Smaller Buildings and Owner Default - Phillips Nizer

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Marc A. Landis, Partner, Phillips Nizer. How can a small or mid-sized co-op best protect itself from a shareholder’s financial default?

BACKSTORY A mid-sized cooperative corporation with a tight budget, limited cash reserves, and pending capital expenditures suddenly finds itself with shareholders who have fallen three months behind in maintenance.

Caught by surprise, the board and managing agent reach out to the building’s counsel to see what can be done. The attorney wants to know if the board knows anything about the shareholders’ current financial condition, but the board members are not aware of any particular problems. Counsel prepares default notices to be sent to the defaulting shareholders, the corporation’s president signs the notices, and the notices are transmitted.

The result: deafening silence. Either the shareholders have secretly vacated their apartments without leaving a forwarding address or they are in denial. In the past, the board worked out payment plans when a shareholder was suffering from a temporary setback, but that’s not an option when the defaulting shareholder doesn’t respond.

The next step: following up with notices to the secured lenders, who have the option to cure the financial default. Finally, a shareholder contacts management and arranges to make up the financial debt over two months. It’s a good thing, since the lender responded by stating that it had no record of her loan.

Another shareholder continues to fall behind in maintenance payments. His lender retains counsel to contact the building’s attorney and managing agent with the message: “Just confirm the amount due, and we’ll send a check.” As good as his word, payment arrives the next week, and the account is current. But this shareholder has another problem – he was already behind on his mortgage payments, and will fall further behind now that the lender’s payment has been added to his debt.

The shareholder makes sporadic maintenance payments, but the board knows that his ability to pay is fragile, and he’s hardly ever around. The attorney senses that a lender foreclosure is coming, and sure enough, lender’s counsel contacts the attorney again to alert the board of an upcoming sale. Counsel obtains an updated lien search, and finds federal tax liens and some small judgments filed against the shareholder.

Public sales are often populated with “bottom-fishers” – bargain hunters more interested in flipping the apartment than in becoming a member of a residential community. Therefore, to protect its interests, this board makes the decision to bid at the foreclosure sale, and sends the attorney with bidding parameters and a check for the down payment. Luckily, the corporation has enough funds available in reserve and from a line of credit to get the deal done.

A month later, the co-op acquires the unit for an attractive price. Simultaneously, counsel negotiates a surrender agreement that allows the shareholder to wind down his affairs and move out. The co-op recovers the apartment, makes some minor repairs to prepare it for sale, and hires a real estate broker.

In the end, the lender is paid in full, and the shareholder receives the surplus funds toward paying other obligations. Ultimately, the corporation anticipates a profit, which will allow the line of credit to be paid down and will enhance the building’s reserve fund.

COMMENT A conscientious, forward-thinking board will take the following steps: Review the governing document

s. The board should consult with counsel to review the relevant provisions of the proprietary lease, bylaws, certificate of incorporation, and house rules to ensure that the board has a full legal arsenal at its disposal in case of default. Apply due diligence

. The board and management should take the time to vet carefully all tax returns, bank and other financial statements, and the like. If the board believes that the candidate shows signs of financial weakness, the board should be prepared to reject the applicant, or to consider other options (such as requiring a substantial maintenance escrow or a guarantee from a financially responsible guarantor) that will address these weaknesses.

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