The Secret Weapon Against Difficult Sponsors

Think your co-op board is powerless against holders of unsold shares? Think again. When sponsors dismiss safety concerns by claiming special privileges, boards actually have significant legal leverage. In this episode, Bruce Cholst, partner at the law firm Herrick Feinstein, reveals how to use the "covenant of good faith and fair dealing" doctrine that can protect your building even when sponsors are technically exempt from rules. Habitat’s Carol Ott conducts the interview.

The business of running a building is demanding work that requires making endless decisions — some that can quickly lead your board into a quagmire of legal difficulties. Legal Talk interviews New York's leading co-op/condo attorneys to find solutions, and get some guidance, on these challenges. For more co-op and condo insights, sign up to receive Habitat's free newsletters or become a Habitat subscriber today!

Transcript

[00:00:00] Carol Ott: Welcome to Legal Talk, a conversation about governance issues that New York's co-op and condo boards are tackling today. I'm Carol Ott with Habitat, the New York City magazine for co-op and condo board directors, and my guest today is Bruce Cholst, partner at the law firm Herrick Feinstein. 

There is a special class of co-op shareholders called holders of unsold shares. This class has rights and privileges that the ordinary shareholder doesn't, and the entities holding them often claim they have blanket exemptions from co-op policies. Bruce, how true is this claim? 

[00:00:40] Bruce Cholst: It often is true, however, boards should not be too quick to accept the blow off from the sponsor or holder, when the sponsor or holder claims an exemption on the ground that it's a holder of unsold shares.

And the reason for that is that on occasion, depending upon the language of your governing documents, and the circumstances of your dispute with the sponsor, you may have far more leverage than what seems to meet the eye. And therefore my message to boards is consult your attorney to see if there are certain legal doctrines which might apply.

[00:01:24] Carol Ott: You had experience with one of your clients where there was a water leak in an apartment owned by the holder of an unsold share. And what happened there? 

[00:01:33] Bruce Cholst: That's correct. What happened is that there was the water leak and the board sent its engineer to inspect the apartment from which the leak was emanating.

It was a sponsor owned apartment. And in the course of the engineer's inspection, the engineer discovered a whole list of potential code violations that were going on as a result of the sponsor renovation. And that was of even more alarm than the leak itself and the source of the leak, which was being inspected because it presents safety issues when the apartment is rife with violations and the potential of unsafe conditions.

And so we raised that issue with the sponsor and we got the typical blow off: we're a holder of unsolved shares. You have no right to interfere with our apartment renovations. And I saw an opening. There is a legal doctrine called the Covenant of Good Faith and Fair Dealing. People who are the parties to a contract where there is no technical violation of a contract term, but the parties are the party who the offending party is engaging in a subliminal course of conduct, which is undermining the other party's right to the bargain that it struck when it entered into a contract.

And I said to the sponsor, you entered into a contract, namely the bylaws in which you obtained this exemption as a holder of unsold shares from each of the shareholders who bought into your building. But there was an implied duty on your part to ensure when you exercise your right to an exemption from board interference with your alterations there is an implied obligation to provide a safe environment to the rest of the community when you do your renovations. And that means complying with the code. Because every code provision is enacted with a safe condition in mind and the goal of safe construction. And you are violating your covenant of good faith and fair dealing by conducting renovations without regard to compliance with the code.

And after a lot of screaming and threats of litigation on both sides, the sponsor relented. And the deal we struck was that the sponsor's engineer would give us a sign off under seal at the conclusion of the renovation that the apartment was code compliant in every respect. And we took that overseal letter as a sign engineer was putting his name on the line. And we would be able to go after the engineer if there was non-code compliance. 

[00:04:36] Carol Ott: In a co-op where there's so much attention paid to signing an alteration agreement and making sure proper insurance, particularly nowadays is held by whatever contractor comes in, for a holder of unsold shares, do they not have to comply with any of that? 

[00:04:53] Bruce Cholst: They don't have to comply with that, and that is a gaping loophole. And I would probably argue that being underinsured is also a breach of the covenant of good faith and fair dealing. But that is really an open question. And the reason for that is that the sponsor reserving its right under the exemption, when drafting the offering plan, it did provide for an exemption from board regulations such as insurance, a precise regulation. So the sponsor does have an argument that this is the letter, not the spirit of the contract, that I'm upholding and defending and therefore you don't have a right to require specific compliance with insurance conditions. And as I said, I would argue otherwise, I would argue the co-op as a community, has a reasonable expectation that your renovations are going to be adequately insured, less there'd be a particular problem, which causes widespread damage throughout the building because renovations are so interconnected, the apartment and building system is interconnected with all the others.

So I think there is a broader obligation, but you may not win on that one. 

[00:06:11] Carol Ott: So is there something a board can do proactively? I mean, that's pretty scary. That's like an invitation to be sued under the labor law, all the big things that we've been talking about. 

[00:06:22] Bruce Cholst: It is, and I think proactively a board can take the stance that I'm taking now and there may be a litigation-averse sponsor who will think twice like the sponsor I confronted on the renovation issue and the code violation issue and they may back down. Of course, in trying to avoid litigation, I would argue to a sponsor that it's in your self-interest to be adequately insured as well. 

[00:06:50] Carol Ott: So a board could proactively take this doctrine , or this legal bit that you just identified and send it to the holders of unsold shares, just to put them on notice. 

[00:07:02] Bruce Cholst: As a sword rather than a shield, and that would be a proactive measure. Absolutely. 

[00:07:07] Carol Ott: I'm just curious, is there a market for investors to buy and sell unsold shares? 

[00:07:14] Bruce Cholst: There is, there always has been. And I think a lot of the recent changes in various laws especially regarding conversions have discouraged it and have put a damper on the market, but there is still a market, at least in theory.

[00:07:30] Carol Ott: So if your building, which would be a building that had been converted by a sponsor, if in your building you still have the sponsor holding unsold shares, or the sponsor has sold it to some kind of investor, for the board to take proactive steps, particularly during today's insurance environment, seems to me that that would be a smart move.

[00:07:52] Bruce Cholst: I think it would be a legal imperative. 

[00:07:54] Carol Ott: All right. Let's leave it on that then. Thank you very much for joining us today. 

[00:07:59] Bruce Cholst: Thank you for having me again.