Scott E. Mollen

Condominium Conversions—Adequacy of Reserve Fund—NYC Administrative Code Definition of “Capital Replacement”

This decision involved the adequacy of a reserve fund which had been established by the defendant sponsor of a condominium conversion (sponsor). The sponsor had moved for a partial summary judgment determining that it had “properly calculated the reserve fund for the condominium” and for an order dismissing the plaintiff's claim that the reserve fund was underfunded. The plaintiff board of managers (board) had moved for summary judgment declaring that the sponsor had failed to adequately fund the reserve fund and declaring that “certain credits taken by the defendant be disallowed.”

New York City Admin. Code (Code) Section 26-703 provides that “when a rental building is converted to a condominium the Sponsor is to adequately create a minimum reserve for the condominium.” The reserve fund is to be three percent of the total price “offered to tenants up to the effective date of the condominium offering plan (plan).”

The plan had been accepted for filing by the Attorney General on Aug. 10, 2016. The sponsor funded the reserve fund with $2,495,166. Sponsors are permitted to “decrease the total amount in the reserve fund by taking a set number of credits for capital replacements begun after the plan was submitted for filing.” The plaintiff alleged that the sponsor had, inter alia, taken “credits for work which does not qualify as a capital replacement,” and had failed to “perform work yet taking money from the reserve nonetheless.”

Code §26-703 requires that “[w]ithin thirty days after the closing of a conversion pursuant to an offering plan the offeror shall establish and transfer to the cooperative corporation or condominium board of managers, a reserve fund to be used exclusively for making capital repairs, replacements, and improvements necessary for the health and safety of the residents of such buildings.” An offeror may “fund the reserve using one of two methods; either 'three per cent of the total price or, three per cent of the actual sales price of all cooperative shares or condominium units sold by the offeror at the time the plan is declared effective, provided, however, that if such an amount is less than one per cent of the total price, then the fund shall be established as minimum of one per cent of the total price.”

The sponsor had funded the reserve “by depositing three percent of the total price into the reserve fund.” “Under the plain language of the governing statutes, the 'total price' referred to §26-703(b)(i) is not the price in effect during the exclusive discount period, i.e., the so-called 'insider price' but rather the 'last price offered to tenants in occupancy prior to the effective date of the plan.'”

The plaintiff argued that the inadequacy of the reserve fund was demonstrated by an affidavit from tenant “A” and an “offering sheet” provided to tenant “B.” However, “B's” offering sheet was undated and it could not be determined whether that offer had been made prior to the effective date of the plan. Moreover, “A's” affidavit stated that in August 2006 she received a plan but then had waited for months while some “tenants attempted to negotiate a lower price.” Those “negotiations ended approximately six months later and only then did [“A”] decide to purchase the apartment.”

The court noted that the sponsor was required to provide a reserve fund of three percent of the “last price… offered to tenants in occupancy prior to the effective date of the plan regardless of number of sales made.” The plan had been declared effective on Feb. 21, 2007. At least two tenants did not purchase their units until after they no longer qualified for the insider price. The court found that there remained “questions as to whether the tenants were offered to purchase their units at the higher price prior to the effective date of the (plan).” Accordingly, the court denied summary judgment on the issue of “the last price offered to tenants in occupancy before the effective date of the [plan].”

The court then addressed whether certain work qualified as a “capital replacement” under Code Section 26-702(c). That statute defined capital replacements as: “A building-wide replacement of a major component of any of the following systems: (1) elevator; (2) heating, ventilation and air conditioning; (3) plumbing; (4) wiring; (5) window; or, a major structural replacement to the building; provided however, that replacements made to cure code violations of record shall not be included.”

Since there did not appear to be judicial precedent which interpreted how capital replacements are defined, the court relied on the “text of the statute” in determining whether the alleged capital replacements were eligible for a credit.

The plaintiff claimed that modifications to the elevator system were not capital replacements since they were made to cure existing violations. The sponsor countered that the elevator renovations were a “complete modernization of the system” and did not constitute a replacement that was “merely to cure a code violation of record.” The court found that this issue presented a triable issue of fact. Since the elevator modernization contract failed to “itemize what services were performed,” the court could not determine if the work went beyond efforts to cure the existing violations. Thus, the court denied summary judgment with respect to the elevator work.

The plaintiff also argued that the HVAC (heating, ventilation and air conditioning) work should be reduced since the total cost of that work exceeded the estimate contemplated in the plan. The sponsor argued that the work was contemplated by the plan and “regardless of the actual price,” it was entitled to a credit. The court found that based on the language of the Code, the sponsor was entitled to recover the actual cost for the replacement of the HVAC system.

The plaintiff further argued that since the sponsor could not show that the HVAC work was actually paid for, the sponsor is not entitled to a credit. However, the statute permits “recovery for the actual cost of replacements,” and the actual costs of the replacements were conceded by the plaintiff and invoices showed the costs of the work by third party contractors. Accordingly, court granted summary judgment for the sponsor on the HVAC expense issue.

The plaintiff also asserted that the sponsor's “addition of a single layer of roofing membrane” did not qualify for a capital replacement credit since the roof was already water-tight and it was “merely tested” not “replaced.” The plan disclosed that the building had been re-roofed on or about 1999, the roof was in “fair condition” and could be expected to last another two to four years and there were no active roof leaks.

The sponsor argued that it spent significant capital to test the roof and place a new layer of roofing membrane over it. Since there was no need to replace the existing roof, the roof was not replaced and there were merely repairs to “test cuts” made when conducting inspections, the court held that the addition of the roofing membrane did not qualify for a capital replacement credit.

Additionally, the plaintiff argued that the sponsor had improperly included terrace work as a “major structural replacement to the building.” The terrace work involved “removal of spalled cement, securing any loose materials, and patching and recoating the terraces.” Since the sponsor failed to address this issue in its brief, the court held that the terrace work failed to qualify as a capital replacement.

The plaintiff further asserted that sponsor is not entitled to credits for the replacement of 156 doors and 30 windows. The plaintiff argued that “windows, not doors, are eligible for reimbursement given that windows are expressly enumerated in the statute.” Doors are not enumerated in the statute.

The sponsor countered that sliding glass doors “should be treated as windows given that the statute describes the broader concept of a window 'system' and that sliding glass doors provide the same access to light and air as a window and, for many in the apartment complex, are the only access point to light and air.” The sponsor had replaced more than five times as many doors as they had replaced windows. The court looked to dictionary definitions of “windows” and “doors” and stated that “with two different purposes, and two different definitions, a door does not qualify as a window.”

However, the statute permits credits for “major structural replacements to the building.” The court cited canons of statutory interpretation which required that the court look to “the full enumerated list of replacements under the statute to determine whether the Legislature intended the replacement of 156 sliding glass doors to be considered as constituting a major structural replacement such that the defendant would be entitled to take a credit under the statute.”

Pursuant to such canons, the court held that the 156 terrace doors constitutes a major structural replacement under the statute. The court noted the sponsor's argument that “windows and terrace doors serve the similar purpose of providing access to light and fresh air which, while expressly not mentioned in the statute, are enjoyed by the tenants” and that here, there are more “doorways in the building than windows.”

The court opined that the Legislature, “in drafting this statute, determined that there could be other major replacement costs associated with the transformation of rental units to a co-op or condominium and thus provided for credits to be granted to the sponsor for 'major structural replacements.'” Thus, the court held that replacement of 156 “sliding glass doors falls within the type of replacement contemplated by the statute” and granted summary judgment to the sponsor with respect to the issue of windows and doorways.

Comment: Adam Leitman Bailey, counsel for the board, explained that this was an important decision which addressed several new legal issues. Kenneth M. Block, of Tannenbaum Helpern Syracuse & Hirschtritt, counsel for the sponsor, stated that notices of appeal by plaintiff and cross appeal by defendant were filed.

I believe that the past significant increase in residential rents, (notwithstanding some recent softening in the market), coupled with proposed changes in rent stabilization and rent control laws and regulations with respect to eliminating vacancy decontrol increases, making preferential rent the base rent for future increases, limiting Major Capital Improvement and Individual Apartment Improvement increases, providing greater eviction protections, lowering rent increases on rent-controlled apartments, strengthening anti-harassment protections (some of which may be overly broad and adversely impact responsible owners), may lead some owners to consider converting their buildings from rentals to condominiums or selling their buildings to condominium converters. If that occurs, we may see increase in conversion related litigation, including disputes over the adequacy of a reserve fund.

Board of Managers of 184 Thompson Street Condominium v. 184 Thompson Street Owner, Sup. Court, New York Co., Index No. 103991/2011, decided Sept. 5, 2018, Bransten, J.

Landlord Tenant—Court Reverses DHCR's Decision Granting Owner MCI Increases—HCR Failed To Provide Justification For Reversing a Rent Administrator's Decision After It Said The Administrator Was Correct—The Agency Decision “Makes No Sense”

Tenant commenced an Article 78 proceeding seeking to reverse a determination by the NYS Div. of Housing and Community Renewal (DHCR). The court granted the petition.

The petitioner was a resident in a building owned by respondent “A.” In March 2009, “A” applied for a Major Capital Improvement (MCI) increase in the maximum legal regulated rent. “A” predicated its application on an elevator upgrade project. Tenants in the building opposed the application and identified two Class “C” violations issued by the NYC Dept. of Housing Preservation and Development (HPD). On Oct. 21, 2011, two and a half years after “A” filed its application, a DHCR Rent Administrator (RA) denied “A's” application and found that “A” had “failed to respond and submit information/evidence required for the processing of this application.” “A” was also requested to cure the “C” lead based paint violation. That violation had continued to exist on the HPD database. Thus, the RA denied the MCI application.

On Aug. 30, 2017, approx. six years after the RA's decision, DHCR granted “A's” petition for administrative review (PAR) and permitted rent increases as of Feb. 1, 2013—“the first rent payment date in which [“A”] could show the lead paint violation was removed.” February 2013 was a year and a half after the RA's decision. DHCR explained that “A” had “attached a copy of an HPD printout showing that all outstanding violations had been removed from the HPD database as of Jan. 2, 2013.” The DHCR Commissioner found that “A's” appeal should be granted, subject to certain conditions.

The commissioner's decision noted, inter alia, “the fact that the owner may have been in the process of clearing the lead paint violations did not satisfy the requirement that such violations had to be removed from the HPD database in order for an MCI to be granted.” The commissioner's decision observed that prior to issuing the denial of the MCI application, the RA “provided the owner with ample opportunity, amounting to two full years time to clear the C violations from the HPD database, yet the owner failed to do so.”

The petitioner argued that DHCR's order was arbitrary since it did not cite any error in the RA's October 2011 decision or “any justification” for permitting the MCI increase predicated on “clearing violations years after the initial MCI application and after the RA's decision.”

DHCR countered that “A” had advised DHCR in September 2011 that it was having “trouble gaining access to the apartments to clear the lead paint violations.” DHCR asserted that the RA's decision was “erroneous” and noted that “A” had requested an extension of time to clear the lead paint violations in September 2011, and “the request that went unanswered.” DHCR argued that it was therefore “rational to permit an MCI increase effective from the date violations were removed HBD's database.”

DHCR also noted that the “version of RSC §2522.4(a)(13) in effect at the time of [“A's”] application prohibited DHCR from granting an owner's application for a rental adjustment if there were immediately hazardous (Class C) violations but also allowed DHCR to issue a conditional approval (the RA in this case did not issue a conditional approval).” DHCR discussed that such code provision was amended in 2014 to “require that violations need to be cleared as of the date of an owner's application and to permit an owner to refile an application (that is, no conditional approvals).”

“A” argued that the RA's order was improper since it did not permit “A” the opportunity to refile within 60 days and that error compelled “A” to file a PAR “demonstrating that it had cleared the lead paint violations.”

The court found that DHCR's decision reversing the RA's initial denial was arbitrary and capricious since it “provided no basis for considering [“A's”] actions to clear the violations, which were completed after the RA issued its decision.” Moreover, the court opined that DHCR's decision embodied “many reasons for why the RA's decision was correct.” The court cited DHCR's finding that “A” had “ample opportunity” to clear the violations while the MCI application was pending before the RA and “A” did nothing. DHCR's decision also noted that “A” “had notice that its MCI application would not be granted if there were Class C violations.”

Although DHCR granted an MCI increase because the outstanding “C” violations were cleared, DHCR's decision failed to mention “DHCR's own argument that [“A”] did nothing for two years or that [“A”] had notice of DHCR's 'long-standing policy' not to grant MCI increases where Class “C” violations exist.” DHCR's decision was silent as to “A's” “purported struggle to gain access to certain apartments” or why the RA “failed to consider [“A's”] request for an extension to clear the violations.”

Thus, DHCR found that the RA was correct in denying the increase, but granted the PAR because violations were cleared as of January 2, 2013, almost four years after the initial MCI increase and approx. a year and a half after the RA's decision. DHCR offered “[n]o authority or reason” to “justify considering information that was not before the RA.”

Moreover, this case did not involve “newly-submitted evidence” that showed that “the violations were issued in error or the evidence was only discovered after the RA issued a decision.” The court reasoned that although the violations were eventually cured, the court “cannot simply ignore the lack of analysis provided by DHCR.” The court noted that “A's” claim that the RA should have granted a leave to refile the MCI application after the violations were cleared was “beyond the scope of this proceeding because DHCR did not address that point.”

Furthermore, DHCR could have remanded the proceeding to the RA on the grounds that the violations were purportedly cleared, and/or on the grounds that the RA failed to address “A's” alleged “struggle” to get access to certain apartments and that “A” failed to respond to the RA's requests for information. In sum, the court found that DHCR had not made any findings that could justify “A's” “delay in remedying violations or to reverse the RA's decision.”

The court concluded that DHCR had failed to make findings that could justify “A's” delay in remedying violations or the reversal the RA's decision. Although DHCR “excoriated” “A” for “not moving fast enough to remedy the violations” and acknowledged that “A” had notice of DHCR's policies, DHCR granted the increase.

The court further opined that DHCR's conclusion was “simply not supported by its own analysis.” The immediately hazardous violations were not cleared until “well after the RA issued its decision.” DHCR has given several reasons why the RA was correct, but then reversed the RA's decision based on evidence that was not before the RA, without providing any justification for why DHCR considered evidence “that did not even exist when the RA made the decision.” DHCR's decision was simply “not rational.”

The court noted that the ultimate outcome of granting the MCI increase would have been rational if DHCR had remanded the matter back to the RA on the grounds that “A” did not know that it had to respond to RA's requests or based on the need for the RA to consider additional evidence. Here, DHCR's decision is “not supported by any binding authority or its even own analysis.” The court stated that although “A” may have encountered difficulty in acquiring access to certain apartments, such difficulty did not explain why it took “nearly four years to clear the violations from the time it initially filed the application in 2009.”

Finally, the court stated that DHCR's decision “effectively nullified the rule that MCI applications must be filed within two years of installation.” The court reasoned that DHCR's decision, based on events that did not exist when the RA's decision was rendered, empowers the owner with the right to file an MCI increase and then “clear immediately hazardous violations on its own schedule.” The court stated that such result “makes no sense.”

Matter of Partman v. N.Y.S. Div. of Hous. & Comm. Renewal, Sup. Court, New York Co., Index No. 158766/2017, decided Sept. 14, 2018, Bluth, J.

Scott E. Mollen is a partner at Herrick, Feinstein.

This article has been updated to include comment by Adam Leitman Bailey.