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Constraints on Board Action – BCL §501(c)

By Adam Leitman Bailey


March 5th, 2008

For decades, Business Corporation Law §501(c),1 which mandates equality of shares in a corporation, has been a limit on actions of cooperative housing corporations, culminating in the 1985 Court of Appeals decision in Fe Bland v. Two Trees Management Co.2 which expressly applied §501(c) to co-ops.

Since Fe Bland, application of §501(c) to co-ops has been curtailed by the Legislature and courts in several contexts. However, courts and co-ops continue to grapple with the application of §501(c) to the co-op, a hybrid entity with both corporate shares and a real property lease component.

As a result, and as shareholders continue to invoke §501(c) in court challenges to board actions which allegedly impose unequal shareholder treatment, confusion exists in the co-op community as to when §501(c) constrains board action.

This column attempts to clarify this confusion, reviews co-op case law under §501(c) and identifies issues to which §501(c)’s constraint should be applied by prudent boards and managers. This column also addresses how the share proportionality embodied in §501(c) is addressed in condominiums.

Section 501(c) and ‘Fe Bland’

Section 501(c) mandates that “each share shall be equal to every other share of the same class.” Therefore, obligations imposed on shareholders should be in proportion to the number of shares owned: no preferential treatment is permitted. In the seminal Fe Bland case, the Court of Appeals invalidated an apartment transfer fee because it violated §501(c) by imposing a fee that varied in amount depending on whether the shareholder was an “original” purchaser from the sponsor and had been an owner for five years or more. And in a companion case, 330 West End Apartment Corporation v. Kelly,3 the court invalidated a transfer fee based on a percentage of the selling price of the co-op apartment. Invalidation of such transfer fees, popularly called flip taxes which generate revenue for the co-op, eliminated a significant source of co-op revenue.

In response to co-op concerns, less than a year later the Legislature enacted §501(c)(3) to obviate the share proportionate requirement of Fe Bland: “Shares of the same class shall not be considered unequal because of variations in fees or charges payable to the corporation upon sale or transfer of shares and appurtenant proprietary leases that are provided for in proprietary leases, occupancy agreements or offering plans or properly approved amendments to the foregoing instruments.”4

Importantly, while §501(c)(3) creates a transfer fee exception to the share proportionate rule, it is silent with respect to other fees imposed by co-ops. Therefore, Fe Bland and §501(c) could arguably invalidate other non-proportionate co-op charges. Further, while the stated legislative purpose of §501(c) is to “deal with matters of corporate finance only,”5 Fe Bland did not address whether the statute applies to leasehold aspects of co-op ownership.

Unsold Shares

Courts have consistently held that it is not a violation of §501(c) to exempt holders of unsold shares from sublet fees and board approval requirements applicable to other shareholders. In Susser v. East 36th Owners Corp.,6 plaintiffs challenged such exemptions, arguing that they violated §501(c); the relief sought was to obtain the exemptions for all other shareholders. The court found that the holder of unsold shares and all other shareholders were not similarly situated, in that only the holder of unsold shares was legally obligated to renew leases of non-purchasing tenants who remained in possession under a non-eviction plan—an obligation difficult to fulfill if it were subject to restrictions on subletting applicable to other shareholders. Finding that the special benefits accorded holders of unsold shares was recognized and approved in §501(c)’s legislative history, the court rejected the §501(c) challenge as against public policy because it would strip co-ops of their essential managerial prerogatives to restrict subletting.

Purchase of Shares

When nonresidential tenants purchase shares from co-ops, courts have rejected §501(c) challenges to variations in price and board imposed fees. In Cohen v. 120 Owners Corp.,7 plaintiff purchased shares for a professional unit for use as a dental practice. A rider to his contract imposed a 20 percent surcharge on maintenance for each additional dental associate occupying the unit. Plaintiff sued to invalidate the surcharge because another dentist who purchased a professional unit was not required to pay it, arguing that the surcharge violated §501(c)’s share proportionate rule and was invalid. The Appellate Division, First Department disagreed, holding there was no violation of §501(c) because the other dentist’s purchase agreement could have been reached under different market conditions and imposed different conditions for subletting, including requiring credit and social references from any proposed sublessee. Thus, §501(c) does not preclude the role of market influences to shape co-op decisions in setting the price for shares it issues and permits the terms of sales to vary.

Assessments for Repairs and Alterations

Assessments for co-op building repairs must be equal per share to comply with §501(c).8 However, where the proprietary lease imposes a repair obligation only on owners of certain apartments, disproportionate assessments are permitted. In Mariaux et al. v. Turtle Bay Towers Corp.,9 plaintiffs challenged an assessment for repairs made by the co-op to terraces appurtenant to their apartments, arguing that because the assessment was not building wide, it violated §501(c). The First Department rejected the claim, holding that where a proprietary lease places responsibility for terrace repairs on owners of appurtenant apartments, the §501(c) challenge is merit-less.

However, in Peckolick v. 135 W. 17 St. Tenant’s Corp.,10 the court rejected the co-op’s attempt to apportion costs of a roof replacement to shareholders whose apartments had exclusive use of a portion of the roof. The court distinguished costs of roof replacement, which under the proprietary lease is an improvement to the corporate property that inures to the benefit of all shareholders and is therefore required to be on a pro rata basis, and repair costs of a portion of the roof, for which the owner of the appurtenant apartment may be responsible, if the proprietary lease so provides.

Sublet Fees and Consents

One view, supported by legislative history, is that §501 should only be applied to corporate aspects of co-op ownership, not leasehold aspects. In McCabe v. Hoffman,11 plaintiff challenged a sublet fee surcharge based on 5 percent of sublet rent collected as not share proportionate and violative of §501(c). The First Department dismissed the claim, essentially holding that §501(c) did not apply to sublet fees.

Although sublet fees are leasehold aspects of coop ownership, §501(c) invalidates fees that differ based on classification of shareholders. In Wapnick v. Seven Park Ave. Corp.12 original purchasers received preferential treatment with respect to sublet fees. The First Department held that varying fees based on whether a shareholder is an original or subsequent purchaser violates §501(c). Further, in applying §501(c) to sublet fees Wapnick calls into question whether the rationale of McCabe, that §501(c) does not apply to sublet fees, is still good law. Under the Court of Appeals’ ruling in Kelly, §501(c) prohibits a transfer fee based on a percentage of shareholder profits. Therefore, if §501(c) applies to sublet fees, it should also prohibit sublet fees based on a percentage of a shareholder’s sublet rent, such as the fee upheld in McCabe. However, this leaves open the question of whether a sublet fee based on a percentage of maintenance charges violates §501(c). Because maintenance charges mirror share proportionality, a fee based on a percentage of maintenance charges should not violate §501(c).13

With regard to co-op board consent requirements for subletting, courts consistently hold that §501(c) applies. In Spiegel v. 1065 Seven Park Ave. Corp.14 the proprietary lease and bylaws provided that original purchasers need only the consent of the co-op’s managing agent to sublet their apartments, which could not be unreasonably withheld. However, subsequent purchasers were prohibited from subletting without board consent, which could be withheld for any or no reason. The First Department invalidated the more favorable subletting rights afforded original purchasers as violative of §501(c).

Disproportionate Impact

In Louis and Anne Abrons Foundation Inc. v. 29 E. 64th St. Corp.15 the co-op board prohibited residential subletting and subsequently imposed a sublet fee, which would impact only commercial shareholders. The court upheld a claim by a shareholder owning an apartment used for commercial purposes that §501(c) was violated by this unequal treatment.

However, in Sherry Assoc. v. The Sherry Netherland,16 as a result of New York City zoning law changes, certain shareholders lost the right to rent their apartments for transient occupancy, making the co-op’s sublet fee applicable only to units that retained such rights. Unlike in Abrons, where the coop banned subletting, in Sherry Associates a change in the applicable zoning created the classification. The Sherry Associates court held that because the disparity was not due to the co-op’s actions, but was a difference in permitted uses created by operation of law, §501(c) did not invalidate the sublet fee.

Condominiums

While §501(c) does not apply to condominiums, the Condominium Act provides analogous proportionality requirements. Section 339-m of the Condominium Act17 provides that common expenses are charged to unit owners proportionate to their interest in the common elements, but may be allocated disproportionately based on exclusive use or control of areas by particular unit owners. The Condominium Act thus establishes the functional equivalent of a share-proportionate regime for condominiums. In Zack v. 3000 East End Avenue Condominium Ass’n.,18 the court held that a disproportionate allocation of common expenses violated the Condominium Act where some expenses were allocated on a proration of floor area and not on a per unit/common element basis and no special use or control by particular unit owners warranted a disproportionate assessment.

Conclusion

Application of §501(c) has been curtailed by the Legislature and courts in many contexts. The Legislature limited application of §501(c) by an amendment that exempts transfer fees from the share proportionate rule. Further, courts have held that §501(c) should not invalidate: (i) special benefits accorded holders of unsold shares; (ii) fee variations in the sale of shares issued by co-ops; (iii) disproportionate assessments for repairs that only certain shareholders are responsible for; and (iv) disparities created by zoning or other laws and not due to co-op actions.

However, §501(c) does invalidate disproportionate assessments for building-wide repairs. Boards can remedy inequities created thereby in other ways. For example, a board may compensate shareholders who, after replacing their own windows, must pay a building-wide assessment on a per-share basis by purchasing the previously installed windows from such shareholders for a price equal to the imposed assessment. In addition, §501(c) invalidates disparate subletting requirements between original and subsequent purchasers. Boards and managers should be mindful of the proportionality constraints of §501(c) when adopting policies or taking actions that impose obligations on shareholders and unit owners. Because of continuing uncertainty about the application of §501(c), when in doubt prudence dictates that boards should err on the side of proportionality.

1. N.Y. Bus. Corp. Law §501(c) (McKinney 2007).
2. 66 NY 2d 556 (1985).
3. 66 NY 2d 556 (1985).
4. BCL §501(c)(3).
5. Mogulescu v. 255 West 98th Street Owners Corp., 135 AD2d 32 (1st Dept. 1988).
6. 262 AD2d 197 (1st Dept. 1999). See also,
Yatter v. Continental Corp., 22 AD3d 573, (2nd Dept. 2005).
7. 205 AD2d 394 (1st Dept. 1994).
8. Siegler, “Sublet Fees and Window Replacement,” NY LJ, Sept. 1, 1999, at 3, col. 1.
9. 301 AD2d 460 (1st Dept. 2003).
10. 268 AD2d 339 (1st Dept. 2000).
11. 132 AD2d 287 (1st Dept. 1988).
12. 240 AD2d 245 (1st Dept. 1997).
13. See, e.g. Zuckerman v. 33072 Owners Corp., 97 AD2d 736 (1st Dept. 1983); Zimiles v. Hotel Des Artistes, 216 AD2d 45 (1st Dept. 1995).
14. 305 AD2d 204 (1st Dept. 2003).
15. 297 AD2d 258 (1st Dept. 2002).
16. NY LJ, June 13, 1996, at 30, col. 4 (Sup. Ct. N.Y.
17. N.Y. Real Property Law, §339-m (McKinney 2006 & Supp. 2008).
18. 306 AD2d 846 (4th Dept. 2003), reargument denied, 309 AD2d 1313.

Adam Leitman Bailey, P.C.

NEW YORK REAL ESTATE ATTORNEYS