Scott E. Mollen

Partnership Dispute Among Owners of Low-Income Housing Development—Alleged Breach of Fiduciary Duty—General Partner Accused of Charging Too Little Rent, i.e., Below Market Rates and Fair Market Rents Set By HUD and Refusing To Sell the Development—Investor's Request for Injunction Denied—Failure To Show Irreparable Harm—Substantial Likelihood of Success on the Merits or a Balancing of the Equities in Their Favor

This litigation involved a dispute “over the direction and control of a limited partnership that was formed to own and operate a real estate investment.” The general and managing partner (GP), had commenced a lawsuit to block an attempt by the limited partners (LPs), to oust the GP from control of the partnership, based on alleged breaches of fiduciary duties. The LPs had moved for a preliminary injunction. The court denied the injunction.

A group of churches had formed the GP entity to create a low-income housing development (development). HUD held a $4.7 million on the development. The GP was required to operate the development in accordance with HUD regulatory agreements. The GP “always intended (the development) to serve low-and moderate-income tenants even without regard to HUD's requirement that it do so.”

In 1979, the GP had conveyed the development to a limited partnership. The purchase price of $5.5 million was secured by a “wraparound mortgage.” The GP held the wraparound mortgage given by the partnership to secure the purchase of the development and was also the co-general partner and sole managing partner of the partnership. The partnership agreement provided that it would dissolve automatically in 2020 and that the development would be “operated as an affordable housing project for low-income residents.”

Since at least 2000, the partnership had “regular audits of its financial statements, which it shared with (LPs).” Since at least January 2015, the GP sent to the LPs, monthly reports “concerning the rent being charged for every unit.” In 2004, the GP became the “sole general partner and managing partner, in addition to holding the wraparound note and mortgage.”

Over the years, the GP operated the development “as it always had been operated, as an apartment complex catering to low-and moderate-income tenants.” The GP had “always set rents at levels that were significantly below the FMR (fair market rent) levels permitted by HUD, purportedly to accommodate the financial means of the tenants.” The GP acknowledged that it could have “charged higher rents” and still complied with HUD's requirements.

Between 1979 and 2012, the partnership made payments on the HUD loan, not towards the wraparound note. However, the LPs were aware of that fact based on the partnership's financial statements. Additionally, the GP did not raise the rents “appreciably after the HUD loan was paid,” even though HUD's FMR restrictions were no longer applicable. The GP asserted that the development was never intended to be a “market-rate apartment complex, regardless of whether or not HUD imposed such restrictions.”

Since 2012, the development made money and the GP accrued such monies in the partnership's bank accounts rather than paying the wraparound mortgage. The GP asserted that the accrued interest paid on the wraparound mortgage had been kept in “what amounts to a 'sinking fund' in order to partially satisfy the Debt Obligation” to the churches when the partnership ends in 2020.

In 2014, the LPs advised the GP that they wanted to sell the development to a third party (“A”) and that (“A”) was offering $8.96 million. That price would allegedly allow the wraparound mortgage to be paid, including all accrued and unpaid interest and generate funds to cover total tax liabilities investors would owe due to their recapture of their negative capital accounts. The LPs thus asserted that (“A's”) offer would expire, if not accepted by November 30, 2014. The LPs also indicated they would sell their ownership interests to the GP for the same price that they would receive from (“A”).

The GP advised the LPs that it was not interested in purchasing the LPs shares, but did not directly respond as to (“A's”) offer. The LPs advised the GP that refusal to sell would violate the GP's fiduciary duties and they threatened to dissolve the partnership. The GP thereafter sent a letter purporting to accept (“A's”) offer. Although the acceptance was made after the deadline in (“A's”) offer, the LPs advised the GP that (“A”) was still willing to buy. However, (“A”) thereafter advised the GP that it was no longer interested in purchasing the development.

Thereafter, the parties met. The LPs accused the GP of violating its fiduciary duties by “failing to charge tenants sufficient rent.” They argued that the GP's insistence on charging “too little for rent,” frustrated the partnership's ability to pay off the wraparound mortgage and eventually, the partnership will default on its debt to the GP. The LPs offered to pay the GP $6.5 million for GP's general partnership interest and the mortgage obligation.

A subsequent letter reduced the offer to purchase the GP's partnership interest. The GP rejected the offer and asserted that the accusations were “without merit.” The GP advised the LPs that the balance due on the partnership's note exceeded the value of the partnership's assets and that on the scheduled termination date in 2020, the GP intended to accept “all of the Partnership's assets in satisfaction of the Partnership's note.”

The LPs then sent a letter to the GP purporting to remove the GP as general partner for cause and indicated that representatives of the LPs would “take control of all records of the partnership and the property.” The GP then commenced the subject action alleging breach of contract and sought damages and a permanent injunction barring the LPs from interfering with the GP's control of the business. The GP also sought a declaration that it had “not violated the partnership agreement or done anything” that could justify removal for cause. The LPs counterclaimed and moved for a preliminary injunction.

LPs argued that the GP “effectively siphoned the equity interest of the (LPs) to its own account by placing itself in a position to foreclose on most or all of the Partnership's assets when the Partnership terminates in 2020.” They submitted, inter alia, an appraiser's affidavit which asserted that the development's income was $741,888.00 below market rents. They also asserted that the GP “torpedoed” (“A's”) offer to purchase the property and that sale would have paid off the wraparound note and yielded more than $2 million in investment gain for the LPs.

The GP countered that the partnership agreement provided that the development would be run a “low-income apartment complex, and that the primary benefit to the (LPs) would be tax losses.” The GP noted that after “decades of reaping tax benefits, and with the scheduled dissolution of the partnership looming, (LPs) are now changing their tune and attempting to both 'eat their cake and have it too.' For nearly four decades, (the GP) has managed the partnership to 'maximize the federal, state and local income tax benefits available to the partnership' as mandated by the explicit 'purpose' provisions of the partnership agreement.” The GP asserted that the LPs made an initial capital contribution of only $400,000, and this “was a classic low-income housing tax shelter, designed to generate 'tax benefits.'” The GP also emphasized that the LPs had “never complained about this arrangement until now, despite having been provided with (the development's) financial information at every step over the past forty years.”

Additionally, the GP noted that the LPs had been allocated “multiple millions of dollars in losses” since their investment in 1980 and that was “what they bargained for….” The GP stated that raising rents would have decreased the amount of losses and minimized the tax benefits, contrary to the terms of the partnership agreement. Although the LPs will have income tax liability upon dissolution of the partnership, the GP explained that was the “nature of the investment they made.”

The GP also argued that its alleged late response to (“A's”) offer to buy was not the reason the potential deal fell through, there was never “an actual purchase offer, and that any breaches of fiduciary duties occurring in 2014 were now time-barred.” Further, the GP stated that the development could not “realistically charge market-rate rents,” given the development's “age, state of repair/renovation, and the lack of amenities typically found in market rate apartments…” and market rate increases would have forced most tenants to relocate from the development.

The court found that the LPs failed to meet the standard necessary to obtain a “prohibitory injunction, much less a mandatory injunction.” They failed to show that they would suffer irreparable harm absent injunctive relief, that they would likely succeed on the merits and the balance of hardships tips decidedly in their favor.

With respect to the irreparable harm, the court cited the LPs delay in seeking injunctive relief. They complained about a situation that existed for “a number of years” and they had knowledge that the GP had been charging “too little for rent.” The LPs knew since at least 2012, the HUD mortgage had been paid off and no payments were being made on the remaining wraparound mortgage.

The LPs claimed that they raised the issue at a meeting in August 2018, then attempted to negotiate a resolution and then tried to remove the GP as the general partner. However, the LPs had “actual notice of the rent level for many years, if not decades.” Additionally, they had requested a meeting with the GP in June 2018 but had not disclosed the purpose of the meeting until August. The LPs, thereafter, waited two more months until they sent a notice to the GP, purporting to remove the GP as a general partner. The court held that given that they had been aware of the facts for “years if not decades,” and they never objected until recently, the LPs were not entitled to the “extraordinary and drastic” relief of a preliminary injunction.

Moreover, the LPs did not demonstrate a likelihood of success on the merits as to plans to remove the GP. The court opined that charging rents that were below fair market rents was “not necessarily indicative of malfeasance” and the GP had “persuasively argued that such fact is consistent with the purpose for which (the development) was established, and with the purpose of the limited partnership, which was to provide tax losses” to LPs.

The court observed that the claim that the development “should have been operated as a market-rate apartment complex once the HUD mortgage was paid in 2012, not only flies in the face of the facts of record, but begs the question why the LP never never complained until 2018.” The LPs had not shown that the purpose of the limited partnership was to “maximize profits, as opposed to tax benefits.”

The LPs had also failed to demonstrate that the GP did anything improper as to the third party's purchase offer or that if it did, that such claim would not be barred by the statute of limitations.

Finally, the LPs failed to show “that the balance of the hardships tips decidedly in their favor because extreme or very serious damage will result from a denial of preliminary relief.” The court noted that the partnership “will merely continue to do business as it has done for the past forty years without objection by (LPs).” In contrast, if an injunction were granted, the GP would be removed from the position he held since 1979, and the operation of the development would “likely be disrupted to the detriment of the tenants.” Accordingly, the court denied the LP's motion for preliminary injunction.

Council of Churches Housing Dev. Fund Co. Inc. v. Arlington Housing Corp., U.S.D.C., WDNY, Case No. 18-CV-6920, decided May 3, 2019, Siragusa, J.

Landlord-Tenant—Tenant Did Not “Commercialize the Premises” and Profit on Large Scale with Airbnb Activity

A landlord commenced a holdover proceeding against a rent-stabilized tenant, alleging that the tenant had “violated substantial obligations of her tenancy and the terms of the lease by using the apartment for a business use and/or are renting the apartment and/or a portion of the apartment as a 'hotel' or 'bed and breakfast' for short-term stays and rentals and that such use constitutes 'profiteering and rent gouging by charging [her] guests sums of money in excess of the rent charged under the lease for the apartment.'” The landlord moved for an order dismissing the tenant's defenses and claims pursuant to CPLR §3211 and for summary judgment pursuant to CPLR §3212 and sought additional discovery.

The tenant lived in the apartment since 1997. The landlord had purchased the building in 2016. The apartment has three bedrooms. The tenant had rented and charged for rooms in the apartment by listing the apartment on websites, including Airbnb. The tenant had “refunded $1,955.61 to eight of the nine Airbnb renters, representing the amount above the proportionate share of her rent-stabilized rent received from such renters, calculated on a daily basis and was unable to refund any money to one renter in the amount of $582, who stayed in her apartment for 4 days in 2013, solely as she could not be located….”

The prior owner of the building had not objected to the tenant renting the premises on Airbnb. The prior owner acknowledged that he knew that the tenant was undergoing certain problems and had “on a few occasions,” rented “an extra room in her apartment on a short-term basis to guests.” He further stated that he had not considered the tenant's activity to be a violation of the lease and, he had no objection to her doing so and he had not requested that she stop leasing her extra room.

The court held that the landlord had not “demonstrated ample need for discovery,” since the tenant had “already provided documents and subjected herself to a deposition” and the facts were “largely undisputed.” The salient issue was whether the tenant's conduct arose “to the level of commercialization and profiteering justifying eviction of respondent from the premises.” The landlord had not demonstrated how further discovery would impact the legal proceeding or would constitute anything other than a “fishing expedition.”

The court explained Rent Stabilization Code (RSC) §2525.6(b) provides that “[t]he rental charged to the subtenant by the tenant shall not exceed the legal rent plus no more than a ten percent surcharge payable to the tenant if the housing accommodation is sublet fully furnished.” RSC §2625.6(f) provides that a landlord “may terminate the tenancy of a tenant who sublets contrary to the terms of this section….”

Courts have recently addressed “this provision in the context of Airbnb activities.” In Goldstein v. Lipetz, 150 AD3d 562, the Appellate Division, First Department, held that “the law is clear that a rent-stabilized tenant who sublets her apartment at market rates to realize substantial profits not lawfully available to the landlord, and does so systematically, for a substantial length of time, places herself in jeopardy of having her lease terminated on that ground, with no right to cure…. In Goldstein, the court affirmed a trial court order granting summary judgment to the landlord, where the tenant sublet her apartment to 93 different customers through the Airbnb website, for 338 days, over an 18-month period and realized almost 56 percent profit above her stabilized rent. The Goldstein court recognized that where respondents overcharged subtenants, but “the illegal subletting generally 'has been of short duration…' a cure is possible. Such cure does not 'mean simply the termination of the illegal subletting, but also the refund to the subtenants of the overcharges…'”

The subject court cited several appellate court decisions which found Airbnb activity justifies eviction of a tenant where the tenant commercializes a regulated unite. The court further noted that decisional precedent held that “the rent-stabilized tenant is not subject to eviction where the tenant's renting the premises does not rise to the level of profiteering and the tenant has cured.”

The court refused to consider Airbnb activity which had occurred prior to the landlord's purchase of the building in 2016, since the prior owner had either waived any right to object to such activity or had “acquiesced to such activity.” Since that time, the tenant had sublet the premises through Airbnb to “three parties for a total of eight nights” and almost “all monies collected in excess of the legal rent were refunded prior to commencement of this proceeding.”

The court found that the tenant's Airbnb activity was “episodic in nature” and the tenant had attempted to “cure” the overcharge. She refunded a small amount above the lawful rent over a period of years and such conduct was not “grounds for forfeiture of her long-term rent-stabilized tenancy.” Accordingly, the court denied the landlord's motion for summary judgment and granted the tenant's cross-motion for summary judgment and dismissed the proceeding.

207-209 W. 107th St. LLC v. Doe, Civil Court, New York County, Case No. 56813/18, decided April 30, 2019, Elsner, J.

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