Co-ops have to be vigilant and address defaults due to nonpayment, objectionable conduct, illegal sublets, bank foreclosures and below market resales, and shareholders declaring bankruptcy. Some proprietary leases and bylaws appear to give co-op boards incredible authority. By a mere majority vote, boards can declare a shareholder, investor or even a sponsor in default due to their own actions, or the actions of the subtenants and renters. Boards may mistakenly believe that by a mere vote and then notification, they can terminate the shareholders’ stock and lease. Boards who read their proprietary lease and bylaws in a narrow and literal way may begin to think they can solve their resident problem cases by eliminating the shareholders’ or investors’ rights and interest in the stock and lease, without a judicial procedure. The court cases cited above show that even with a court action, the co-op may not be able to terminate the stock and lease! Boards often believe that after stock is terminated, the apartment and stock automatically revert back to the co-op, as the co-op’s property without a private, public or foreclosure sale.
I am not an attorney. As director of Diversified Property Management in Brooklyn, I work under the "law of agency" representing cooperatives. Like many of our colleagues, Diversified has established an active closing department in which transferring stock to a shareholder purchasing a co-op is fairly routine. Stock transfers are based on long-established presumptions that the co-op corporation (the Lessor ) has absolute control over the stock it issues and has a primary, built-in lien on the shares. That lien allows the co-op to collect maintenance and other charges ahead of any other lien, including bank loans or other encumbrances. But is this presumption actually clearly established in the laws of New York State? Surprisingly, the answer is no. There have been a number of court rulings, unknown to boards and managing agents (and even to some real estate attorneys) that shake the foundation of this core belief that co-ops have automatic liens on their own stock.
Inaccurate Interpretations of Co-op Rights
I recently encountered a situation where, despite advice from their attorney and myself, a co-op board was moving forward to terminate the lease and cancel the stock of an investor. Their goal was to expedite evicting the investors’ subtenant, John Doe, due to his objectionable conduct. In order to genuinely rid themselves of this subtenant, the board also sent notice to the sponsor that they were terminating one of his leases and canceling the stock appurtenant to one of his free market apartments, where John’s girlfriend (Jane Doe) rented. The board wanted to make sure that John didn’t simply move in with Jane and continue to live in the co-op.
The actions of this board became increasingly radical. Their inaccurate interpretation of the proprietary leases’ "use of premises" clause was that residents had the right to use inside apartment space, but not the common areas outside the apartment, such as the private parking lot and swimming pool, without the explicit consent of the board. They ignored my advice that this distinction was not stated in the lease or anywhere else in the offering plan. This board decided that they could restrict anyone who they declared to be in default of the proprietary lease (including subtenants) from using the co-op amenities, as if they were trespassers. They hired a security guard service to stand guard at the pool gate entrance to physically restrain John and Jane from access to the pool. They even sought the involvement of the police and chairman of the neighborhood community board.
Simultaneously, they began a holdover action (eviction proceeding) against the investor and his subtenant, and against the sponsor and his tenant to gain possession of these apartments. Their case was not based on a hearing of the facts of the resident’s objectionable conduct, but based solely on the board’s vote to terminate the lease and cancel the shares of stock. The board’s claim was that the co-op should be awarded possession of the apartment and that these "squatters" should be evicted because they were now residing in the units without valid leases.
This led me to begin my research into proper and improper legal approaches to terminate leases. I began contacting prominent attorneys throughout New York City, such as Errol Brett, Esq. of the Law Offices of Errol Brett in Manhattan, and Kenneth Jacobs, Esq. of Smith Buss & Jacobs in Manhattan and chairman of the Southern chapter of the New York State Community Association. I expected to be told of standard procedures co-op boards need to follow and to learn of several landmark court decisions as precedent.
I was genuinely surprised to learn of the conflicting opinions throughout the legal community. Even more surprising were the conflicting opinions in court decisions which I obtained, including rulings from the Appellate Division of the State Supreme Court. The conflicts seemed to center on how to classify co-op stock, and how to deal with liens on co-op stock. This issue has become so contentious that there are even several court decisions challenging whether a co-op’s built-in lien on its own stock (as described in the proprietary lease and bylaws) is a perfected security agreement.
A number of attorneys warned me that managing agents must be very careful when they are involved in transfers of stock, and terminating leases and stock because of the way liens against the stock are viewed, and because of how co-op stock itself is viewed. Attorney Richard Siegler, Esq. of Stroock & Stroock & Lavan in Manhattan referred me to Joel E Miller, Esq, of Miller & Wrubel in Manhattan, who served as chair of the Liens Subcommittee on Condominiums and Cooperatives of the New York State Bar Association’s Real Property Law Section. Joel forwarded to me a report he authored from the subcommittee, "Liens On Individual Cooperative Apartments," which presented the various arguments put forth by attorneys, law professors and courts on different sides of this issue. He invited me to attend a meeting of the entire subcommittee (who was finalizing their recommendations on these issues) and answered as many questions as I could ask.
None of my interviews or meetings with these attorneys and law professors, however, prepared me for reading the actual court case rulings. Judges wrote decisions that seemed to contradict what I had taken for granted for years as a managing agent. Some of these decisions go against conventional ideas prevalent throughout the co-op community and management industry in New York. It seems that something is wrong, or unclear in the New York State statutes if the courts themselves are confused. A few actual cases will illustrate the problem.
Easier Said Than Done
Case #1: A co-op board sent a default notice to a shareholder for nonpayment. When the shareholder refused to pay the arrears, the board voted to terminate the lease and cancel the stock, which was done by mailing notices prepared by the co-op’s legal counsel, exactly according to the standard terms of a proprietary lease (typically clause #31). Simultaneously, the attorney sent a copy of the default notice and then a copy of the termination notice to the shareholder’s lender, who had a lien on the shares. When the shareholder still refused to pay the arrears, the co-op terminated the lease and stock. Ultimately the bank paid the co-op more than $20,000 for all unpaid maintenance fees, legal fees and disbursements to protect their security interest. The bank then requested that the canceled stock be reissued in the bank’s name. The former shareholder sued to restrain the co-op from conducting a foreclosure sale and issuing the stock in the bank’s name. The Supreme Court, Kings County, ruled against the shareholder. The shareholder appealed the decision, and the Appellate Court, Second Department reversed the decision, and held that the shareholder was entitled to a preliminary restraining order.
This court decided, in part, that the co-op did not have an enforceable security interest because the proprietary lease did not constitute a valid security agreement. The judges wrote:
"Since reservation of title under a lease does not create a security interest unless the parties so intended, the mere existence of a proprietary lease, without more, does not establish an enforceable security agreement to which the Uniform Commercial Code applies. Preservation of the status quo, absent a clear showing of entitlement to proceed under Uniform Commercial Code Article 9 [the UCC section dealing with judicial sales, private sales and foreclosure sales] is essential because, otherwise, a Cooperative corporation would be able to divest shareholder-lessees of their ownership interests in their apartments without any judicial determination of equitable defenses or counterclaims."–J. McMillan v. Park Towers Owners Corp., Supreme Court, Appellate Division, Second Department 3/25/96
It is clear that no co-op has a right to simply take equity ownership of stock from a shareholder, regardless of the language in the bylaws and the proprietary lease, without a judicial proceeding. But, beyond that, is the mere existence of a proprietary lease an enforceable security agreement? This court ruled that it is not.
Case #2: A co-op sent notice to a shareholder of its intent to terminate the lease and cancel the shares of stock due to nonpayment of almost $14,000. The shareholder sued and obtained a restraining order, based on a claim of breach of warranty of habitability due to water leaks. The co-op tried to use the Lien Law provisions regarding enforcement of its lien against personal property (the stock). The court granted the restraining order in favor of the shareholder, and stated that they can find no reported case where a co-op successfully asserted the Lien Law, as opposed to the UCC Article 9 clause, to enforce a proprietary lessee’s obligation to pay maintenance. (Berman v. 300 W 108 Owners Corp. - NYLJ 3/19/97)
I questioned which New York State statute should a co-op cite to enforce their lien right to collect unpaid maintenance? Actually, this is a gray area in the law! The current statutes do not clearly refer to co-op stock, the perfection of a co-op’s right to collect maintenance charges or late fees (perfection of the co-op’s built-in security interest), and the various remedies available to a co-op to enforce such collection rights. Some courts have ruled that co-op stock are securities, and come under the rules of UCC Article 8, while other courts classify co-op stock as a real estate leasehold which comes under the rules of Article 9.
Case #3: A co-op sued a sponsor for failure to perform its obligations. The bylaws contain typical provisions which assert the co-op’s built-in lien. Almost every co-ops’ bylaws are copied verbatim from one of the three model forms supplied by the Department of Law. Article VI of co-op bylaws usually includes the following: "The Corporation shall at all times have a first lien upon the shares owned by each shareholder for all indebtedness and obligations owing and to be owing by such shareholder…"
In this case, the sponsor failed to pay his maintenance, but also failed to pay his mortgage payments on the loan secured by his unsold units. The bank foreclosed on the sponsor’s loan, and paid the unpaid maintenance to the co-op to protect their secured interest. The co-op, however, sued to prevent the bank from taking title to the unsold apartments through a foreclosure sale. The co-op claimed that the sponsor also owed money for unfulfilled promises regarding renovation and repair work that were agreed upon and disclosed in the offering plan. The New York State Court of Appeals ruled against the co-op, stating that the co-op cannot claim a lien with respect to the non-maintenance (rent) obligations of the sponsor, because such obligations are not printed conspicuously on the actual stock certificates. Specifically the Court stated:
"The strict notice requirements (to print the co-op’s liens on shares of stock on the actual certificate of stock) do not permit a party to create what would essentially be a hidden lien by referring merely to the existence of a separate document on a stock certificate (namely the bylaws or the offering plan), without specifying in any way the particular language in that document which is applicable. The failure of the shares’ certificates to conspicuously indicate any lien other than that arising under the proprietary lease for unpaid maintenance charges not only fails to inform a potential creditor where to look for the existence of any other lien, but as noted above, strongly implies that no such lien even exists. If the issuer (the co-op) may not, at the inception of its relation with the registered owner, create a secret right in its own favor, much less may the issuer (the co-op) do so after the owner has used his certificates to obtain credit from a lender." – ALH Properties Ten, Inc. et al, v. 306 -100th Street Owners Corp. - Court of Appeals of New York 11/30/95.
This co-op fought the stock transfer to the bank on the sponsor’s unsold shares and lost.
Case #4: A shareholder sought a preliminary injunction to prohibit a co-op’s assertion of its right to take possession of and sell shares of stock to satisfy its claim for unpaid maintenance charges. The court issued the injunction, in part based on the shareholders claim of breach of warranty due to water leaks. But, surprisingly, this court also ruled that a proprietary lease for a co-op apartment unit is not automatically security agreement for purposes of applying UCC remedies, and that the co-op did not have a security interest in the tenant’s stock on which it could foreclose to satisfy its claim for maintenance charges. Specifically, the court wrote:
"Here the cooperative does not advance a security agreement nor does it demonstrate that it has filed the agreement. The relevant proprietary lease clauses refer to a conditional limitation and the cooperative’s ability to issue substitute shares and a lease. The clauses do not refer to a security agreement. However desirable recourse to Article 9 might be, a cooperative must demonstrate entitlement to Article 9 rights, which it has not done here. A claim of arrears in maintenance, standing alone, does not give rise to the remedies of Article 9 of the UCC". –Saada v. Master Apts. Inc., Supreme Court, New York County, 5/29/91
In a similar case two years later (DeCastro v. Karen Gardens Apartment Corp., HCR, NYLJ 7/28/93) the court wrote: "It has been held that the customary form of proprietary lease, without more, is not a security agreement to which the Uniform Commercial Code applies (Saada v. Master Apts.)." This court concurs in such holding.
These cases clearly go against the presumption that a co-op can simply take back ownership of stock from a shareholder by following the step-by-step proprietary lease approach of declaring a shareholder in default, completing a court proceeding, and then terminating the lease and canceling the shares if the default is not cured. They illustrate the vagueness in the New York State statutes when judging the rights of shareholders and co-op’s over ownership of stock, and challenge the enforcement of a co-op’s lien to collect maintenance.
Avoid Litigation and Liability
As a managing agent, one thing has become very clear to me. There are issues that can create huge potential liability for co-ops, boards, transfer agents, managing agents and attorneys. The common misunderstandings and confusion, the occasional misuse of power by boards, and the new laws that must be complied with, come just at a time when the co-op market is rebounding, and boards are trying to improve the quality of the tenancy within their co-ops and increase the value of the shareholders’ investment.
Co-op boards may believe that by acting according to the step-by-step language in their proprietary lease, they are merely exercising their legal rights on behalf of the co-op. However, such boards may, in fact, be acting unlawfully, and incur liability and expense to their co-op. Further, if they act with knowledge that they are bypassing the judicial procedures required under state laws, or without following the new administrative rules of New York City, the individual board members, managing agents or their transfer agents may be subject to personal liability. Remember, insurance doesn’t cover intentional acts that are wrong and that inflict harm.
New York Courts, including the Appellate Division, have clearly ruled that the mere language in the proprietary lease does not mean that a co-op can bypass the judicial proceedings required to terminate a shareholder’s interests in the shares. The courts have ruled that co-ops can’t simply transfer the shares to a bank because a bank pays the outstanding maintenance. Some courts have ruled that the typical language in a proprietary lease is not currently adequate to give a co-op a perfected secured interest in its own stock for unpaid maintenance charges!
Any Chance for Clarity?
The Liens Subcommittee of the Committee on Condominiums and Cooperatives of the New York State Bar Association’s Real Property Law Section has met for several years. They are preparing to publish their final recommendations regarding co-ops under the Uniform Commercial Code, Article 9. This report, along with other recommendations, will be passed on to the New York State Law Revisions Commission by law professor Paul Schupack, who has now become co-chair of the subcommittee. These revisions, if adopted, will give co-ops, lien holders, courts, and attorneys clear language regarding: classification of co-op stock; perfection of a co-op’s built-in lien on collecting its maintenance charges; notification filing requirements for a co-op, or any institution or creditor claiming to have a lien against the co-op stock; rules, including notification requirements for future advances (increases to loans, such as may result by refinancing an end loan or adding a second line of credit loan); notification filing requirements to terminate a filed lien; creation of a central UCC state-wide filing system; and a host of other issues critical to the co-op community.
It should be noted that the National Conference of Commissioners on Uniform State Laws has recently published a prototype of Article 9, which is being adopted by states throughout the nation. New York requires additional language to this prototype, as cooperatives exist primarily in New York, and need to be specifically addressed when New York State adopts their new version of Article 9.
In the meantime, until the current state laws are revised and clarified, managing agents, co-op boards and transfer agents may, unfortunately, remain confused or unaware or liability issues and need to be wary to protect their co-ops (and themselves) from lawsuits.
Mr. Grant is director of Diversified Property Management in Brooklyn.