Sponsor Defaults: Helping Boards to Help Themselves

Fortunately, in New York City, cooperative housing corporations and condominium associations rarely face this type of financial peril. In fact, during the last 50 years, less than half a dozen co-ops and condos have actually failed. The situation today is very different primarily because there are a large number of market-rent apartments and the rents under the rent stabilization laws are much higher than previously.

In dealing with a sponsor default, there are two primary ways of handling a co-op or condo: bringing in a so-called "white knight" to rescue the property, or utilizing self-help techniques. When my clients faced sponsor defaults, I advised them to use the latter option. Although it was usually complicated, it protected the co-op or condo's long-term viability.

The White Knight

Like knights, these investors rescue people in distress, but the analogy ends there. They take ownership of the unsold apartments and pay the maintenance or common charges. Then they do anything required to get the rent-controlled or rent-stabilized tenants to leave the building, so they can fix up the apartments and then sell them for the maximum price. In the meantime, the knight/investor will try to control the actions the board may want to take to reduce costs or gentrify the building to make it more attractive to buyers. The knight/investor is typically more concerned about having the co-op or condo spend money on the lobby and the hallways than on making certain that the heating system works efficiently. The goal, always, is to make as much money as possible for the investor. I have nothing against making money, but the alternative makes money for the co-op or condo rather than an outsider.

Self-Help

The self-help method involves the following steps:

•  The board obtains the unsold apartments from the sponsor by exercising its legal rights.

•  The board negotiates with the building's lender to split the debt on the building, placing a portion of the debt on the unsold apartments. That accrues until the apartments can be sold and then it is repaid with interest.

•  The debt service paid by the corporation is reduced because the principal has been reduced, which brings down the building's operating costs.

•  If necessary, the board increases the indebtedness in order to pay unpaid real estate taxes. The interest on that accrues at 18 percent per annum. This has a higher priority than the mortgage, so it is to the lender's best interest to keep payments current.

The philosophy behind the self-help alternative is that, as the economy improves or the co-op or condo's other problems are dealt with, the value of the unsold apartments increases. The appreciation is then used to pay the lender everything owed, plus interest. The balance goes into the co-op or condo's reserve funds. This money can then be used to pay the cost of long-term capital improvements, pay down the mortgage, or otherwise provide additional financial security to the shareholders and unit-owners. This turns a liability into an asset while enabling the shareholders and unit-owners to maintain control over their homes, which is usually their largest single asset. It is not as simple as turning the building over to a knight/investor. It requires a great deal of time and focus, but it preserves the element that attracts people to this kind of housing: control over their environment.

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