Reasonable Is as Reasonable Does

May a co-op’s managing agent reject a potential buyer of unsold shares solely on the basis of the co-op’s “financing rule”? That was the issue addressed in Elias v. Orsid Realty Corp.

Simon Elias and Izak Senbahar were the holders of all of the unsold shares of 75 East End Owners Inc., representing about 18 apartments. In December 2007, they had purchased the unsold shares from the original sponsor of the 1974 co-op conversion. The proprietary lease states that unsold shares stay “unsold” until an actual occupant buys them. Because Elias and Senbahar did not purchase the shares for occupancy and never lived in the apartment, their shares remained “unsold.”

Assigning shares and proprietary leases to tenant-shareholders needed the consent of the board, but assigning shares and leases to holders of unsold shares required only the consent of the managing agent, Orsid Realty Corp. In addition, the board had implemented a policy, called the “financing rule,” which said that the board would not consent to a sale if the buyer proposed to finance more than two-thirds of the purchase price. Orsid Realty adopted that same policy to apply to prospective buyers of unsold shares.

Following the Finance Rule

In 2010, when two apartments were being sold, Orsid asked Elias and Senbahar to see that their purchasers met the terms of the financing rule or risk losing the sales. (Orsid also requested that Elias and Senbahar tell their brokers about the financing rule so that future sales would not be challenged.) On April 26, 2010, the management company informed Elias and Senbahar that it would not consent to selling Apartment 5-C – for which the contract had been signed in February – because the potential buyers proposed to obtain 75 percent financing, violating the rule.

In response, Elias and Senbahar sought a declaratory judgment that their shares were not subject to the financing rule adopted by the board, and sought a corresponding injunction prohibiting Orsid from applying the rule to the sale of their shares. Orsid then sought a summary judgment.

The Court Rules

In reaching its decision, the court relied on the language of the proprietary lease and the rationale behind the board’s use of the financing rule on tenant-shareholders. Unlike the board, it stated, Orsid was not permitted to “unreasonably withhold or delay its consent to the sales of unsold shares.”

The court acknowledged that the financing rule was intended to safeguard the co-op’s interests in the financial stability of its shareholders. Orsid, acting on the co-op’s behalf, owed a duty to protect the interests of tenant-shareholders by reviewing prospective buyers’ finances for financial integrity. The court reasoned, however, that buyers who propose to finance more than two-thirds of the purchase price were not necessarily financially weak; and by limiting its analysis of a prospective buyer to only the proposed financing of the purchase price, Orsid excluded other factors bearing on a buyer’s financial adequacy, and consequently, the co-op’s interests.

There was plenty of additional information: at Orsid Realty’s request, applications to purchase Elias and Senbahar’s unsold shares had included potential buyers’ employment records, income tax statements, contracts of sale, and applications to and commitments from financing institutions – documentation not considered by Orsid in cases where the buyer failed the financing rule. The court concluded that consideration of only the financing rule, to the exclusion of all other factors that may bear on the buyer’s finances, was unreasonable.

The Takeaway

This case reminds us that there is a difference between the Business Judgment Rule and a requirement that a board or its agent act “reasonably.” Under the rule, a court defers to a board if its actions are taken in good faith, with honest judgment, for the lawful and legitimate furtherance of corporate purposes. Although some of the case law is unclear, typically, the Business Judgment Rule will not apply if the document at issue – a proprietary lease or bylaws, for example – requires consent to be “reasonable” or “not unreasonably withheld.” Cases have said that this reasonableness standard requires that the board or its agent take actions “legitimately related to the welfare of the cooperative.”

In many circumstances, this is a distinction without a difference. As demonstrated in this case, however, boards and their agents must be mindful that there can be actions that may be protected under the rule but may not be acceptable.

It has been the law for several years that a managing agent has the right to impose the rules of a cooperative if the proprietary lease requires the agent – and not the board – to approve purchasers of unsold shares. Here, the court determined that the board’s rules could be applied in principle. But because specific language in the lease required the managing agent to be “reasonable,” it could not reject a purchaser solely because the financing was in excess of the amount permitted by the board.

This decision is subject to appeal and therefore could be modified or reversed.

Danielle Grunwald, a law school graduate awaiting admission to the bar, assisted in the preparation of this article.