New Peril In Co-Op Foreclosure

A co-op is a strange beast to begin with (quick refresher to follow in a moment) but adding to the basic confusion is a new danger highlighted by a recent case: The purchaser at the co-op foreclosure sale can be personally liable for rent overcharges for which the prior owner had been responsible! [Muscat v. Gray, N.Y.L.J., Jan. 14, 2004, at 18, col. 1 (Civ. Ct., Housing Part, N.Y. Co., Lebovits, J.)]

The practical danger should be apparent. If the lender or servicer is the successful bidder at the sale (and, of course, it happens) they assume the liability.  (In the cited case which made the point, that amount was a whopping $61,000 plus years of interest.)  If a third party intended to purchase, this principle could have a chilling effect on bidding. And what makes all this particularly insidious is that the result is the opposite of what happens in a real estate mortgage foreclosure action.

Now some brief details on co-ops and how this danger comes about.

A co-op is not real estate.  When a lender loans money on a co-op, the money is used not to purchase real property, but rather to purchase personal property in the form of shares in a corporation, which corporation owns the building and then leases a unit to shareholders.  The shareholder thus owns shares and a proprietary lease which serves as the security for the loan, all embodied not in a “mortgage” but in a security agreement. If there is a default, the lender forecloses on the shares and the lease under the Uniform Commercial Code, Article 9, in a fashion very much akin to non-judicial foreclosures which servicers recognize from many states – other than judicial states like New York.  So the documentation is different and there are other responsibilities, such as monthly maintenance due to the co-op and the problems that portends for lenders.  To explore these thorny subjects further, attention is invited to a number of previous articles we have done on this subject.^[1]

In the cited case, there was a rent stabilized apartment in New York City (which means that the rents are controlled by law) and there was a tenant in that apartment as of 1985.  The apartment building was converted to a cooperative use in 1990 and when the tenant did not pay rent to the sponsor who owned that particular unit, the sponsor sued for the unpaid rent.  The tenant counterclaimed (for what is called breach of the warrant of habitability) and was awarded a substantial judgment – none of which was paid.

By mid-2001, there was a UCC Article 9 foreclosure sale.  After the closing, the successful bidder – new owner – sought rent from the tenant from the date of the closing.  The tenant responded with a claim to hold the new owner liable for the judgment it had obtained against the prior owner.  The new owner was held liable for the prior owners’ debt on the theory of carryover liability.  A section of the rent stabilization code in New York makes a current owner responsible for a prior owner’s rent overcharges unless, among other things, the new owner purchased at a judicial sale – which does not happen in a co-op foreclosure; hence, the potential danger to any purchaser at a co-op foreclosure sale.

Concededly, the situation of tenants, rather than owners being in the premises at a co-op, are likely to be a minority of the cases.  Moreover, rent overcharge judgments will be yet a smaller percentage of the cases so that in the end the peril presented here will not be so common.  Nevertheless, it will occur and is something which is well avoided.  And as noted before, to the extent that this concept becomes widely recognized, bidders at co-op foreclosure sales may be reluctant to purchase, thus diminishing the value of secured loans on co-ops.

In the end, it is important for lenders and servicers to be aware of this additional point of concern in the co-op lending and foreclosure process.

¹“What’s Up With Co-Ops?  Documentation and Foreclosure” The USFN Report 7 (Spring, 2003); “A Potpourri of Cases – These Interesting Items Deal With The Right of Redemption, Foreclosure Sale Adjournments and Co-Op Dangers”, 9 Servicing Management 7 (March, 1998); “Co-Op Foreclosure Methodology – What Is Your Choice?”, 24 N.Y. Real Property Law Journal, 107 (Summer, 1996); “The Dangers of Co-Op Lending”, 7 Servicing Management 25 (November, 1995); “Still More Peril In The Co-Op Loan, N.Y. Real Property Law Journal, 149 (Fall, 1995); “A Cooperative Loan Default – Pursuing a Mortgage Foreclosure Strikingly Unlike Any Other”, New York Law Journal (July 27, 1994)

Mr. Bergman, author of the four-volume treatise, Bergman on New York Mortgage Foreclosures, LexisNexis Matthew Bender (rev. 2017), is a partner with Berkman, Henoch, Peterson, Peddy & Fenchel, P.C. in Garden City, New York. He is also a member of the USFN, The American College of Real Estate Lawyers, The American College of Mortgage Attorneys, an adviser to the New York Times on foreclosure issues and writes a regular servicing column for the New York Law Journal. He is AV rated by Martindale-Hubbell, his biography appears in Who’s Who In American Law and he has been for years listed in Best Lawyers In America and New York Super Lawyers.