The residential co-operative corporation is a strange breed of closely held business entity. In New York, the co-op is formed as a for-profit corporation under the Business Corporation Law (BCL), yet it doesn’t operate for profit in the traditional sense of returning cash dividends to shareholders. Instead, ownership of co-op shares entitles the shareholder to occupancy of an apartment under an appurtenant long-term proprietary lease. The co-op’s income derives mostly if not entirely from tenant-shareholder maintenance payments, the level of which is designed merely to cover the common charges for building expenses. The market value of the shares held by individual shareholders within the same co-op can vary greatly, not just due to the number of shares allocated to the particular apartment, but also due to the unique characteristics of the apartment.
One of the consequences of being a for-profit corporation is that co-ops in New York are subject to the same statutes governing voluntary and involuntary dissolution as any other closely held business corporation, including BCL Section 1104-a authorizing a petition for judicial dissolution by an “oppressed” minority shareholder holding at least 20% of the corporation’s shares. At least in New York City, where co-ops tend to have many apartments, the shares usually are too widely dispersed for any single tenant-shareholder to own 20%. In addition, and with all due respect to noise and odor complaints, the idea of a co-op dweller being oppressed by her neighbors is a far cry from the usual freeze-out/squeeze-out scenarios involving loss of employment, removal from the board, financial abuse by the majority, and lack of a market exit.
The fact is, however, that New York City also has many smaller co-op buildings such as converted townhouses and brownstones featuring four or five apartments, each of which may be allocated 20% or more of the co-op’s shares. And, New York City being a litigious kind of town when it comes to expensive real estate (think Trump), it’s inevitable that an alienated tenant-shareholder in such a co-op would opt to bring a dissolution proceeding instead of exiting by selling her apartment on the open market. A rational shareholder presumably would do so only if she believes she’ll get more value from a liquidation of the corporation’s assets than from selling her apartment, i.e., that the value of the entire building is greater than the sum of its parts.
That appears to be the theory behind the dissolution petition by a 20% co-op tenant-shareholder named K.C. McDaniel in McDaniel v. 162 Columbia Heights Housing Corp., 2009 NY Slip Op 29390 (Sup Ct Kings County Sept. 29, 2009), recently decided by Kings County Commercial Division Justice Carolyn E. Demarest. The case involves a multi-faceted dispute between McDaniel and her fellow apartment owners of a five-unit co-op (pictured above) located on a beautiful street in Brooklyn Heights near the promenade facing the lower Manhattan skyline. Readers of this blog may recall my April 2009 post reporting on a prior ruling in the McDaniel case involving interpretation of the co-op’s bylaws. The prior post noted that the non-petitioning shareholders had exercised their right under BCL Section 1118 to purchase McDaniel’s shares for “fair value” and thereby avoid adjudication of the oppression claim. In the latest decision, Justice Demarest is presented with radically different valuation approaches in which, on the one side, McDaniel asks for her pro rata share of the building’s value based on its “highest and best use” as a single family residence without regard to the legal impediments posed by the existing proprietary leases and, on the other side, the respondents ask that McDaniel be awarded the appraised value of her apartment.
[Note: If you read Justice Demarest’s lengthy decision you’ll see that most of it is taken up with a complex factual recitation and analysis relating to a companion lawsuit between the same parties in which McDaniel sued to recover almost $800,000 arising primarily from the defense and settlement of a prior litigation with a former tenant-shareholder. I’m not going to address this aspect of the case, other than to speculate that the existence of significant money claims may help to explain as a tactical matter McDaniel’s decision to sue for dissolution rather than sell her apartment on the open market.]
In her prior ruling on the bylaws, Justice Demarest preordained that the fair value of McDaniel’s interest will “largely depend on the appraisal value of the building at the valuation date, but will also include any other assets, such as bank accounts, less any liabilities such as debts of the Corporation.” In her latest decision, she elaborated that “there is no profit in the operation of the Corporation, the only purpose of which is to provide housing for the five tenant shareholders” each of whom was allocated the same number of shares; that the only “return” on their investment is use of their apartment and the possibility of profit upon sale; that the share valuation “is logically the net asset value of the Corporation as a whole on the valuation date”; and that “[m]arket value is clearly implicated in this analysis as the value of the Corporation’s primary asset, the Building,will depend upon appraisal of its value on the valuation date.”
At the valuation hearing, each side presented expert testimony by a licensed real estate appraiser, neither of whom stayed within the confines of the court’s valuation guidelines. McDaniel’s expert concluded that the building was worth $5.6 million based on comparable building sales assuming a “gut renovation” of the building to achieve its “highest and best use” as a single family residence, i.e., unencumbered by the existing proprietary leases. The expert also commented that “the sum of the parts is worth less than the whole.” Here’s what Justice Demarest wrote in rejecting this approach as a measure of fair value:
Petitioner owns a twenty percent interest in a building which is subdivided into five dwelling units. The Corporation is encumbered in its use of the Building by proprietary leases granting occupancy well into the future. It is not reasonable or fair to suggest that the respondent shareholders should be forced to vacate their homes in order to sell the Building vacant so as to afford petitioner the maximum possible return on her investment. Given the nature of the Corporation as a residential co-operative, measuring the “fair value” of a single occupant’s interest based upon the highest and best use of the entire structure is not appropriate. A more flexible standard is needed. . . . To mandate that an asset be sold in order to maximize value, so as to put the Corporation out of business, would be contrary to law.
The respondents’ expert fared no better. Rather than valuing the building, he appraised McDaniel’s apartment alone as of the valuation date, using comparable apartment sales to arrive at a value of $734,000 net of broker’s commission and transfer taxes, which he further discounted to $550,000 for the “detrimental effect on marketability of the pending litigation.” This methodology, however, ignored Justice Demarest’s explicit direction to value the shares based on the market value of the building as a whole. In her own words:
This Court rejects respondents’ attempt to establish the fair value of petitioner’s shares based upon the market value of her apartment alone, as such measure fails to account for other assets and liabilities of the Corporation. Petitioner is the owner of 400 shares of the Corporation, the fair value of which must be ascertained upon the value of the Corporation as a whole on the valuation date.
Justice Demarest also rejected respondents’ reliance on an appellate court precedent, Matter of Balk (125 West 92nd Street Corp.), 24 AD3d 194 (1st Dept 2006) (read here), which affirmed a trial court’s valuation of a 30.75% stock interest in a four-apartment Manhattan co-op corporation (read here). In Balk, both sides submitted appraisals of the market value of the petitioner’s apartment. “While most instructive,” Justice Demarest remarked, ” the case did not implicate competing standards of valuation.”
The circumstances thus required Justice Demarest to arrive at her own valuation of McDaniel’s shares, which she did by valuing the building as a whole at $4,250,000 based on the $850,000 sale one year earlier of another of the subject co-op’s five apartments which also was allocated one-fifth of the corporation’s shares. As a reality check, Justice Demarest relied on a comparable $8 million sale (which translated to $741 per square foot) of a nearby but larger apartment building “similarly burdened with tenancies that are not easily terminable.” The $741 per square foot price translated to a value of $4,342,260 for the subject co-op’s building. (I interpret the court’s reference to “similarly burdened with tenancies” as meaning the comparable building was not a co-op but was occupied by rent stabilized or rent controlled tenancies. I’ve never heard of an occupied co-op building being sold.)
The court’s final tally of the amount due McDaniel for her shares came to $839,760.68, computed as one-fifth of the corporation’s value of $4,257,755 ($4,250,000 for the building plus cash deposits less liabilities) less deductions for unpaid maintenance charges of about $11,000. Justice Demarest refused to apply a discount for the pending litigation, as requested by respondents, although she did say that any effect the litigation had on value was offset by the general rise in market values between the 2006 sale of the other apartment for $850,000 and the valuation date in May 2007. Justice Demarest also rejected McDaniel’s argument for a surcharge against the respondents for failing to make building repairs.
In case you’re wondering about the mechanics of the buyout, the decision notes that McDaniel previously vacated the apartment which therefore was available to be immediately marketed for sale. Justice Demarest directed the parties to submit proposed terms of sale and ordered that, “barring a different agreement between the parties, it is expected that the Corporation will either obtain a mortgage on the Building in order to pay the full value of petitioner’s shares or will attempt to sell the apartment in order to fund payment to petitioner.” The court’s order also mandates that the apartment’s $1,000 per month maintenance charges pending the completion of the buyout be deducted from the amount due McDaniel, so, depending how long the process takes and what problems with a financing or sale are encountered, it wouldn’t surprise me if these litigious former neighbors aren’t done fighting.