Reacting to Sponsor Default Take Swift Action to Avert Disaster

Reacting to Sponsor Default

tarting in the mid '70s and continuing through the latter part of the '80s, New York City was engulfed in the co-

oping craze. As prices spiralled upward, owners of residential property were cashing in by converting buildings from rentals to co-ops.

However, many of the conversions that took place in Brooklyn and Queens in the mid-'80s were effectuated by Johnny come lately's who, to get in on the feeding frenzy, were buying residential properties at high prices, pledging their unsold shares to local lenders, and trying to pyramid their holdings into the proverbial pot of gold.

By 1990, the bottom had dropped out of the real estate market and sponsors who had purchased properties for exorbitant prices and had leveraged their holdings through pledges to local lenders, were beginning to default. The inability to sell apartments, coupled with the negative cash flow resulting from apartments where rent-stabilized and rent-controlled tenants were paying less than the sponsor's maintenance and debt service, brought down many a sponsor's house of cards.

The Sponsor-Co-op Relationship

In most cases, the sponsor of a cooperative conversion is the owner of the building immediately before conversion. The sponsor organizes and forms a cooperative corporation and transfers the property to that corporation. In exchange for the transfer to the cooperative corporation, the sponsor receives all of the shares of the corporation and all of the proprietary leases. These leases, together with the shares for each individual unit, are thereafter sold to the tenant/shareholders.

After conversion, each shareholder is obligated to pay his proportionate share of the building's yearly upkeep in the form of a monthly maintenance fee. Included in the yearly upkeep is the payment of principal and interest on the mortgage, real estate and other taxes, capital expenditures and all other operating expenses.

The sponsor remains the owner of the shares and holder of the proprietary lease appurtenant to each apartment which goes unsold, and is obligated to make his maintenance payments to the corporation. This is so whether his units are vacant or rented.

The by-laws for each cooperative corporation provide that the corporation has a lien upon each tenant/shareholder's (including the sponsor) shares and lease for unpaid maintenance. Moreover, it has been held by the courts that the lien extends to other unfulfilled obligations of the sponsor. The lien covers all apartments owned by the sponsor, whether or not he is delinquent on them.

When a shareholder fails to shoulder his maintenance responsibility, the shortfall in the building's cash receipts must be paid by all of the other tenant/shareholders. When a sponsor, who is the owner of a large block of apartments (perhaps 30 or even 50 percent of the building), stops making his monthly payments, we realize a co-op's worst nightmare. Accordingly, each co-op with significant sponsor ownership must be prepared to take immediate action at the first sign of a default.

Seize the Sponsor's Rents & Notify Lenders

Quick action is the key to protecting the building's interests against a defaulting sponsor. A board cannot afford to wait until payments are so delinquent that the bank is threatening to foreclose the mortgage and vendors are threatening to cut off s ffb upplies.

Most proprietary leases provide that a co-op may seize the rent which the sponsor (or any tenant/shareholder) is collecting from his own subtenants, should a default occur. Moreover, in 1991 the New York State legislature passed a law giving every co-op this same mechanism to utilize against a defaulting sponsor. Now all co-ops are permitted to collect rents directly from non-purchasing tenants occuM-pying sponsor-owned apartments.

The attachment of the sponsor's rents should be the first step in any default situation. By doing so immediately, the co-op will be receiving part of the funds which are owed to them. The co-op can then pay their bills more easily without the need for seeking additional funds from the other tenant/shareholders, or at the very least minimizing those demands.

Serious discussion should begin with the sponsor to learn his exact financial condition. Recent legislation has aided this effort by requiring sponsors to amend their offering plans each year to disclose a myriad of data concerning their financial situation in each co-op wherein their ownership exceeds ten percent . By keeping close watch on these amendments a board of directors is better able to forecast future sponsor problems and react more expeditiously to them.

If it appears that the sponsor has no immediate prospect of making good on his default, a notice should be sent to his lender, alerting it of the arrearage. This notification could very well result in payment being remitted by the sponsor's lender so as to protect the bank's secured position vis-a-vis the co-op.

If the sponsor's lender is reluctant or refuses to make monthly maintenance payments, the co-op may wish to meet with its own mortgage holder. It may be possible to structure a deal between the co-op, its lender and the sponsor's lender. The co-op's lender may be willing to restructure the mortgage so as to temporarily reduce mortgage payments. This type of temporary reduction will help absorb the shortfall resulting from the sponsor's default. Simultaneously, an understanding should be negotiated with the sponsor's lender to repay the arrearage, together with interest, and perhaps a bonus to the co-op, as it resells each of the sponsor's apartments that the lender will inevitably retake upon foreclosure. Under this scenario, the co-op's lender will be repaid all of its funds, the shareholders will not be required to shoulder the extra financial burden of the sponsor, and the sponsor's lender will not be required to go out of pocket before it has managed to liquidate the sponsor's holdings.

There have been several recent cases that have permitted co-ops to auction, without court process, the shares and proprietary leases owned by defaulting sponsors. However, these cases have been criticized by the bench, and it would appear that seeking such action under the provisions of the proprietary lease relating to non-judicial sale upon default is a dangerous self-help method.

Evict The Sponsor

Although more time-consuming, and more costly, the safer approach would be the service upon the sponsor of a Notice to Cure and Notice of Termination as specified under the proprietary lease. After termination of the proprietary lease, an action should be commenced in State Supreme Court. The suit should demand a judgment declaring that the co-op's lien is foreclosed; that the co-op be granted possession of the apartment if not occupied by a rent-stabilized or rent-controlled tenant; that the proprietary lease and shares be sold; and that the proceeds be distributed to the co-op, the sponsor and its lender, as their interest may appear.

In some buildings, the sponsor has sold blocks of apartments to investors to whom the sponsor has given the formal designation of Holders of Unsold Shares. These investors receive the benefits which were granted to the sponsor under the offering plan. However, in exchange for receipt of these benefits, the sponsor, through the offering plan, is obligated as the guarantor of the maintenance payments assumed ffb by the investor. Accordingly, if an investor who has been designated as a Holder of Unsold Shares defaults in his maintenance obligation, and the sponsor is still a viable entity, demand should be made upon the sponsor for payment under its guarantee. If the sponsor is not forthcoming, immediate suit should be started against the sponsor to enforce the sponsor's guarantee appearing in the cooperative offering plan.

Beware Other Wrongdoing

A sponsor's maintenance default may be intertwined and interrelated with other sponsor wrongdoing. For example, misstatements in the offering plan; overt and intentional deceptions concerning the condition of the building or facets of its operation; the appropriation by the sponsor, or related entities, of long-term low rent leases for portions of the cooperative building (sweetheart leases) which provide ancillary building services (i.e., garage, laundry room, etc.). These tangential problems should be dealt with simultaneously.

For misstatements or intentional concealments (failure to disclose) within the offering plan itself, or within any of its amendments, the Attorney General should be immediately notified so that he can take appropriate action under the Martin Act. To alleviate the burden of sweetheart leases, the co-op should avail itself of the provisions of the Federal Condominium and Cooperative Conversion Protection and Abuse Relief Act to terminate the self-dealing leases. The misstatements and concealment's can also be dealt with by suits for common law fraud against the sponsor. Moreover, the federal courts have already held that a purchaser who has been defrauded by a sponsor may, under certain circumstances, assert a claim under the Federal Racketeer Influenced and Corrupt Organizations Act (RICO).

The New York economy is hopefully beginning to come out of what has been an exceptionally long recession. Co-op prices are starting to firm up, and many of the weak sponsors have already been shaken out of the market. However, every board in every building with significant sponsor ownership, must remain vigilant to respond quickly to a sponsor default. Only through such vigilance and swift action can a co-op avoid a possible disaster under which each tenant/shareholder's equity is placed in jeopardy. Remember, a foreclosure will reduce the status of an owner to a rental tenant, while he remains personally liable for the balance of any co-op loan which he may have secured in conjunction with his purchase. As previously alluded to, this would be a co-op's worst nightmare.

Mr. Braverman is senior partner of Braverman & Associates, P.C., a Manhattan law firm that specializes in cooperative and condominium housing law.

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  • The sponsor's duty was to sell all of the apartments containing the proprietary lease to the apartment and shares of the corp included. Unsold units cannot occur if the sponsor had issued option-to-purchase leases for those customers who could not or did not get a proprietary lease. In other words, unsold apartments such as vacant or occupied by rent stabilized or controlled tenants would have been sold if the option-to-purchase leases were issued thus relieving the sponsor from owning such units. There would be no rent stabilized nor controlled tenants in each apartment and each of them would have been non-shareholder tenants other than shareholder tenants in the co-op building. This is aside from subtenants or under-tenants under either shareholder tenant or non-shareholder tenants renting their unit partially such as one or more bedrooms inside a co-op apartment. Furthermore, how can a default notice alerting the arrears be sent to the sponsor's lender when the lender is his cousin whom he gave money to, to be the corp's mortgagee? How is the sponsor's "lender" going to remit payment in the default when all of the money used to lend was coming from the sponsor? If the sponsor defaults in this case, what then? The sponsor goes to bank for a loan on behalf of the corp and leave it in debt with the bank paid for by the shareholder tenants? The sponsor may default for a new (and cheaper) mortgage at the auction to buy back the units for other purpose or agendas.