000 loan with a recognition agreement that was not signed by any officer of the cooperative, although the name of the president of the cooperative was handwritten onto the document.

At this point, the cooperative was resolved to protect its interest through an eviction of the defaulting tenant-shareholders. Other shareholders in the building were outraged because their loan applications were being delayed or denied and sales of apartments in the building were being blocked by cautious attorneys and lenders who were concerned about the $1.15 million mechanics’ lien. Quite understandably, the cooperative was unwilling to risk its reserve fund to either pay the contractor or bond the lien. The board authorized and directed continuation of the holdover eviction proceedings without interruption.

In what can best be characterized as a “gangplank” move, shortly before the cooperative was going to evict these tenant-shareholders – a major step in its efforts to sell the apartment and use the proceeds to pay the mechanics’ lien – the wife filed for bankruptcy and stopped the eviction. This now resulted in a free-for-all among the creditors as to the propriety of filing the lien against the cooperative and the proper amount of the lien. During this period, the tenant-shareholders were living in the apartment without paying maintenance. A full-blown litigation with multiple parties, full discovery, motions, court appearances and conferences ensued. Ultimately, the case went to trial on the issue of whether the contractor’s mechanics’ lien was properly filed against the cooperative building. Under New York State’s lien law, the consent of a landlord is required before a tenant’s contractor may file a lien against the landlord’s property. The contractor claimed that the lien was properly filed because the cooperative approved the tenant-shareholders’ work by signing the alteration agreement and by signing application submitted by the shareholders to the Department of Buildings (DOB). The cooperative claimed that the approval was insufficient to meet the requirements of the law because it derived no benefit from the work and that the approval was for the purpose of protecting the common areas and assuring that the work would not unduly disturb the other residents of the building.

COMMENT May a contractor file a lien against a cooperative for work performed for a tenant-shareholder simply because the cooperative approved the alterations according to the dictates of the proprietary lease and signed the necessary forms? Well, the answer is a big maybe. The decisions and cases on the subject are mixed. Some courts say that the contractor may file the lien, but the preferred view (and the one that was favored by the court in this case) is that the mere approval of the work under the proprietary lease and the subsequent signing of the alteration agreement and DOB application are not dispositive. The court looked behind these acts and examined both the degree to which the cooperative was involved in the work and the overall benefit to the cooperative. If, as was the case here, the work was performed entirely within the tenant-shareholder’s apartment, the cooperative did not actively participate in design or performance of the work. Since the cooperative’s consent was primarily to ensure that the common areas and other tenant-shareholders were protected, the approvals given by the board to the work would not be seen as satisfying the consent requirements under the lien law.

Fortunately, my client was successful in getting the lien removed from its property through a settlement reached in the middle of the trial. The co-op ultimately evicted the tenant-shareholder and upon the sale of the newly renovated apartment, the cooperative recovered every cent owed to it for maintenance charges, late fees, and legal fees. The contractor received less than one-half of the amounts it originally claimed and the lender made only a small recovery against the amount it lent to the defaulting shareholders to purchase the apartment and the subsequent $650,000 loan.

What is the lesson to be learned? Apartment alterations are a serious and expensive business. A board should consider whether a shareholder has resources to complete an alteration before it grants approval and that the documentation of the approval confirms that it is for limited purposes in keeping with the case law that would prevent the approval from being used by a contractor to file a lien against the cooperative’s property.

—Steven R. Wagner