Unsold Shares Pose Liability for Co-Op Boards

There is a special class of shareholders in co-ops known as holders of unsold shares. These shareholders — typically sponsors or investors — often claim broad exemptions from co-op policies, which can present liabilities for buildings. As a result, boards shouldn’t be too quick to accept these assertions at face value. Depending on the governing documents and the specific circumstances of a dispute, you may have more leverage than is initially apparent.

POLICY AND CODE VIOLATIONS  We had a co-op that was dealing with water damage originating from a sponsor-owned apartment. When the co-op’s engineer went to investigate, he found in addition to the water damage, a range of alarming and unsafe code violations in the sponsor unit, which were in fact far more serious. The sponsor attempted to brush off these violations, citing its unsold shareholder status as a defense against board interference. 

RULING PRINCIPLE  There is, however, a legal doctrine known as the covenant of good faith and fair dealing. This applies when one party’s actions, although not in direct violation of a contract, undermine the essence of the agreement. So while the sponsor may have had an exemption from co-op rules, under this doctrine there is an implied obligation to comply with building code requirements. After intense negotiations, the sponsor eventually agreed to fix the problems and have its engineer sign off on the renovations. Having the engineer put his name on the line meant we would be able to go after him if anything was non-code compliant. 

INSURANCE RAISES THE STAKES  Sponsors don’t have to sign alteration agreements nor hold proper insurance, and this is a gaping loophole. I would argue that a co-op has a reasonable expectation that renovations are going to be adequately insured, but I’m not sure that would win in a litigation. To address these risks, boards can proactively put holders of unsold shares on notice that they are expected to comply with safety and insurance regulations, particularly in today’s hard insurance market.