All too often boards of co-ops and condos find themselves at the mercy of the conversion sponsor. Wielding his influence over the building and all its affairs, the sponsor's goals are frequently in contrast with those of the board and building: He wants to sell his units quickly and make a profit, while the board wants to enhance the quality of life and financial stability of the corporation. With knowledge of the building's governing documents and constant planning, however, boards can move out from under the sponsor's thumb.
Failure to do so can lead to serious damage to the building's finances and affect the quality of life of all residents. In one Nassau County complex, for example, the sponsor voted to keep monthly maintenance levels artificially low in order to spur the sales of his units. Since the co-op was deprived of necessary operating income, the building sank into disrepair. Three years later, after the sponsor had sold all his units, the new board was forced to increase maintenance fees by 30 percent to cover the cost of necessary repairs. In another example, a Manhattan co-op's sponsor used his influence to veto a security system it deemed too expensive, even though every tenant-shareholder in the building was willing to be assessed to have the system installed.
Staying in Power
The main way sponsors continue to influence decisions is by maintaining representation on the board. This is accomplished long before the conversion, when their attorneys first draft the offering plan and bylaws. Virtually every set of bylaws contains a section which describes the qualifications for board membership. Most sponsor's attorneys are careful enough to provide that non-residents (i.e., absentee investor sponsors) may serve as directors. In addition, most qualification provisions state that board members need not be shareholders, thus permitting a sponsor's employees to serve as his representatives on the board.
Many bylaw provisions and offering plans contain legal devices specifically designed to enhance the sponsor's voting power. While in straight voting, each shareholder is entitled to cast only one vote per share per director, devices such as cumulative voting provisions and designation rights enable the sponsor to cast more than one vote per share for each contested board position.Cumulative voting allows the sponsor (and any other shareholder or unit owner) to concentrate all of his voting power on a small number of candidates rather than forcing him to dilute it among the entire slate of candidates, thus enabling him to target candidates of his choice. The typical designation provision allows the sponsor (and only the sponsor) to appoint a specified number of board members irrespective of his actual voting power. For example, he has the right to appoint or designate three out of seven directors so long as he retains a 35 percent equity interest, two directors so long as he retains a 25 percent equity interest and one director so long as he continues to own at least one unit. The sponsor is thus assured board representation vastly out of proportion to his voting power.Sponsors almost invariably protect themselves against the possibility that these safeguards will be amended out of existence by a resident majority by providing that any by-law amendment which is prejudicial to their interest requires their written consent before taking effect.
Limits of Sponsor Control
While the building sponsor may use legal loopholes to keep his position on the board and thereby exert his influence, board members should be aware that their hands are not tied in limiting the sponsor's voting power.
First of all, Business Corporation Law Section 612 (a) requires that any deviation from the one vote per share standard must be memorialized, or written, in the Certificate of Incorporation. Thus, any bylaw or offering plan provision requiring cumulative voting that is not memorialized is void. Unfortunately, the courts have held that designation provisions do not need to be memorialized in the Certificate of Incorporation, because The procedure does not infringe upon the right of any shareholder to vote equally at a shareholder's meeting...
A more significant limitation upon the exercise of sponsor voting power is contained in the Attorney General's regulations which provide that the sponsor may not exercise voting control of the board for more than five years from the conversion date or whenever his equity interest drops below 50 percent, whichever is sooner. (This regulation is also codified as a bylaw provision in the vast majority of offering plans).
Unfortunately, our courts have construed the phrase exercise of voting control extremely narrowly to mean simply that a sponsor cannot run his own slate of candidates or use his voting power to install a majority of board members who are his employees or otherwise receive remuneration from him. He may, however, use his block voting power to help elect those independent candidates whom he feels will most facilitate his interests. He may also independently solicit proxies from any shareholder or unit owner for use in the election.
The prohibition against exercise of voting control only protects against the most obvious form of sponsor interference in elections--the stacking of the board with his cronies. It does not prevent the sponsor from using his voting power to influence the outcome of elections. The sponsor's block vote is often decisive in determining which of two opposing resident factions controls the board. Occasionally, however, bylaw language restricting sponsor voting power goes much further than merely preventing him from exercising voting control, and instead precludes him from electing a majority of the board after the fifth anniversary of conversion or whenever his equity interest drops below 50 percent, whichever is sooner. The courts have construed this language to mean that the sponsor may be prevented from casting votes for more than one less than a majority of the seats up for election. For example, if there are seven directors to be elected, the sponsor would not be permitted to cast votes for more than three candidates. The effect of such a provision is to prevent the sponsor from even being able to influence the election of a majority of the director positions up for grabs.
A word of warning is in order for boards who attempt to enforce this favorable bylaw language against the sponsor: Since the restriction deviates from the one share one vote rule, it must be written into the Certificate of Incorporation. If it is not contained therein, the Certificate of Incorporation should immediately be amended. Fortunately, the amendment process is not too difficult, requiring approval in person or by proxy of shareholders owning only 50 percent of the stock.
What the Board Can Do
Following are some strategies that board members can use in order to minimize the prospect of board domination by the sponsor:
- Always keep track of both the time that has elapsed from the conversion date and the extent of the sponsor's equity interest, so that you know when to invoke the applicable Attorney General's regulation and/or bylaw provision limiting the sponsor's right to control the board.
- If your board is governed by the exercise of voting control provision, make sure you always assemble enough proxies to use in support of the management slate so as to counteract block voting by the sponsor. If your sponsor voluntarily relinquished board control within the five year period following conversion, but retains more than a 50 percent equity interest, be aware that he can re-assert control at any time until the fifth anniversary of the conversion. Therefore, resident board members should not adopt such a confrontational posture toward the sponsor that he will be provoked into exercising that right.
- If your building is governed by the shall not elect a majority of the board provision, make sure that this favorable language is memorialized in the Certificate of Incorporation. Also, apprise the Inspectors of Election at your annual meeting to be on lookout for and to reject as invalid a sponsor ballot that reflects votes for more than the permissible number of candidates.
- If your bylaws or offering plan contains a designation provision, keep track of the sponsor's equity interest, so that you know when the right expires.
- If your bylaws contain a cumulative voting provision which the sponsor is using to his advantage, check to see if it is memorialized in the Certificate of Incorporation. If it is not, then the provision is invalid.
- Have counsel thoroughly review your building's governing documents for any other quirky (i.e., non-standard) provisions which might be useful in limiting sponsor influence
- If you are forced to live with a sponsor presence on your board, try to contain his influence. To the extent possible, do not allow him to assume the presidency. (Most bylaws provide for election of officers by majority board vote so every attempt should be made to keep him out of that official capacity.) In addition, he can be isolated through the appointment of a resident-dominated Executive Committee.
- Independent professionals can be of assistance in helping protect the board from the overriding influence of the sponsor.
Bruce Cholst is a senior attorney with Rosen & Livingston, a Manhattan law firm specializing in the representation of co-op- and condo boards.