Published: Winter 1995

SIGNIFICANT LEGAL DECISIONS OF 1994

Marc Luxemburg, president of the Council of New York Cooperatives & Condominiums, is an attorney specializing in cooperative and condominium law. In each issue of the CNYC Newsletter, Mr. Luxemburg reviews recent court cases. In addition, at the annual Cooperative Housing Conference he presents a workshop on significant legal decisions of the year.

CNYC frequently takes advocacy positions on key legal issues in briefs of amicus curiae. If your building is involved in a legal action that you think is significant to other buildings, please be sure to keep CNYC informed of the status of the case.

The four major areas covered in this text include: the exercise of the powers of the board of directors, which principally focus on cases involving rights and obligations of tenant-shareholders; the board's relationship with the sponsor, particularly with respect to the cancellation of wraparound mortgages of defaulting sponsors; the board's relationship with banks pursuant to recognition agreements, particularly with respect to rights arising out of difficulties by tenant shareholders; and rights involving sales or foreclosures of individual apartments.

WHEN CAN FAMILY MEMBERS USE A COOPERATIVE APARTMENT?

Mr. Luxemburg revisited the important issue of the right of family members to occupy a cooperative apartment in the absence of the named shareholder. As previously mentioned in this column, one strange decision, Barbizon Owners Corp. v. Chudick, 607 NYS2d 880 (Civ. Ct. Queens County 1/12/94), held that the brother of a shareholder was neither a subtenant nor a guest, and could occupy the apartment as of right in the absence of the named shareholder, even though the lease stated that the apartment was intended for use by the shareholder and the family of the shareholder. The court interpreted the word "and" to mean "or", so that either the named shareholder or members of his immediate family could occupy the apartment as of right. However, in Thwaites Terrace House Owners Corp. v. Vega, N.Y.L.J., p.30, c.2 (Civ.Ct. Bronx County 6/29/94), the court held that the grandson of the shareholder was not authorized to occupy the apartment in the absence of the shareholder, who admittedly lived out of state. The court found that the purpose of the occupancy clause in the lease was to ensure occupancy by the named shareholder as a prerequisite to keypunch by other members of the shareholder's family.

Sublet fees are another issue of significance to boards of directors. In Bailey v. 800 Grand Concourse Owners, Inc., 604 NYS2d 562 (1st Dept. 12/2/93), the Appellate Division, 1st Department, held that a relatively obscure paragraph in the bylaws restricted the board's right to charge a sublet fee.

The bylaws of a cooperative will typically authorize the board to charge a fee to cover the actual expenses of the cooperative with respect to transfers of apartments, and some bylaws extend the same authority to sublets of apartments. The court interpreted this clause to be a limitation on the powers of the board, finding that if the sublet fee could not be justified on the basis of the actual expenses with respect to the subleasing, the fee would be illegal.

In Zimiles v. Hotel des Artistes, Inc., N.Y.L.J., p.22, c.1 (Sup. Ct. New York County 3/15/94), the court went even further in treating a proprietary lease as a restriction on the powers of the board, finding that a lease that authorized the withholding of consent to a sublease did not authorize the imposing of conditions on such consent, such as a fee, in the absence of express language authorizing the imposition of conditions. The lesson of these two cases is that the directors should carefully check the language in the proprietary lease and bylaws before enacting any fees.

Mr. Luxemburg also reviewed the rights of a board in cases involving the exercise of board discretion covered by the business judgment rule. In Lewis v. 1025 Fifth Avenue Corp., N.Y.L.J., p.30, c.6 (App. T. 1st Dept. 2/24/94), a board decision to compensate existing shareholders who had replaced windows was governed by the business judgment rule, and it was not for the court to determine the method or criteria for calculating the credit. Furthermore, in Cohen v. 120 Owners Corp., 613 NYS2d 615 (1st Dept. 6/21/94), a board decision to reallocate shares to certain professional apartments was also covered by the business judgment rule, and was not subject to reexamination by the court or by the owner of another professional apartment whose shares were not reallocated.

Another area of significance discussed was the interplay between the rights of a bank pursuant to its security agreement against a defaulting shareholder, and the rights of the cooperative. It was interesting to note that in many instances the banks were given greater powers to collect from the shareholders than were the cooperatives.

In Israel v. Merrill Lynch Credit Corp., 614 NYS2d 684 (Sup. Ct. New York County 12/13/93), the bank, in order to protect its interest, was entitled to pay the shareholder's maintenance default, and collect it in full from the shareholder, notwithstanding that the shareholder had a claim of breach of warranty of habitability against the cooperative. The shareholder retained its right to litigate with the cooperative to recover damages for the breach. In this instance, the presence of the bank reversed what has become the standard procedure with respect to warranty of habitability claims - namely that the shareholder withholds the maintenance, and the cooperative cannot claim the maintenance until after it has litigated such claims. A similar result was obtained in Matter of Nadelson v. Citibank N.A., NYLJ, p.22, c.6 (Sup.Ct. New York County 2/4/94), where the bank was held to have a right to pay disputed late charges in order to protect its lien, and could collect such charges from the shareholder, leaving the shareholder with the necessity to litigate with the cooperative its right to recover the disputed late charges.

PROGRESS IN THE LONG STRUGGLE TO AFFIRM THAT I.R.S. 277 DOES NOT APPLY TO COOPERATIVES

Decided too late to be reported upon at the Conference was an important federal decision that is of great interest to New York cooperatives. On November 9, 1994, the United States Tax Court handed down a key decision in the matter of Buckeye Countrymark, Inc. v. the Commissioner of Internal Revenue (Docket No. 29412-87). Judge Lawrence Whalen ruled that Section 277 of the Internal Revenue Code does not apply to this cooperative, which is subject to the provisions of subchapter T of the Internal Revenue Code.

While Buckeye Countrymark is a farmers cooperative that helps its members market their products, this decision still holds great significance for housing cooperatives. Section 277 was enacted in 1969 to close tax loopholes enjoyed by membership organizations such as golf clubs or burial societies. It requires that non-member income of these membership organizations be taxed at the corporate rate. When Congress drafted this legislation, it considered whether it was applicable to cooperatives, but determined that this was not appropriate. Then, seven years after Section 277 became law, the Internal Revenue Service invoked this provision to tax cooperatives, specifically demanding taxes on the revenue from reserves and on commercial assets of housing cooperatives, including the rent from laundry rooms and garages.

Contending that Section 277 does not apply to cooperatives, Trump Village III, a Mitchell-Lama housing cooperative in New York City, brought suit in the Tax Court in 1988 challenging the applicability of Section 277. The Trump case was argued before Judge Whalen, but his decision is still pending. The Internal Revenue Service has virtually halted its practice of auditing housing cooperatives for 277 income, but it has made it clear that it will be guided by the decision in Trump III.

In the Buckeye case, Judge Whalen discusses Section 277 and its intent, including a detailed look at cooperative housing corporations. Judge Whalen finds that "the application of Section 277 to nonexempt cooperatives would lead to absurd or futile results. This is a strong indication that Congress did not intend Section 277 to be applied to nonexempt cooperatives... and that nonexempt cooperatives are not `membership organizations' within the meaning of Section 277."

The breadth of Judge Whalen's comments give good reason to believe that Trump III will be decided in a like manner, freeing thousands of co-ops of the specter of significant additional taxes under Section 277.