How to Part Ways

Everybody who owns a co-op or a condo apartment expects that when the time comes, they will be able to sell it. But sometimes they can't, and the reason has to do with sublets and sponsor or investor-owned apartments. You dealt with a co-op facing that problem recently.

Subletting is a major issue for many reasons. When a sponsor owns a lot of apartments, that makes it much more difficult for shareholders to sublet. Excessive subletting affects sales prices, the ability to get an underlying mortgage and quality of life. At this building approximately 25% of the shares are owned by the sponsor. The co-op has been allowing subletting, and it's gotten to the point where there's another 20%, so that’s 45% of the total number of units being sublet. And the co-op has had distinctive problems with end loans. They had an offer for a refinancing, but on terms that were not as advantageous. Complaints had been coming in about quality of life matters. So the board decided they had to take action to reduce the sublets. And if you're not going to put pressure on the sponsor, the only party that you can control are the other shareholders.

    The co-op proposed reducing the sublets to 35% in the hope that would mitigate the problems they're experiencing. Well, as you can imagine, the 20% of shareholders who are subletting got very upset and held a special meeting to unseat the board. The point is that the sponsor element is a major problem. The building wouldn’t have these same restrictions if there wasn’t such a liberal subletting policy and the sponsor wasn't taking up so much space. Combining the two has put the co-op in a dangerous place. 

What can a board do to encourage or force a sponsor to sell?

The first thing is to look at the offering plan and see what it says about the obligation of the sponsor to sell. There is always some standard language, which is typically neutral or ambiguous, pointed to by the sponsor and lawyers that says that they have a right to sublet without board approval. For the most part, the courts say that viability, that is, whether a sponsor must sell, is dependent on the facts and circumstances of each particular case. The court looks at various issues, including the ability to get end loans, to get a wrap mortgage and quality of life issues. The courts have also mentioned the potential control a sponsor retains on a board of directors, especially when combined with other shareholders who might be of a similar mind in terms of allowing subletting. So there's no absolute definition of viability. But I think the more units the sponsor has and refuses to sell, the stronger the case against them.

And how would a board decide whether to take legal action? It costs money and there are risks. How does a co-op weigh that against the problems it’s facing?

If they can’t sell units and they can’t get financing, it becomes a crisis in many cases. It’s a pretty serious thing, to say the least, if people aren't willing to buy into the building. I represented a prospective buyer at a building where the  sponsor had 40 or 50% of the units, and told them, “Unless you’re getting a great deal, you should look elsewhere because there are just too many disadvantages." In those circumstances, if the sponsor won't agree to gradually start selling units, hopefully the board will be able to negotiate something. But if that fails, the board will have to go to court and deal with the expense and risk. I should also point out the fact that when boards decide to bring legal action, the sponsor springs into action and tries to remove the board. They'll call up special meetings and may look for other shareholders who have their own ulterior motives for removing the board. That also has to be dealt with. 

Then again, if a board and its lawyers have talked to the sponsor and gotten nowhere, going to court will certainly get the sponsor’s attention because it’s also going to cost them money. 

There's no question. But when these issues come to a head, some resolution is typical, as with most litigation because of the costs of prosecuting or defending the case and the turmoil and risk on both sides. Many of these actions are started and some agreement will be arrived at where the sponsor won't have to market all their units, but at least a certain amount. Also, if a board does go to court, you have to have a strong case. You can't just allege that you're having difficulty with financing or sales or that people don't want to buy. You have to provide specifics where a person entered into a contract, for instance, and the buyer couldn't get a mortgage. If you're refinancing an underlying mortgage and you're having difficulty, or the rates aren't as favorable, or you were shut out by certain banks that didn't want to get involved, that also would be relevant. Repairs in the building when there's overcrowding and sponsor units have also been cited in cases. You have to be prepared to cite chapter and verse as to what’s occurring to make your case. 

Is it a long road if you end up in court?

Unfortunately it can drag out. There’s definitely that potential if there is no middle ground that can be arrived at. Given that uncertainty and the cost of litigation, there’s every reason to try to reach an agreement with a sponsor.