Maintenance reductions jeopardize lenders' interest in cooperatives.

In recent years, with the tight economy, sponsor defaults and reduced market value for cooperative apartments, cooperative housing corporations have experienced difficulties in keeping their mortgages current. As a result, a large number of foreclosure actions have been commenced against cooperative corporations. This in turn has resulted in imaginative defensive tactics created by boards of directors of these troubled cooperatives.

One such case is East New York Savings Bank v. 520 W. 50th Street Inc., (Supreme Court New York County, 608 N. Y. S. 2d 974). The East New York Savings Bank was the holder of a mortgage for $1.5 million covering the property of the cooperative at 520 West 50th Street in New York City. Although the cooperative corporation, in a prior lawsuit, was successful in invalidating a larger wrap-around mortgage held by the sponsor, it was still in difficulty in meeting the debt service requirements of the underlying first mortgage held by the East New York Savings Bank, which was still valid.

After the default by the cooperative due to failure to pay principal and interest on the mortgage, the East New York Savings Bank commenced foreclosure proceedings and had a receiver appointed by the court. While the duty of the receiver was to collect rent (maintenance charges) from the tenant/shareholders of the cooperative and to pay the operating expenses of the building, the receiver did not have authority to use those maintenance charges for the payment of principal and interest on the mortgage to bank.

As a result, the board of directors of the cooperative adopted a resolution which stated that inasmuch as the East New York Savings Bank may not receive debt service payments on its mortgage without a court order, the debt service amounts were not actually bona fide expenses of the cooperative corporation. Therefore, the board resolved to eliminate the debt service from the budget of required expenses and reduced the maintenance charges by $3 per month per share, which it calculated by dividing the monthly debt service requirements by the number of shares of the cooperative.

The action of the board in reducing the maintenance charges prompted the East New York Savings Bank to make a motion before Justice Lewis R. Friedman for an injunction to invalidate the board's decision.

The bank contended that paragraph 14 of the mortgage provides that the cooperative may not modify any proprietary lease so as to shorten the term of the lease, decrease the rent or make any other modification in the terms thereof. Further, the bank contended that Real Property Law [section]291-F specifically states that such provision as contained in paragraph 14 of the mortgage is effective on all tenants. The bank argued that a reduction in the maintenance charges represents a modification of the leases, which the provisions of the mortgage and the statute specifically prohibit.

Justice Friedman realized that the issue before him was important beyond this case, since the mortgage paragraph relied upon by the bank is part of the basic "boiler plate" provisions of nearly every mortgage on real property in New York State, including cooperatives. He therefore closely analyzed the position taken by the cooperative in defense of its board's actions.

The cooperative argued that the acts of its board of directors were protected from judicial review under the "business judgment" rule set down by the seminal Court of Appeals case of Levandusky v. One Fifth Avenue Apartment Corp. (75 N. Y.S. 2d 530, 554 N. Y.S. 2d 807), which held that if a board of directors of a cooperative makes a decision in good faith within the scope of its authority, the court may not substitute its judgment for that of the board of directors.

Justice Friedman ruled that the bank's challenge of the board's decision cannot be defended under the business judgement rule because the bank is not bound by the board's decision or its business judgment. The Judge stated, however, that he has power to nullify the board's decision if he finds that the board's action constituted a breach of paragraph 14 of the mortgage instrument.

Justice Friedman then analyzed the language of the mortgage itself and interpreted it in a straight-forward manner. He decided that the injunction sought by the bank must be denied. The Judge ruled that provision 14 does not prohibit rent reduction; rather it only prohibits the owner (here the cooperative) from "modifying" the leases (proprietary leases) to reduce the rent. Here, as in every cooperative building, the amount of rent is not fixed on the face amount of the proprietary lease. Rather, the rent varies with the cash requirements set by the building's board of directors from time to time. The proprietary leases in this building are typical of nearly all of those used in housing cooperatives throughout the state. These leases provide that rent (sometimes called maintenance) is set each year to equal the tenant/shareholder's proportion of the cooperative's cash requirements for that year. The leases provide that cash requirements are to be set by the board of directors and are to be based upon operations, reserves and obligations, liabilities and expenses.

Since the cooperative was not required to pay interest or principal on the East New York Savings Bank mortgage from the time the receiver was appointed, its cash requirements were thus reduced, and the maintenance could properly be reduced accordingly.

The Court stated that when a mortgagee, particularly, a sophisticated one such as the East New York Savings Bank, lends money and enters into a mortgage on real property, the leases are part of the security against default. The mortgagee's business judgment as to whether to make the mortgage is based upon, among other things, its evaluation of the rent roll. All of the leased terms are carefully scrutinized as part of every lenders "due diligence" investigation, which means looking at foreseeable changes in the rent roll because of lease provisions, lease renewals, lease expirations, rent escalations and automatic rent increases and decreases.

Fluctuation in the amount of rent, up and down, are inherent in a cooperative lease. As a result, there are concomitant fluctuations in the value of the mortgagee's security. Changes in value of the security of a bank, whether in the rent roll or in the market value of the building, are recognized business risks inherent in lending money secured by mortgages on buildings owned by cooperative housing corporations, the court ruled.

The board's action in setting the cash requirement at a lower figure after default is not a modification of the proprietary lease. Rather, it is a risk that the bank undertook when it agreed to make the mortgage in the first place.

Justice Friedman stated that he must enforce the mortgage according to its clear terms. The Court realized the far-reaching significance of his decision and that it may make lenders more reluctant to issue mortgages to cooperatives, since the maintenance charges may be illusory collateral. He said that is, however, for the lending community to deal with, not the courts.

The Judge also recognized that while the tenant/shareholders will benefit by a windfall because of the reduced expenses, such rent reduction will be short-lived; until the sale of the property in foreclosure. The potential harm to the cooperative shareholders of losing their entire investment because of the mortgage foreclosure is surely a disincentive to needless rent reductions.

Edward L. Schiff is senior partner of the New York law firm of Schiff, Turek, Kirschenbaum, O'Connell, LLP.