Publication Date: Spring 1997

CNYC's annual Cooperative Housing Conference, held each autumn on a Sunday, is New York's most comprehensive source of cooperative and condominium information and education. With product exhibits to visit from early in the morning, a video theater showing Co-op Roundtable throughout the day, and dozens of workshops and seminars, the Conference brings together hundreds of CNYC members for a day of learning and sharing.

The 17th Annual Cooperative Housing Conference will be held on Sunday, November 16, 1997 (see Coming Events). This Website, as well as the summer issue of the CNYC Newsletter, will include a brochure featuring the full line-up of workshop offerings.

Reviewed below are two presentations from the 16th annual Cooperative Housing Conference: Improving Your Building's Bankability and Creating Rules that Work.

IMPROVING YOUR BUILDING'S BANKABILITY

Many cooperatives and condominiums, while functioning very well, do not precisely meet the standard borrowing profile set by lenders. This makes it difficult for potential purchasers to obtain loans to buy apartments in the building. But according to Neil Davidowitz, Esq., vice president of Orsid Realty Company and Patrick Fay, of Bank of New York Mortgage Company, there are ways to overcome the obstacles and to improve the chances of bringing financing to your building. This includes a series of practical guidelines for presenting your building in the best possible light.

To get started, Mr. Davidowitz advises the board to compile a comprehensive and well-organized packet which includes all the information that a lender may request about the building, supplemented with documentation that accentuates all positive features. Lenders refer to this as a "due diligence" packet. It should include:

1. Cover Letter. A succinct and readable cover letter should provide a snapshot of your building, describing its current financing including underlying mortgage amount(s), the lender, the rate and the maturity date and the current distribution of units among homeowners, sponsor, investors and rental tenants. It should also offer a quick summary of the building's history both financial and physical, including what work has been done and what projects are planned. Your goal is to show that this is a well-run, well-financed building, worthy of the attention of this lender as it considers share loans. If the building is seeking underlying financing, the cover letter should describe how the loan amount will be used.

This cover letter, as well as any accompanying charts and documents you provide, are your opportunity to stress all that is positive. In many cases you will use the package to counteract negative impressions that the bank could derive from information available in public records, including your own offering plan and its amendments. "It is critical, especially if your building does not hit many of the so-called standards of the lending market, to cast your building in its best possible light," says Mr. Fay. "Banks look at the whole picture, not just a portion, so a lot of good points can overshadow a few less-than-good points."

2. Offering Plan. Lenders will ask for the Offering Plan for buildings where the sponsor still holds units. Make sure that the plan is up-to-date, with all amendments. Sponsors actively selling shares by prospectus are required to amend their plans annually and to include a financial disclosure amendment, which lists the remaining number of sponsor-owned units and describes any cash shortfall between the maintenance payments and the rent that the sponsor collects.

The financial disclosure amendment also contains information on all buildings where your sponsor still has an interest of 10% or more, which raises another issue: "He may be okay on your building, but behind on his other buildings," says Mr. Davidowitz, who suggests that your cover letter stress the positive situation in your own building, or that you bring to bear additional information that improves the way the lender deals with potential problems. "Negative cash flow is not always a problem," Davidowitz notes, "particularly if the sponsor holds an income-producing wrap-around mortgage or is collecting income from commercial units."

Mr. Fay stresses that sponsor units are now of less concern to lenders because of a change in the General Business Law passed in 1992, which allows cooperatives and condominiums to collect rent directly from the tenants of a defaulting sponsor's units, ensuring continued cash-flow. "All in all, the 51% owner-occupancy threshold has become less of an issue," he says.

3. Financial Statements. At a minimum, all buildings should include their past two years' audited statements, notes Mr. Davidowitz. If your building shows a low reserve fund (less than the equivalent of three months of maintenance collections), compile a detailed list of completed capital improvements, including the date and cost and an engineer's report discussing the condition and expected life of building systems. "You want to tell the bank in very clear terms that you have been taking care of the building, despite a low reserve," he says, adding that you should "also mention any lines of credit or other sources of funds that the building may have in lieu of a reserve fund."

4. The Budget. If your building does not have a current budget, make one, suggests Mr. Davidowitz. But be realistic -- even if it means raising maintenance. "I don't recommend showing operating deficits, but don't rob the reserve fund when you should be raising maintenance," he says. "That is not a situation that banks look favorably upon."

5. Sublets. Disclose the number of sublets in the building. Mr. Davidowitz feels that the number of sublets is less of a liability today than it was a few years ago. "Banks still want to see the number, but it's a less crucial part of the analysis," he says. "The reason," explains Mr. Fay, "is that a strong rental market has reduced the number of negative cash-flow sublets. And, lenders almost always consider sublets preferable to sponsor-owned or investor-owned blocks of units. If an investor goes down, you have 10 or 20 apartments going down at the same time. But sublets (at least from a creditor's perspective) go down one at a time." Include information on market rental rates in your area if it strengthens your profile.

6. Protective Building Policies. If your cooperative or condominium has policies designed to protect the financial health of the building, feature them. For example, lenders like to know if your building restricts the duration of sublets. "They want to see that their exposure is limited," notes Mr. Davidowitz. "In addition, lenders are also reassured to see limitations on the level of financing that a cooperative will permit its shareholders to have on their units." A good percentage of cash requirement is 20% or 25%. "If people only have to put 5% or 10% down, then the building doesn't look so good to lenders," he says.

7. Sponsor Information. Banks like to see confirmation of the sponsor's information, including a certified copy of the sponsor's rent roll, even if it does no more than repeat what is stated in the offering plan. Break out the number of rent controlled and rent stabilized units, and mention any other information that might prove how responsible and financially sound the sponsor is -- for example, the sponsor's personal reserves or his last two months' bank statements. In addition to the concrete information that this documentation provides, it also attests to a cooperative relationship between the sponsor and the building.

8. Comparable Sales. Banks like to see what prices apartments have been selling for. This sales information is readily available from your managing agent. A review of recent sales gives you the opportunity to document any special situations. If negatives like foreclosures have been dragging down your comparable sales figures, mention this in your package.

"Put an asterisk next to individual sales and footnote them as bank foreclosures," says Mr. Davidowitz. "Don't think you can hide these. Explain that the problems are in the past, and show that the building is healthy going forward."

9. Floor Plan. Banks analyze your building on a room, apartment and square-foot basis, so they are pleased to have a floor plan showing the size of the apartments. "It could be beneficial if you can show your building has one-bedrooms that are 1,200 square feet where other buildings have two-bedrooms that are 800 square feet," says Mr. Davidowitz.

10. Building Highlights. "If there's something unique and special about your building, its worth addressing," he says. "If your property is a landmark or in a landmarked district, mention this in the packet." He tells of one landmarked West Side building that included architect's sketches highlighting details and elegant floor plans. "It was a hit with the lender," he says. However, if the unique aspect of your building is less than positive, such as the lack of an elevator, Mr. Davidowitz advises against highlighting it.

Even the best due diligence packages can't work miracles. "There are a few progressive lenders who are willing to overlook certain problems," says Mr. Fay, "but ultimately they all tend to bend to what the secondary market has to say." Yet the basic theory holds true for any building. "To improve your building's bankability, pave the way for the lender as much as you can," concludes Mr. Davidowitz. "When it's easier for them, it's easier for you."

CREATING RULES THAT WORK

Not all cooperative and condominium rules are created equal. Some are clear, even-handed and readily accepted by shareholders and unit owners. Others stir up animosity, and can provoke expensive lawsuits brought by unhappy residents. A board's goal, says attorney Bruce Cholst, a partner in the Manhattan-based law firm of Rosen & Livingston, should be to put together rules that keep the building running smoothly and also keep the peace.

"When it is within the board's power to make rules, the board needs to use that power intelligently," says Mr. Cholst. "People get ticked off when they think that the board is being arbitrary or capricious in passing rules. It's up to the board to help avoid this."

There are two levels of rulemaking in a co-op or condo: amending the governing documents and passing house rules. The former, which constitutes making a change to the proprietary lease or bylaws of a cooperative or the bylaws of a condominium, is more difficult since it typically requires a two-thirds majority vote of the owners. An amendment can generally be proposed by the board or by a group of owners holding at least 25% of the common interest or allocated shares. Voting would take place at a meeting of shareholders or unit owners. However, under many co-op proprietary leases, you don't need a meeting to amend the document. If the amendment provision allows, you can pass the proposal by collecting proxies representing the requisite number of votes. Proxies are valid for 11 months after their issuance.

Amending governing documents can be more difficult in buildings with a large sponsor presence, says Mr. Cholst. Many sponsors have provided in their offering plans that the board "cannot amend the governing documents in a way that diminishes any of the sponsor's interests without the sponsor's written consent," he says. "That really is a restriction on your ability to amend."

According to Mr. Cholst, the governing documents "tell you in general terms what a board can do and how far it can go in making rules with respect to any given facet of community life. They don't contain any specific directives for shareholders or unit owners to follow." For example, the governing documents might say that the board can attach conditions to subtenant approval. A co-op board might then put through a house rule specifically limiting sublets to two out of every five years of ownership.

PASSING HOUSE RULES
By comparison, house rules are almost completely within the board's domain. According to Mr. Cholst, house rules are "edicts that regulate the use of dwelling units and common areas of the development. In a co-op, they also regulate the sales and sublet policies. These are policies and guidelines that can be passed by board resolution alone, without shareholder or unit owner approval."

House rules cover such specific areas as how long sublets can last, how much the co-op or condo will charge as a late payment fee, move-in/move-out restrictions and deposits, and even specific restrictions on pets and noise.

House rules apply to shareholders and unit owners, or to subtenants and tenants of sponsor-owned apartments. In the case of sublets and rentals, the legal recourse for violation would be against the owner or the sponsor. "In 9 out of 10 cases, the misconduct will stop once you lean on the sponsor to speak to his tenant," says Mr. Cholst.

Yet passing a house rule is more complicated than just voting upon a resolution at a board meeting. After a board votes to adopt a house rule, it must notify the shareholders or unit owners before putting the rule into effect. "House rules are not binding on residents until you've disseminated them," says Mr. Cholst. "No court will hold someone liable for violating a house rule unless he's been notified in advance."

There are specific steps the board must generally take in notifying residents. "Virtually every set of governing documents has requirements for serving formal notice to residents," says Mr. Cholst. "This is most often by certified mail. My strong suggestion is that when you pass new house rules you do it in accordance with the notice provisions contained in your building's governing documents. This gives you a way of documenting that you've served notice of the house rule, and nobody can say you didn't abide by the legal requirement of serving a formal notice. There's a good chance that a judge would say a house rule isn't binding unless it is served properly."

Why go through the trouble of amending a governing document with a super-majority of shareholder/unit owner approval, when you can pass a house rule by mere board resolution? The answer is that not every form of regulation can be implemented by means of a house rule.

Boards often run into trouble when passing house rules because the new rule oversteps the boundaries set by the governing documents. "The house rules cannot go further in restricting residents' freedom than the governing documents permit," says Mr. Cholst. "A rule of thumb is that if the restriction exceeds the board's rulemaking power as defined in the governing documents, then the regulation can't be done by house rule. You need to amend governing documents.

For example, if the governing documents say that a co-op board can't impose a sublet fee greater than the actual costs incurred by the co-op in the transaction, the board has to keep its sublet fee beneath that limit. If it wants to impose a greater fee, it would need a shareholder vote to change the governing documents, says Mr. Cholst.

That was the outcome of the 1993 case, Bailey v. Grand Concourse Owners, Inc., in which the Appellate Court found the co-op could not impose a sublet fee of 30% of the annual maintenance charge because, says Mr. Cholst, its "authority to regulate subletting was limited by the requirement in its bylaws that any fee bear a 'reasonable' relationship to 'actual' expenses in the transaction." Those expenses, said the court, might include attorney's fees and a service fee.

Whenever the board attempts to redefine the shareholders' responsibility to the co-op or condo - such as by requiring them to pay a flip tax (many condos are enacting a form of "flip tax" called "capital contribution fees") - it requires an amendment of the governing documents. "You can't afford to be confused on this matter," says Mr. Cholst. "Courts will strike down improper house rules and the building will have to refund any money it has collected." In the case of a flip tax, the amendment must include the amount of the fee; such fees cannot be set with a house rule.

House rules can also be overruled if they conflict with any local, state or federal laws. "A practical application is the Americans with Disabilities Act (ADA), which says 'reasonable' accommodation has to be made available to the disabled," says Mr. Cholst. "A strict no-pet policy that prevents a tenant from keeping a seeing-eye dog would give way to this statute."

Another danger area is when a house rule results in a breach of the board's fiduciary duty to act fairly on behalf of all shareholders. This can be through the rule itself, or in the way the rule is enforced, and in such instances, courts will overturn the house rule. According to Mr. Cholst, there are three ways boards can breach their fiduciary duty with a rule:

1. Self-dealing. When a board member benefits personally or financially from a board activity, it is called "self-dealing". "If you put yourselves on top of the waiting list for parking spaces in the building's garage, you're breaching your fiduciary responsibilities," says Mr. Cholst.

2. Personal vendetta. If board members use a rule to harm someone they don't like, it's a breach. Example: If someone is denied a repair that would normally have been done for others.

3. Selective enforcement. "Any time you give favorable treatment to one resident, you are breaching your fiduciary responsibility," says Mr. Cholst.

Business Judgment Rule Protects Good Rules

The Business Judgment Rule, applied by the courts since 1990 after the decision in Levandusky v. 1 Fifth Avenue, states that the courts will not interfere with the judgment of the board in carrying out the business of operating the cooperative or condominium. Basically, this shields certain board decisions against judicial intervention. In the case of house rules, the board's judgment is protected if the rule is: (a) authorized by the association's governing documents; (b) doesn't violate any local, state or federal laws; (c) is conceived in good faith for a valid corporate purpose; and (d) is applied in a manner that is consistent with the board's fiduciary duties. According to Mr. Cholst, the Business Judgment Rule is "not a rationale for regulation; rather it is a shield with which to fend off unwanted judicial interference with regulation provided that the applicable guidelines are met."

Indeed, the board's ultimate goal when making and enforcing house rules is to run an orderly building where people get along well and therefore stay out of court. According to Mr. Cholst, the best way to start is with effective communication. "If people understand what you're doing and why you're doing it, they will be less likely to challenge it," he says. "You can do this through letters and door-to-door campaigns, newsletters and informal chats. If it is a controversial topic, explain to residents how your solution addresses the problem. Explain it both in quality of life terms and economic terms - which is how most residents will view it."

Boards can also work to keep potentially contentious people out of the building. "When you're doing pre-admissions screening, don't just look at the financials, but see if the person has been a problem tenant elsewhere," says Mr. Cholst. "If he has, he's likely to break your rules, too." He notes that condominium boards can use their right of first refusal to deny such buyers.

The board can also avoid problems and protect itself in the event of legal challenges by carefully documenting all rule changes. Before passing a new rule, detail in the meeting minutes what you want to accomplish and how a new rule will bring it about. Then write a letter to shareholders explaining why you're making the change. And finally, scrupulously enforce the policy evenhandedly, documenting all cases in the minutes.

Perhaps the best way to steer clear of problems is to create rules that don't unnecessarily step on residents' toes. According to Mr. Cholst, the worst rules cover too much ground. For example, if there is a problem with a resident practicing her piano 11 hours a day, a bad solution would be to pass a rule ending all music-playing at a certain time. A better answer would be a rule that limits instrument practice sessions to, say, two hours.

"The board should of course listen to all complaints, but it should then contemplate the nature of the complaint and create a house rule that addresses a particular issue in the narrowest way possible," says Mr. Cholst. "Don't draft house rules that go broader than the problem at hand, because you will get complaints that you are being too restrictive. If you apply a degree of common sense to making your house rules, you're most likely to stay away from trouble."