NEW YORK STATE BAR ASSOCIATION JournalJournalJULY/AUGUST 2001 | VOL. 73 | NO. 6 LEGALLEGAL WRITING:WRITING: OLDOLD vs.vs. NEWNEW

Inside Securities Laws and LLCs Special Coverage: • • Usury Risks • Financing Issues • Mechanic’s Liens BOARD OF EDITORS C ONTENTS Howard F. Angione The Legal Writer: Dress for Success: Be Formal But Editor-in-Chief Queens Not Inflated e-mail: [email protected] Gerald Lebovits 8 Rose Mary Bailly Albany Courts Apply Investment-Contract Test to Determine Willard H. DaSilva When LLC Membership Interests Are Securities Garden City Peter A. Mahler Louis P. DiLorenzo 10 Syracuse Philip Dixon Mortgage Foreclosures Involve Combination of Law, Albany Practice, Relationships and Strategies Judith S. Kaye Bruce J. Bergman 19 New York City John Nesbitt Lyons Confusury Unraveled: New York Lenders Face Usury Kenneth P. Nolan Risks in Atypical or Small Transactions New York City Joshua Stein 25 Eugene E. Peckham Binghamton Sanford J. Schlesinger Wall Street Remains a Key Player in Commercial Real New York City Estate Financing Despite Capital Market Fluctuations Richard N. Winfield Joseph Philip Forte 34 New York City Eugene C. Gerhart Businesses Considering Renting in Commercial Editor Emeritus Binghamton Condominiums Face Unique Contractual Issues Matthew J. Leeds Daniel J. McMahon 43 Managing Editor Albany Understanding Mechanic’s Liens Reveals Approaches e-mail: [email protected] Philip Weiss To Thwart a Developer’s Improper Filing Brian G. Lustbader Associate Editor 51 Oceanside The Journal wishes to thank Prof. Robert Zinman of St. John’s University, William EDITORIAL OFFICES One Elk Street Colavito of Bedford Hills and Harry Meyers of Buffalo for their assistance in de- Albany, NY 12207 veloping the articles on real estate matters in this issue. (518) 463-3200 FAX (518) 463-8844 D EPARTMENTS

ADVERTISING REPRESENTATIVE President’s Message ______5 Index to Advertisers ______61 Network Publications Editor’s Mailbox ______56 2000–2001 Officers ______63 Sheri Fuller Classified Notices ______58 Language Tips ______64 10155 York Road, Suite 205 Crestridge Corporate Center New Members Welcomed ______59 by Gertrude Block Hunt Valley, MD 21030 (410) 628-5760 O N T HE C OVER e-mail: [email protected] This month's cover illustration of an Elizabethan courtroom is from Historical Picture ON THE WORLD WIDE WEB: Archive/Corbis. The cover was inspired by a statement in the new Legal Writer column: “Some rules will help lawyers get out of Elizabethan courts and into American courts of http://www.nysba.org the twenty-first century.” Cover design by Lori Herzing.

The Journal welcomes articles from members of the legal profession on subjects of interest to New York State lawyers. Views expressed in articles or letters published are the authors’ only and are not to be attributed to the Journal, its editors or the Association unless expressly so stated. Authors are responsible for the correctness of all cita- tions and quotations. Contact the editor-in-chief or managing editor for submission guidelines. Material accepted by the Association may be published or made available through print, film, electronically and/or other media. Copyright © 2001 by the New York State Bar Association. The Journal (ISSN 1529-3769), official publication of the New York State Bar Association, One Elk Street, Albany, NY 12207, is issued nine times each year, as follows: January, February, March/April, May, June, July/August, Sep- tember, October, November/December. Single copies $12. Periodical postage paid at Albany, NY with additional entry Endicott, NY. POSTMASTER: Send address changes to: One Elk Street, Albany, NY 12207. Journal | July/August 2001 3 “Well, if that doesn’t beat all.” Effie (one even using the Internet to do it). Gunderson dropped her magazine to But not Effie. She had to be different. her lap. PRESIDENT’S After the kids left home and the farm If there was another person in the shut down, Effie Gunderson had room, he wasn’t letting on. MESSAGE taken out subscriptions to every “BOB? You listening?” lawyer magazine in the country, and “I hear you, Effie. What did those read those bar journals cover to cover bar fellows do now?” Bob Gunder- every month. And today she was fix- son scarcely looked away from the ated on the President’s Message from television set. But then, if he had, he the June 2001 New York State Bar would have had a hard time finding Journal. Effie, who had created a fortress of Effie was not a lawyer, nor were stacked magazines on the tables sur- any of her kin. She had limited con- rounding her ancient rocking chair. tact with lawyers in her lifetime. Effie “Did you know that over there in had a lawyer draw up her will, and New York State the attorney discipli- had seen the same lawyer (Mr. An- nary system is closed to the public?” dersen, rest his soul) when she and Bob was in no hurry to respond. Bob decided to put the Lundegaard Bob was happy to kick back and family farm into both their names, watch his “stories” after 41 years of but otherwise hadn’t ever had the raising durum wheat. Now that the need. So whatever she knew about government was paying him not to lawyers and lawyering came from grow his crops, he made an easy those journals she devoured on an transition into the world of daytime hourly basis. television. STEVEN C. KRANE “They make such a big secret Effie became impatient. “BOB!” about it,” Effie muttered as if to her- “Whaddya want?” Bob finally Meet the self but in a perfectly audible tone. shifted his gaze from the television’s Gundersons Bob relented after another pro- gray glow (low signal strength in longed silence, figuring he would northwestern North Dakota) to the piles of publications have to engage in this conversation surrounding his wife. sooner or later. Effie could be very patient while lying in Effie leaned forward and peered over the rim of mag- wait. “Well, they must make something public sometime, azines piled on the table that separated her from Bob. “I don’t they?” said, did you know that over there in New York State “Well, sure, once it’s all over with, and it’s been the attorney disciplinary system is closed to the public?” through the grievance committee and through the Bob hesitated for a moment, as if genuinely trying to courts, they announce the result. You can’t disbar or sus- remember whether he did in fact know anything at all pend a lawyer in secret, Bob. And you surely can’t have about attorney discipline in New York or any other a private public censure!” Effie broke into peals of state. laughter the likes of which Bob hadn’t heard from her in years. “No, Effie, I did not know that.” This time he wasn’t going to bite. If he engaged her in conversation he’d Bob saw the humor, but wasn’t quite ready to “bust a miss several key plot elements and would have to buy gut” with his wife. Yet, having joined in the talk, he the digest over at the convenience store to catch up. He jumped in with both feet. As was his pattern, he usually was going to say no and leave it at that. started by baiting her. “Well, why should they?” Effie was prepared for this stratagem and allowed the “Should they what, dear?” silence to grow. She remained almost motionless behind “Make anything public.” her barricade, knowing full well that Bob would not “Don’t you know anything?” Effie leaped from her survive the lull in conversation and that he eventually seat, now towering over the parapets of her bar journal would be compelled to join. Bob remained resolute, try- fortress, and strode to the bookshelf that held the family ing to reinsert himself into the plot of the soap-of-the- Bible and other important volumes. “Remember the moment. Why couldn’t Effie have a normal hobby, like McKay Report?” the other ladies her age in Winston? Other ladies hooked rugs, took up needlepoint, played cards, be- Steven C. Krane can be reached at 1585 Broadway, New came ham radio operators, collected decorative spoons York, N.Y. 10036

Journal | July/August 2001 5 PRESIDENT’S MESSAGE “Well, here’s what the McKay Report said about that: “Not more MDP! Please!” ‘The public does not accept the profession’s claims that lawyers’ reputations are so fragile that they must be “Not MacCrate, but McKay!” Effie began to recite. shielded from false complaints by special secret pro- “Dean Robert McKay, chairman of the ABA Commis- ceedings. The irony that lawyers are protected by secret sion on Evaluation of Disciplinary Enforcement, report proceedings while earning their livelihoods in an open adopted by the ABA House of Delegates in 1992.” system of justice is not lost on the public. On the con- Bob didn’t remember. He must have still been riding trary it is a source of great antipathy toward the profes- the tractor back when this report came out. sion.’” “Here. Page 33. Here’s what the McKay Report says: “And on what did they base that conclusion?” ‘The Commission is convinced that secrecy in discipline “They held nationwide public hearings, then circu- proceedings continues to be the greatest single source of lated a draft report for comment to all sorts of groups, public distrust of lawyer disciplinary systems. Because including bar associations around the country, client it engenders such distrust, secrecy does great harm to protection funds, consumer groups, and so on. It was a the reputation of the profession.’ You listening?” big deal, Bob. And remember the Craco Report in New “Yes, Effie.” York?” She cleared her throat. Effie was not done. “‘The pub- Bob did remember. The Craco Report had come out lic’s expectation of government and especially of judi- just as Effie had begun her new hobby, and that was all cial proceedings is that they will be open to the public, Bob heard about at dinner for a week. He could see its on the public record, and that the public and media will frayed blue cover peeking out from the bottom of one of be able to freely comment on the proceedings.’” Effie’s stacks. “Was that part of it?” “Well, Effie, what do you know about what other “Yes, and they held public hearings, too, and did all states do?” sorts of research on the subject. The public doesn’t trust “About two-thirds of the states open their attorney the system because it’s all so secret. They think prob- disciplinary proceedings somewhere along the line, lems are being swept under the rug, in private.” usually after there has been an initial complaint, some “Well, do they have anything to hide?” sort of investigation, and a determination that probable “No, that’s just it. The system works well. They catch cause exists to believe that the lawyer has committed a the bad ones and discipline them in a fair system in violation of the rules of ethics. Some states open the which judges, lawyers and laymen all take part. It’s re- process completely, so every complaint is available to ally quite good. Could use some uniformity within the the public, but that is not what is being proposed in system, but overall it works.” New York.” “All right, then, Effie, how do you go about balanc- “So what’s the big issue, if most other states do it this ing the public interest in having access to attorney disci- way? Have there been problems in other states caused plinary proceedings against the need to avoid unneces- by opening the process?” sary harm to lawyers’ reputations?” “That’s just it!” Effie had obviously done her home- “Well, what if you couldn’t file formal disciplinary work on this topic. “I’ve contacted people all over the charges until a Justice of the Appellate Division made a country and asked them about their experiences with determination, based on presentations by the prosecu- open disciplinary proceedings—” tor and by the respondent, that probable cause existed “How’ve you managed that?” Bob interrupted. to support a finding of a disciplinary violation? And “On the Internet, of course. And there’s no evidence, what if at the same time the Justice was required to de- anecdotal or otherwise, that opening the process has termine whether there were any special circumstances had a negative effect on lawyers or on their reputation, that warranted keeping this particular proceeding and the feedback from the public and the press has been closed to the public? And what if you raised the stan- very positive.” dard of proof in attorney disciplinary proceedings from “So why the resistance?” a preponderance of the evidence, where it is now, to “The opponents are concerned that if charges are clear and convincing evidence, which is what the stan- filed against a lawyer who is later cleared, the lawyer’s dard is almost everywhere else in the country?” reputation will have been damaged for no good rea- Bob nodded. Effie was on to something. “Sounds son.” like a lot of protection for the lawyer.” Bob looked On first hearing, this sounded reasonable to Bob. He thoughtful. switched back into baiting mode. “So if they have that protection, why should they agree to give it up?” CONTINUED ON PAGE 42

6 Journal | July/August 2001 The Legal Writer Dress for Success: Be Formal But Not Inflated Editor’s Note: Gerald Lebovits is the author of Advanced Judicial Opinion Writing, a handbook for New York State’s trial and appellate law clerks and court attorneys. The Journal has asked him to adapt, in the coming months, portions of his 328-page work to the needs of practicing attorneys, applying his principles to briefs, position papers and client memorandums. His first column addresses an issue of tone applicable to all legal writing. Future columns will explore the philoso- phy of style, usage, persuasive legal writing, legal-writing myths, citation and other issues.

BY GERALD LEBOVITS

awyers must dress for court. No ripped jeans, but No implied intransitives. In an implied intransitive, no top hat, tails, and spats, either. A well-dressed the object is indeterminate. What do waiters mean when Llawyer is formal but not inflated. Clothes do not they serve food and tell you to “enjoy”? To enjoy the make the lawyer. But they get the lawyer into court. food? To enjoy yourself while you digest? Implied in- Just as lawyers must dress appropriately, lawyers transitives are acceptable in conversation but not in for- must write appropriately. Lawyers who write must do mal writing. more than shape law, apply fact, and organize coher- No de-transitivizing. A verb may be transitive (“I ently. They must do more than master grammar and need you”) or intransitive (“I need”). A de-transitivized usage. They must also adopt an effective style and tone. verb is neither. Safire’s examples of what not to write: Whatever the legal writer’s goal—to persuade, to in- “[P] wait while your credit card is authorizing” and form—the right tone is formality without inflation. “[T]his book usually ships in three days.”2 The problem Some rules will help lawyers get out of Elizabethan with de-transitivized verbs is lack of clarity, not merely courts and into American courts of the twenty-first century. informality. What subjects of Safire’s sentences are au- No contractions or ampersands. They aren’t formal thorizing and shipping? What objects are the verbs’ ac- & shouldn’t be used. But use ampersands in names of tion being done to? businesses and professional associations that use am- Do not “verb” nonverbs. Parts of speech evolve into persands. The law firm: “Dewey, Cheatem & Howe.” verbs called “changelings,” which in time function as No slang. You betcha bottom dollar! In legal writing, nouns and verbs: calendar, chair. But do not overnight “[s]lang often deformalizes, thereby deemphasizing the nonverbs overnight. seriousness of a situation.”1 Fad words are groovy—not! No colloquialisms. Go ‘round the barn to avoid ‘em. And trendy writing is flaky. No abbrev. in your text unless nec. OK? Eliminate No recent back-formations. They enthuse no one. It the following: i.e. (id est—in other words, that is); e.g. (ex- is hard to orientate people to new back-formations. A empli gratia—for example); re: (about, concerning, in the back-formation is formed by subtracting an affix from a matter of, regarding—except as a reference in a letter); etc. longer word. Older back-formations such as diagnose (et cetera—and so forth, and so on, and the like); N.B. (nota from diagnosis are acceptable. Readers find new back- formations grating. A friendlier relative of the back-for- GERALD LEBOVITS, a principal court at- mation is the functional shift. Through shifts in parts of torney in Supreme Court, Criminal speech, a verb may become a noun (to run may shift to a Term, New York County, is also an ad- run) and a noun may become a verb (a blacklist may be- junct professor of law and the Moot come to blacklist). Court Faculty Advisor at New York Law School. His e-mail address is The “ize” sometimes have it. No one objects to old [email protected]. -ize suffixes that turn nouns or adjectives into verbs: crit- icize, rationalize. All disfavor recent -ize formations: con- cretize, prioritize.

8 Journal | July/August 2001 bene—note well); q.v. (quod vide—which see; see also has re- not to be conversational, as one would be in an informal, placed q.v.); viz. (videlicet—namely). relaxed setting. The goal, however, is to use words you N.B.: Use commonly abbreviated titles such as Mr., would use in polite conversation. Ms., and Dr. Do not abbreviate less common titles. Pre- Good legal writing is planned, formal, noninflated fer Officer A to P.O. A, Professor X to Prof. Y. Q.V.: speech. If you want to write the Queen’s English, make Acronyms you have already defined are permitted: FBI. sure the Queen is not Elizabeth I. Clothes do not make No parenthetical remarks. (They are informal and the lawyer. But writing well does. (usually) easily avoided.) 1. George D. Gopen, Writing from a Legal Perspective 56 No strong interjections. “Good grief!” Interjections (1981). express emotion too strong for legal writing. 2. William Safire, On Language, N.Y. Times Magazine, Oct. No shortened words. Whether you write on a p.c. in 22, 2000, at 38 (emphasis in original). your auto or dictate over your phone on a plane, go the 3. Laurie E. Rozakis, The Complete Idiot’s Guide to Gram- max: Write words in full. “ET, phone home” becomes mar and Style 233 (1997). “ET, telephone home.” Quibble over quotation marks. Avoid quotation marks except to quote, define a term of art, or reference a word or phrase. Not following this rule marks you a “paranoid” or an “egocentric.” Forget figures. Prefer words to figures when giving lists, for 1 reason: Words are more formal than figures. No pontificating or high-falutin language. Write like a person, not a personage. Those who use inflated language are, well, full of hot air. Big words are bad. Never use a gargantuan, hu- mongous, or capacious (big) word when an infinitesi- mal, lilliputian, or diminutive (small) one will suffice, be adequate, and satisfy your requirements (do). Big words impress no one. Perhaps your sixth-grade teacher taught you to use $10 words. Perhaps you learned big words for the SAT. Perhaps big words brought you high grades in college. Perhaps you paid big money for a big thesaurus to learn big words. If so, your writing can use a big adjustment. Here is an authoritative guide from Professor Roza- kis’s fun book: “[A]cademic writing is all-too-often ver- bose and didactic for the sake of mere pedantry. After you graduate and enter the business world, your task Struggling shifts from writing to impress to writing to communi- cate . . . . Much of the time . . . big words just set up bar- riers between you and your audience.”3 with an Besides, big words can mean big mistakes. Incor- rectly using a big word turns pretense into buffoonery— a perception a legal writer can ill afford to create. Recall ETHICS ISSUE? the times you have heard people confuse subsequently with consequently. These people should have preferred later to subsequently. NYSBA CAN HELP! Strive for balance in formality. Be neither impene- trable nor casual. (That would be a tummy-wrenching E-mail: [email protected] experience.) Be neither inhibited nor egocentrically breezy. (Which reminds me of an interesting story . . . ). or fax your question to: Be neither gratuitously judgmental nor opinionated. 518-487-5694. (Nobody asked me, but . . . ). The goal in legal writing is

9Journal | July/August 2001 Journal | July/August 20019 Courts Apply Investment-Contract Test to Determine When LLC Membership Interests Are Securities

BY PETER A. MAHLER

an a membership interest in a limited liability of the Securities Exchange Act of 1934, 15 U.S.C. company (LLC) be considered a security for pur- § 78c(a)(10). The U.S. Supreme Court has observed that Cposes of federal and state securities laws? Yes and the definitions “are virtually identical and will be no, depending, sums up the collective wisdom of the treated as such in our decisions dealing with the scope handful of reported cases to answer the question so far. of the term.”1 The definition of “securities” in New LLCs are authorized in all 50 states and the District of York’s Blue Sky Law generally tracks the federal defini- 2 Columbia. New York was one of the last states to join tion. the LLC bandwagon in 1994; Wyoming was the first in The statutory definition specifies a number of finan- 1977. The attraction of the LLC business form comes cial instruments, such as stocks, bonds and debentures, from its hybrid nature, combining the pass-through tax that traditionally are recognized as securities but clearly treatment of partnerships, the limited liability of corpo- do not encompass LLC membership interests. Attempts rations and some of the organizational attributes of lim- to apply the securities laws to such interests have fo- ited partnerships. LLCs can be member-managed or cused on the statute’s reference to “investment contract” managed by one or more managers who need not be which, as construed by the Supreme Court in SEC v. W.J. members. LLC statutes, including New York’s, gener- Howey Co.3 requires (1) an investment of money or other ally give organizers broad freedom contractually to tai- consideration (2) in a common enterprise (3) with an ex- lor ownership, management and economic rights and pectation of profit (4) to be derived “solely” from the ef- duties to the needs and aspirations of the individual en- forts of others. terprise, and to alter or negate the statutory default pro- Howey’s analysis “embodies a flexible rather than a visions, by adopting comprehensive operating agree- static principle, one that is capable of being adapted to ments. meet the countless and variable schemes devised by The great flexibility and variability of the LLC’s or- those who seek to use the money of others on the ganizational structure suggest caveat emptor as the suit- promise of profits.”4 The Howey decision also stressed able credo for any prospective, non-controlling LLC that, in defining an investment contract, form should be member. And perhaps that is as it should be, in the disregarded for substance and emphasis should be greater interest of fostering capital formation and entre- placed upon economic reality.5 preneurial activity. Howey’s first three elements usually will not pose an The securities laws, however, embody a more pater- obstacle to classification of an LLC membership interest nalistic approach to achieving the same ends, with an as a security. The key factor is whether the profit expec- emphasis on protecting investors by compelling full and tation is derived “solely” from the efforts of others. Al- fair disclosure relative to the issuance and transfer of the CONTINUED ON PAGE 11 many types of financial instruments covered by the statutes. When securities regulators or a disappointed PETER A. MAHLER is a partner at LLC member seek relief under the securities laws, the Derfner & Mahler, LLP, in New York courts must reconcile, on the one hand, the opacity that City (e-mail [email protected]). He freedom-of-contract engenders under the LLC laws and, practices in the area of business litiga- on the other hand, the transparency sought by the secu- tion, including shareholder, partner- rities laws. ship and LLC membership disputes. A graduate of U.C. Santa Barbara, he re- Investment Contract ceived his J.D. from New York Univer- The term “security” is defined in § 2(1) of the Securi- sity School of Law. ties Act of 1933, 15 U.S.C. § 77b(a)(1), and § 3(a)(10)

10 Journal | July/August 2001 CONTINUED FROM PAGE 10 cised “the ultimate power” over the company by virtue of Nevada’s LLC law and under the terms of the oper- though the Supreme Court post-Howey has not con- ating agreement. The court disagreed, finding that fronted the issue directly, the Second Circuit and other one of the defendants exercised near-total control over federal courts (in cases not in- the LLC’s management; that volving LLC membership in- management had submitted terests) have concluded that The first reported cases to only one issue to the mem- Howey’s use of the word bership involving the pur- “solely” is not to be taken lit- grapple with the application chase of a wireless cable op- erally, and that the test is met eration; and that “[w]hile the when the investor’s prospec- of the securities laws to LLC investors theoretically may tive returns hinge primarily membership interests were have possessed a right to on the essential managerial manage the affairs of [the efforts of others.6 enforcement actions. 7 LLC] under the terms of the In Williamson v. Tucker, Operating Agreement, the in- which involved joint venture experience and geographic interests in real estate, the Fifth Circuit further refined diversity of the 700-odd investors essentially precluded this aspect of the Howey test, holding that a general part- this from ever coming to pass.”9 nership or joint venture interest can be designated a se- A second SEC enforcement action the following year, curity on one of three alternative grounds: SEC v. Shreveport Wireless Cable Television Partnership,10 (1) an agreement among the parties leaves so little also involved the sale of LLC membership interests, as power in the hands of the partner or venturer that the well as general partnership interests, in several wireless arrangement in fact distributes power as would a lim- cable operations, allegedly in violation of the 1933 and ited partnership; or (2) the partner or venturer is so in- 1934 Acts. The defendant promoters raised almost $18 experienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his part- million through the sale of full and partial membership nership or venture powers; or (3) the partner or ven- units in a Louisiana LLC to almost 1,500 investors lo- turer is so dependent on some unique entrepreneurial cated in all 50 states and abroad. The defendants moved or managerial ability of the promoter that he cannot re- for summary judgment, arguing that the partnership place the manager of the enterprise or otherwise exer- and LLC membership interests did not meet the Howey cise meaningful partnership or venture powers. test of an investment contract because, based on the partnership and operating agreements, the investors Regulatory Enforcement Actions “agreed to participate significantly in the management The first reported cases to grapple with application of and operation of the cable entities in which they in- the securities laws to LLC membership interests were vested” and therefore did not purchase units with the enforcement actions brought by state and federal securi- expectation that the efforts of others would generate the ties regulators. In two cases, the courts held that the LLC profits.11 membership interests were securities and granted relief In denying summary judgment, the court examined against promoters. In a third case, the court found ques- the language of the agreements as well as the degree of tions of fact and denied the promoter’s motion for sum- operational control exercised by the promoters. The mary judgment. 8 agreements contained various provisions for majority or The first case, SEC v. Parkersburg Wireless LLC, de- super-majority voting by the membership concerning cided in 1997, involved the sale of LLC memberships in management decisions, allocations, composition of the a Nevada company to more than 700 individuals in 43 management committee and major decisions regarding states, many of whom were unemployed or retired or the sale, ownership or indebtedness of the company. elderly, and each of whom made a required minimum The court found that these provisions did “not appear to investment of $10,000. The SEC alleged that the defen- confer managerial responsibilities on the . . . members dants sold unregistered securities in violation of the beyond those of a limited partner or a voting share- 1933 Act and failed to register as broker-dealers in vio- holder in some corporations.” The court also found that lation of the 1934 Act. the sale of such large numbers of membership interests The court found that the first three elements of the could result in the investors having “such limited input Howey test for an investment contract were readily sat- that their ownership interests constitute securities de- isfied. As to the fourth element, the defendants con- serving of the protection of federal securities laws.” Fi- tended that the members’ hoped-for profits in the com- nally, citing an investor’s affidavit stating that the mem- pany’s wireless cable operations were not to be derived from the efforts of others because the members exer- CONTINUED ON PAGE 12

Journal | July/August 2001 11 CONTINUED FROM PAGE 11 fendant venture capital firm to form a member-man- bers were precluded from participating in “essential aged New York LLC. The plaintiff and the other owner managerial decisions” made before the management each received a 25% interest in the LLC in exchange for committees took control, the court found a triable issue transferring to it their interests in the mortgage lender. whether the “investor’s profits after the time of sale are The defendant contributed cash and financing expertise primarily dependent upon the promoter’s efforts.”12 in exchange for a 50% interest in the LLC. Plaintiff’s complaint alleged that the defendant subsequently di- Two weeks after Shreveport was decided came Nutek luted his interest and squeezed him out of the business Information Systems, Inc. v. Arizona Corporation Commis- through various means, and asserted claims under sion.13 Nutek was an appeal from an administrative de- §§ 10(b) and 29(b) of the 1934 Act. The defendant sought termination by Arizona securities regulators that the dismissal on the ground that the alleged fraud was not promoters of LLCs formed under Texas law to operate a in connection with the purchase or sale of a security. network of dispatch communications systems violated Arizona’s Blue Sky Law. The promoters collected District Judge Shira Sheindlin agreed with the defen- more than $10 million from 920 investors from Arizona dant and dismissed the claims, finding that the plain- and elsewhere. The articles of organization of each tiff’s LLC membership interest was not an investment LLC specified that the com- contract under the Howey test pany was member-managed, because the plaintiff “in- thereby giving the members In three cases the courts ruled tended to maintain some de- “legal control.” Applying gree of control” in the LLC at the Howey test and the that the LLC membership the time he made his invest- Williamson factors, the court interests were not securities ment. The court primarily nonetheless found that sev- looked to the provisions of eral circumstances negated and dismissed the complaints. the LLC agreement as sup- the members’ ability to exer- plemented by the New York cise “effective control” over LLC Law, which on the face the LLCs and that the membership interests therefore of it gave the plaintiff broad management and voting were investment contracts covered by Arizona’s Blue rights that the court found “antithetical to the notion of Sky Law. The circumstances included long-term con- passivity” required under Howey. In rejecting the plain- struction and management agreements that turned over tiff’s contention that the economic realities of the defen- all principal management functions to a separate com- dant’s squeeze-out measures should trump the plain- pany wholly owned by the promoters, which agree- tiff’s formal rights, Judge Sheindlin noted that ments were in place before most members invested in “although the degree of control [plaintiff] actually exer- cised was less than he expected to exercise, that fact the LLCs; the dilution of member power resulting from 15 the large number of geographically dispersed investors; does not convert his interests into securities.” the investors lacked the technical expertise to manage The defendant in Great Lakes Chemical Corp. v. Mon- 16 the LLCs and relied on the skills of the promoters and santo Co., decided last year, also won a pre-answer mo- their management company; and the financial success tion to dismiss a complaint alleging securities law viola- of the individual LLCs depended largely on the man- tions arising from the purchase and sale of a 100% agement company’s ability to establish networked oper- membership interest in a manager-managed Delaware ations. LLC. The LLC was formed and owned by Monsanto Co. and one of its wholly owned subsidiaries to market cer- Subsequent Private Actions tain pharmaceutical compounds. The LLC’s operating In the wake of Parkersburg, Shreveport and Nutek came agreement specified that the members had no authority four reported decisions in private litigations asserting to directly manage the LLC’s business and affairs, over federal securities law violations arising from LLC mem- which a board of managers had sole authority. The de- bership interests. The scorecard in the private actions fendants, accused of making financial misrepresenta- looks quite different—in three cases the courts ruled tions to induce the plaintiff’s acquisition, argued that that the LLC membership interests were not securities the LLC membership interest was not an investment and dismissed the complaints; in the fourth the court contract under Howey because the plaintiff did not in- ruled that the complaint adequately alleged a security vest in a “common enterprise” and because its profits in but dismissed the complaint on other grounds. the enterprise were not “solely from the efforts of oth- In Keith v. Black Diamond Advisors, Inc.,14 decided in ers.” 1999, the plaintiff and a second owner of a mortgage- The court agreed with the defendants on both counts. lending business entered into an agreement with the de- First, the plaintiff acquired the entire LLC membership

12 Journal | July/August 2001 interest without pooling its contributions with those of manage, control, administer, and operate the business other investors, as is required for horizontal commonal- and affairs of the Company.” The operating agreement ity. After the sale, the sellers (i.e., the LLC’s original pro- expressly limited member authority to voting on ex- moters) retained no interest in the LLC, hence the plain- traordinary matters such as dissolution and admission tiff’s fortunes were not linked to those of the promoters, of additional members.19 as is required for vertical commonality. Second, even The defendant’s argument for dismissal under though the operating agreement gave all management Howey, that the plaintiff had adequate opportunity to authority to a board of managers, it also gave the mem- engage in the LLC’s business affairs, carried no weight bers the power to remove any manager with or without with the court. The court relied entirely on the express cause, and to dissolve the company. Such authority, ac- provisions of the operating agreement in holding that cording to the court, gave the plaintiff “the power to di- the plaintiff did not have the capacity to exert essential rectly affect the profits it received” from the LLC. The managerial efforts, making it “possible” that the plain- court also cited as evidence of such power the com- tiff’s interest in the LLC “may be a security.”20 The court plaint’s allegations that, prior to the sale, the sellers con- nonetheless dismissed the complaint with leave to re- trolled the managers’ actions by prohibiting them from plead for failure to allege fraud with particularity. speaking directly with the plaintiff regarding certain In a case decided earlier this year by the South sales and customer data.17 Dakota Supreme Court, Tschetter v. Berven,21 the four in- In KFC Ventures, LLC v. Metaire Equipment Leasing 18 dividual plaintiffs invested approximately $100,000, Corp., also decided last year, the corporate plaintiff combined to purchase minority membership interests in paid $250,000 to acquire a 15% membership interest in a a South Dakota LLC formed to construct and own a manager-managed LLC providing medical imaging ser- franchise restaurant, the operations of which were to be vices. A year later, the plaintiff sued the 85% owner on managed by the franchisor. The business quickly failed various claims including securities fraud for failing to and the plaintiffs, along with the promoter, were sued make certain capital contributions and other acts of mis- by the LLC’s lender on their personal guarantees. The management. The LLC’s operating agreement named plaintiffs then sued the promoter for fraud under South the 85% owner as the initial manager with the full and Dakota’s Blue Sky Law, which defines “security” con- exclusive power to acquire , sell assets in the or- sistent with federal law. dinary course of business, enter into contracts and “to

Journal | July/August 2001 13 The LLC’s operating agreement vested authority for tion is overcome.” According to the Maryland court, the day-to-day decisions in two managers who were re- better approach is the one taken in Great Lakes and quired to be members and who were selected by the Nutek, where the courts recognized that, because LLC other members. The agreement also permitted the mem- interests lack the unlimited liability associated with gen- bers to call membership meetings, authorize company eral partnerships, the “Williamson presumption” against loans and incidental expenses up to $12,500, engage investment contracts should not apply.25 counsel, select officers, remove the LLC’s accountant Conclusion with or without cause, and gave all members access to LLC records. The minutes kept by the LLC also showed The few courts that have examined whether LLC that the plaintiffs were “informed and active” in the membership interests are securities have sought guid- LLC.22 ance primarily from case precedents applying Howey to interests in general and limited partnerships. As the On these facts, the court had little trouble conclud- court in Great Lakes pointed out, the different presump- ing that the plaintiffs’ LLC membership interests did tions developed for those kinds of interests, predicated not constitute investment on the presence or absence contracts under the Howey of limited liability as an in- test. The LLC’s operating centive or disincentive to be agreement established that The result has been a fact- involved in enterprise man- “substantial power and re- intensive, case-by-case approach agement, do not apply to sponsibility was vested in LLCs, members of which its members” and that the that yields few if any bright-line can be active managers yet plaintiffs in fact exercised still retain limited liability.26 the powers. In so ruling, the rules. Nonetheless, it is safe to say court specifically rejected the that the decisions thus far suggest The result has been a fact- plaintiffs’ main argument, intensive, case-by-case ap- that the LLC’s management several emerging principles. proach that yields few if any agreement with the fran- bright-line rules. Nonethe- chisor established their de- less it is safe to say that the pendence on the efforts of others. This argument failed, decisions thus far suggest several emerging principles wrote the court, because the relevant inquiry “is the that provide at least some guidance for practitioners [plaintiffs’] role in the [LLC]” and because the LLC re- and their clients, as follows: tained the ability to terminate the management contract • LLC membership interests are likely to be classified for non-performance. The court also observed that only as securities, even in an LLC that is nominally member in “unusual circumstances” would an investor in a managed, when they are mass marketed and sold to nu- member-managed LLC be able to establish reliance on merous, geographically dispersed investors who lack the entrepreneurial efforts of others, especially where, the business acumen and expertise to participate in unlike a case such as Nutek involving advanced technol- management in any meaningful way, regardless of their ogy enterprises, the investment is in an uncomplicated actual expectations. business such as the restaurant in Tschetter.23 • In a member-managed LLC with more concentrated membership, where the operating agreement endows Nutek, Redux all members with management authority, under a rea- In April of this year, Maryland securities regulators sonable expectations standard the courts are highly un- won a $178,000 fine for violation of that state’s securities likely to treat such interests as securities even if a mem- laws against the organizers and promoters found liable ber effectively is excluded from management. for violating Arizona securities laws in Nutek, discussed • In a manager-managed LLC, a member’s power to above. remove the managers may be enough to preclude appli- In Ak’s Daks Communications, Inc. v. Maryland Securi- cation of the securities laws. 24 ties Division, the Maryland Court of Special Appeals • Acquisition of a 100% membership interest likely will applied the Howey test to the investors’ LLC interests in be treated as a non-stock sale of the business outside the mobile communications networks, essentially tracking protections of the securities laws. the analysis in Nutek. What makes Ak’s Daks interesting • A member who invests in a manager-managed LLC is its criticism of Tschetter and Shreveport for starting whose operating agreement expressly limits the mem- “from the premise that an interest in a limited liability bers’ authority to voting on extraordinary matters, such company is not a security and apply[ing] the factors set out in Williamson to determine whether that presump- CONTINUED ON PAGE 15

14 Journal | July/August 2001 CONTINUED FROM PAGE 14 10. 1998 WL 892948 (D.D.C. Oct. 20, 1998). as dissolution and admission of new members, likely 11. Id. at *5. may seek relief under the securities laws. 12. Id. at *6-7. The courts undoubtedly will have much more to say 13. 194 Ariz. 104, 977 P.2d 826 (Ct. App. 1998), cert. denied sub on the subject as new refinements and permutations of nom., AKS Daks Communications, Inc. v. Arizona Corp. the LLC form of business enter the picture. Comm’n, 528 U.S. 932 (1999). 14. 48 F. Supp. 2d 326 (S.D.N.Y. 1999). Keith is one of the ear- liest cases to decide that the citizenship of an LLC for 1. Landreth Timber Co. v. Landreth, 471 U.S. 681, 686 n.1 purposes of diversity jurisdiction is based on the citizen- (1985). ship of the LLC’s individual members. See P. Mahler & D. 2. All Season Resorts, Inc. v. Abrams, 68 N.Y.2d 81, 87, 506 Gillett, Limited Liability Companies as Litigants, N.Y.L.J., N.Y.S.2d 10, 16 (1986). Oct. 22, 1999, p. 1, col. 1. 3. 328 U.S. 293 (1946). 15. Keith, 48 F. Supp. 2d at 332-34. 4. Id. at 299; see SEC v. C.M. Joiner Leasing Corp., 320 U.S. 16. 96 F. Supp. 2d 376 (D. Del. 2000). 344, 351 (1943) (investment contract defined broadly to reach “[n]ovel, uncommon, or irregular devices, what- 17. Id. at 390-92. ever they appear to be”). 18. 2000 WL 726877 (E.D. La. June 5, 2000). 5. 328 U.S. at 298. 19. Id. at *2. 6. See SEC v. Aqua-Sonic Prods. Corp., 687 F.2d 577, 582 (2d 20. Id. at *3. Cir.), cert. denied sub nom., Hecht v. SEC, 459 U.S. 1086 21. 2001 S.D. 11, 621 N.W.2d 372 (2001). (1982); Williamson v. Tucker, 645 F.2d 404, 418 (6th Cir.) (en banc), cert. denied, 454 U.S. 897 (1981); Aiena v. Olsen, 69 F. 22. Id. at 377. Supp. 2d 521, 534 (S.D.N.Y. 1999). 23. Id. at 377-78. 7. 645 F.2d 404, 424 (5th Cir.) (en banc), cert. denied, 454 U.S. 24. 138 Md. App. 314, 771 A.2d 487 (2001). 897 (1981). 25. Id. at 332. 8. 991 F. Supp. 6 (D.D.C. 1997). 26. Great Lakes Chem. Corp. v. Monsanto Co., 96 F. Supp. 2d 9. Id. at 9 n.3. 376, 392-93 (D. Del. 2000).

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Journal | July/August 2001 15 Mortgage Foreclosures Involve Combination of Law, Practice, Relationships and Strategies

BY BRUCE J. BERGMAN

or some practitioners, the intricacies and unending In regard to the legal inquiry, assume that the lender nuance of major commercial mortgage foreclosures expects to be in a first position. (Second or even more ju- Fare of great interest. But for most attorneys, cer- nior mortgage loans can be made, but for this example, tainly those who do not practice regularly in the field, a contemplate a first mortgage.) A title search will be ob- broader picture of what a mortgage action is tained and if there are any extant liens or about, and what the respective goals of plaintiffs and on the property—such as mortgages, mechanics liens, defendants are, may be more captivating. judgments, life estates, among a host of others—the Why, for example, was your client named in the fore- lender will require that all be satisfied or disposed of as closure? Or, what are the unique compulsions from a a condition of granting the loan. plaintiff’s point of view? Then too, experience suggests Suppose that after the mortgage is executed, deliv- that genuinely appreciating the underpinning of the ered and recorded, the owner-borrower (more precisely, proceedings helps unlock the mysteries of what is often the mortgagor) persuades some other lender to take a viewed as an arcane pursuit. Yes, the novel details can mortgage on the property for $100,000. The aggregate be stimulating, but for many, something more akin to a burden of debt on the property is now the equivalent of primer might just be in order. the property’s value, $300,000. Does the original lender care? To the extent that such a quantum of debt por- Ultimately, foreclosure is a startling combination of tends the borrower’s inability to remit mortgage install- law and practice, the chemistry of the relationships and ments, yes. But in a more compelling procedural sense, the strategies. no. Should the borrower default, the original lender rec- The Goal of a Foreclosure ognizes that the subsequent, junior, subordinate, mort- The goal is not as obvious as it might first appear. gage holder will be named and served with process in Aside from the plaintiff’s desire to be made whole, the the resultant foreclosure action. Presuming the efficacy technical (although ultimately practical) goal of a fore- of the service, one consequence of the foreclosure will be closure action is to cause the secured property to de- that the interest of the second mortgagee will be extin- volve through the foreclosure in the same legal condi- guished.1 The purchaser at the foreclosure sale will own tion it was when the mortgage was delivered. To more the property free and clear of the junior mortgage. In readily appreciate the portent of this stolid pronounce- ment, observe that at the inception, a mortgage lender motivated by commercial considerations makes two de- BRUCE J. BERGMAN is a partner at Cer- cisions—one business, one legal. (This is in contradis- tilman Balin Adler & Hyman, LLP in East Meadow, N.Y., where he heads tinction perhaps to an elderly couple moving to Arizona the mortgage foreclosure department. who must take back a purchase money mortgage to fa- He is the author of the three-volume cilitate the sale). treatise Bergman on New York Mortgage The former examines the prudence of the loan. Thus, Foreclosures (Matthew Bender & Co., if someone has $100,000 to spend and is buying a house Inc. 2001), a member of the USFN, the assertedly worth $300,000, the need is to borrow American College of Real Estate $200,000 to complete the transaction. The question the Lawyers, an adjunct associate professor of real estate at lender asks is, would someone at a foreclosure sale pay New York University’s Real Estate Institute and a special $200,000 to buy a house worth $300,000? The answer is lecturer at Hofstra Law School. A graduate of Cornell University, he received his J.D. from Fordham University “yes,” suggesting that the business question has been School of Law. satisfied.

Journal | July/August 2001 19 short, the goal of the foreclosure will have been Acceleration Most mortgages require periodic pay- achieved—the property emerged from the foreclosure ment installments, usually monthly and most often of action in the same pristine legal condition it was when both principal and interest. Any marginally well- the first mortgage came into being, free of all liens and drafted mortgage will also provide that upon the hap- encumbrances. Conveniently, the business decision is pening of certain events of default—such as failure to also confirmed. Someone would pay $200,000 for a house pay principal, interest or taxes, neglect to maintain worth $300,000. Conversely, insurance, among many oth- the business contemplation ers—the lender has the op- would not have been ful- Unlike most other litigation, which tion5 to declare due the en- filled unless all subsequent tire outstanding balance of lienors would be wiped out has few defined stages beyond principal and interest.6 If in by the foreclosure action. initial pleadings and ultimate our example the monthly And the scenario of elimi- mortgage payments were nating the peril imposed by judgment, the foreclosure case has $1,500, after three months, later encumbrances applies specific plateaus, each of which the lender might prefer to re- to most later interests. So, if frain from pursuit of the the borrower sells the prop- must be achieved in order. $4,500 in arrears (plus applic- 7 erty, the grantee takes sub- able late charges ) and in- ject to the mortgage and if stead accelerate the full bal- named and served in the foreclosure action, that title is ance of some $200,000. Acceleration is almost invariably lost. Junior judgments are extinguished; likewise tenan- the final act of the mortgage holder before the file is con- cies and so on. The only exceptions are veyed to counsel to foreclose. taxes and certain municipal “super liens,” the latter par- Foreclosure Search Achieving the foreclosure goal ticularly of concern in New York City. necessitates naming all those with junior interests. The issue of taxes is dealt with by the lender assuring Knowing who those potential parties are is revealed by payment by escrowing for taxes. Alternatively, the analysis of a title search, the variety particularly tailored for a foreclosure action referred to, not surprisingly, as a lender would procure tax searches, becoming thereby 8 armed to insist that the borrower pay delinquent taxes, foreclosure search. Pleadings Possessed with a listing of all junior inter- failing in which the lender can advance those sums, add 9 them to the debt and foreclose for the tax default.2 ests, counsel prepares the summons, complaint and, most often, the notice of pendency, commonly, the lis Steps in the Foreclosure Action pendens (discussed, infra). The prevalent method of foreclosure in New York3 is Filing of Pleadings An action in New York is insti- judicial foreclosure, governed by N.Y. Real Property Ac- tuted by the filing of the initial pleadings. Because it is tions and Proceedings Law article 13 (RPAPL), although possible that interests could attach to the mortgaged any attorney who could prosecute the case in sole re- premises between the time the foreclosure search is liance upon the desultory statutory provisions is worthy completed and the pleadings filed, plaintiff’s counsel is of deification. (Non-judicial foreclosure in this state is best advised to direct the title company to continue the new and of much narrower application.4) search to the moment of filing. Unlike most other litigation, which has few defined Service of Process Litigators recognize the burdens stages beyond initial pleadings and ultimate judgment, of this endeavor. CPLR article 3 generally and CPLR the foreclosure case has specific plateaus, each of which 308(1), (2) and (4) and the service by publication dictates must be achieved in order. Inclusive of the internal pro- of CPLR 316 engender an extraordinary volume of inter- cedures of mortgage servicers—which as a practical twined case law. This is a particular problem in the fore- matter need to be recognized—these stages are as fol- closure case both because there are often multiple defen- lows. dants (all those junior lienors) and because an infirmity Collection Procedures In part because professional in service may not emerge—that is, may not be raised by mortgage servicers want to preserve performing loans a chagrined defendant—until the eve of the foreclosure and avoid foreclosure, they initiate various calls and let- sale. If service was defective, the ritualistic foreclosure ters to the borrower, designed to elicit payment of ar- process can be banished to the inception of the action. rears and reinstatement of the mortgage. Even though Appearance and Answer10 In addition to a CPLR there is no firm rule, traditionally the duration of collec- 3211(a) motion to dismiss (which will only seldom have tion efforts typically does not exceed three months. legitimate application) a defendant has four basic

20 Journal | July/August 2001 choices of response to the foreclosure complaint: de- rection of the referee, typically at the Supreme Court fault, notice of appearance and waiver, general notice of building (although in Suffolk County the venue is the appearance and answer. Default is the least desirable of town hall) where the property is situated. course. It forgoes notice to a defendant of any proceed- Closing17 If the plaintiff is the successful bidder, the ings in the action. Even plaintiffs tend to be ill at ease and its related papers can be signed (or executed) with a default because it presages a defendant’s eve of at the moment of the sale. When there is a third-party sale claim of lack of service. bidder, the usual terms of sale schedule a 30 The notice of appearance and waiver imposes mini- days after the sale. The grantor of the property is the ref- mal delay (thereby reducing case duration and accrual eree and the closing is usually held at the referee’s office. of interest) while still preserving notice of the most cru- 18 cial stages, perhaps referee’s computation and definitely Role of the Notice of Pendency notice of sale and notice of proceedings to obtain sur- A predicate to obtaining judgment of foreclosure and plus monies. sale is a lis pendens on file 20 days before issuance of the 19 The general notice of appearance which, like the no- judgment. Although such is the mandate, there are significant advantages to filing the lis pendens at the in- tice of appearance and waiver can be interposed at any 20 time, creates greater delay and entitles the party to no- ception of the action, and it is often done. tice of all subsequent proceedings. As noted, the foreclosure search suggests to plain- An answer engenders the greatest delay and serves tiff’s counsel who the necessary defendant parties to contest the case, thereby putting the plaintiff to its should be. These are the persons and entities who are proof either via a motion for summary judgment or a then served with process. Suppose that, after being trial. Because an answer is also an appearance, even served, a clever defendant borrower “sells” the mort- after it is stricken, the party who interposed it remains gaged premises to a friendly cousin. Because, obviously, entitled to notice of all proceedings. the cousin is unknown to the plaintiff, that new owner Appointment of Referee to Compute (Order of is not served. Upon the assumption that an owner not served will retain an interest not extinguished by the Reference)11 Once the time has passed for the last de- foreclosure, a plaintiff might be compelled to periodi- fendant to appear or answer (and when any answer cally update the search to ferret out holders of these which may have been interposed has been stricken by later interests. But with what frequency should the motion for summary judgment),12 an application is search continuations be obtained? made for a referee to compute. If there has been neither general notice of appearance nor answer, the order is ob- Even if such an update timely unearths the cousin, tainable ex parte. Where there is an appearance or a what is to prohibit a new conveyance to yet another stricken answer, the application is by notice of motion. compliant relative—or any other cooperative friend or a corporation created for the very purpose of owning the Referee’s Computation The referee is to file an oath property? And each time a new defendant is unearthed, and report of amount due. In practice, these are pre- a motion to amend the caption of the action would be re- pared by plaintiff’s counsel. Duties of the referee are quired. Worse, a new defendant could be discovered a strictly constrained by the order of appointment and are day before the sale. If that person has to be added to the almost invariably confined solely to computation of the case, then served and empowered to answer the com- sum due and determination of whether the property is 13 plaint, it makes the point that no foreclosure would ever to be sold in parcels. If any party has appeared and not end. waived it, or has answered, the formality of a referee’s Borrowers would instantly discover this procedural hearing is required.14 glitch and could effectively cripple the mortgage fore- Judgment of Foreclosure and Sale15 The judgment closure process. But it doesn’t happen that way—be- decrees that the mortgaged premises can finally be sold. cause of the lis pendens. Anyone acquiring an interest in Because it is unnecessarily time-consuming to do so, the real property after the filing of the lis pendens is bound referee’s report should not be confirmed separately but by the action as if they had been served.21 So, if someone should be part of the judgment, sought either ex parte or protests that they were never served in the foreclosure, by motion under the same standards as the order of ref- observing the filing date of the lis pendens may be dis- erence. The judgment also (among other things) ap- positive of any issues. points a referee to sell the property and adjudges defi- ciency liability. Special Consequences of Time Foreclosure Sale16 After statutory advertising re- Legal matters rarely proceed with the dispatch that quirements are fulfilled (approximately four weeks), the clients and their attorneys would prefer. To some extent, foreclosure sale is conducted as an auction under the di- however, this is built into the process and accepted in

Journal | July/August 2001 21 advance with some modicum of equanimity. In the neg- Since most—but certainly not all—mortgage loans ligence case, for example, there are investigations and are designed at the inception to be prudent, there is depositions susceptible to multiple adjournments, fol- often a “reasonable” relationship between the quantum lowed by lengthy trial calendars. But in the foreclosure of the loan and the value of the property it secures. The case, interest upon the obligation accrues every day, foreclosure sale should make the lender whole. The often at a default rate in excess of the note rate. Eventu- greater the positive disparity between the sum due ally, with enough delay, mounting interest will create a the lender and the value of the property, the greater is debt greater than the value of the property. It is appar- the likelihood of a surplus. Only when the property ent, then, that time bears a relationship to generation of is worth less than the amount due the lender can there a surplus (a circumstance amenable to all) or a defi- be a possibility of a deficiency. ciency (an unwelcome occurrence for all). That the usual can readily become unusual should be A surplus emerges when the sum bid at a foreclosure immediately apparent. For example, if the foreclosure sale exceeds the sum decreed due in the judgment to the under discussion raced ahead in six months (unlikely foreclosing lender. A deficiency is a shortfall in recovery though that is) and the property precipitously increased that may be viewed as the converse of a surplus, al- in value by 10% during that time, the numbers would though the reverse correlation is not so exact. The defi- clearly be different. Then, the sum due the lender would ciency is the difference between the sum due the fore- be $430,000 (10% interest for six months instead of a closing lender, inclusive of interest (to which is added year would total $20,000 rather than $40,000). With a the amount owing on all prior liens and encumbrances, 10% increase in value, the property would be worth also with interest, plus costs and disbursements of the $550,000. Under these circumstances, the difference be- action), and the greater of the market value of the fore- tween the total owed the lender ($430,000) and the mar- closed property on the date of the foreclosure sale or the ket value of the property ($550,000) is a whopping proceeds of the foreclosure sale. $120,000. This suggests a considerable probability that All parties to a foreclosure should be to some degree any number of bidders would be most anxious to bid concerned about whether either a surplus or a defi- higher than the upset price. Every dollar bid above ciency will result. One way to gauge the importance of $430,000 then becomes surplus. these possible events is to note the effect upon parties Although surplus is of no consequence to the fore- when there is neither a surplus nor a deficiency. closing party (who cannot receive more than the debt), Suppose for illustration a of $400,000 or to senior encumbrances (whose liens remain attached on a property worth $500,000. (The concept would be to the property), surplus is meaningful to the owner of the same for a $40,000,000 loan on a property worth property (usually, but not always, the borrower) who $50,000,000.) Assume that the mortgage bears interest at was divested of title by the foreclosure, as well as the 10% and that the borrower defaults upon the initial pay- holders of all interests of record junior to the foreclosed ment. Presume further that the foreclosure consumes mortgage. Each of these persons or entities shares in the one year of time to reach the juncture of a sale. The judg- surplus in the order of their respective priorities.22 ment of foreclosure and sale will have decreed that the Returning to the converse—the deficiency—different sum due the foreclosing lender totals $450,000, consist- assumptions in the scenario could reverse the result. ing of $400,000 in principal and $40,000 in interest, with Suppose that instead of taking one year, the foreclosure the remaining $10,000 consisting of accrued late is contested and takes two years to complete. Now the charges, an escrow overdraft to pay taxes, together with interest component of the debt increases from $40,000 to legal fees, costs, disbursements and allowances. $80,000. Assume also that the litigation adds $10,000 in On the final assumption that the value of the prop- additional legal fees and that the property declined in erty had remained stable at $500,000 during the course value by 10% rather than remaining stable or increasing. of the foreclosure, there is some likelihood that the Given the newly recited facts, the sum due the mort- highest price bid at the foreclosure sale will be that sum gage holder aggregates $500,000. With the property now of $450,000 due the lender. If the lender receives all the worth $450,000, it is apparent that no one will bid a sum money due to it, it has neither necessity nor legal sufficient to make the lender whole at the foreclosure grounds to seek recompense from anyone liable for the sale. The probability is that the lender will simply suc- debt—most often the borrower. Hence, there is no defi- ceed to title by bidding a nominal sum at the sale. The ciency. lender will be deemed to have received $450,000—the Nor is there a surplus. So long as the amount bid is value of the property. Having been owed $500,000, how- no higher than the amount due the lender, no money is ever, the loss, or deficiency, is $50,000. Whoever is per- “left over.” All proceeds go to the lender, so nothing re- sonally liable for the mortgage debt can then be sub- mains against which anyone can claim. jected to a motion to obtain a deficiency judgment.23

22 Journal | July/August 2001 Personal Liability for the Debt was declared due.27 Among other sums are what vari- Inherent in the concept of mortgage foreclosure is ous statutes may refer to as costs and allowances. sale of the property to satisfy the debt. But what if the Of usually greater significance are legal fees.28 Al- property is worth less than the sum due to the mortgage though no statute authorizes recoupment of legal fees in holder? That, of course, is the noted deficiency situation, a foreclosure action, the contract (the mortgage) can so which then leads to contemplation of who the parties provide and typically does. Then, reasonable legal fees might be who are liable to the mortgagee. as determined by the court Although it is a more ex- (not the referee) can be pansive subject than this, added to the judgment. Es- anyone who has promised to Notwithstanding that the pecially in a heavily litigated pay the debt is a person so mortgagee’s counsel is armed case, these sums can be quite liable. Conspicuous in this substantial. category are signers of the with all the techniques Also in the category of mortgage note (or bond) and meaningful items are ad- guarantors. They must be to solve the early problems in a vances made by the plaintiff made defendants in the fore- foreclosure, a mortgagor could to protect the lien of the closure action if that shortfall mortgage, such as taxes, in- is to be assessed against choose nevertheless to litigate. surance and payments to se- them. nior mortgagees. Depending That such people or enti- on the nature of the property, ties could be in jeopardy suggests that a mortgage these can be weighty amounts. And then there is the holder might choose to forego a lengthy and possibly matter of interest on those advances. Here, the same tortuous foreclosure, opting instead for an action at law concept controls as with interest on the principal. If the on the note or guarantee. That could be a faster route to mortgage is silent, the note rate applies. But if a separate success and, if the obligors have the proverbial deep provision is made, a higher rate can prevail. It is there- pockets, maybe the most efficacious way to proceed.24 fore easy to observe how a mortgage debt can precipi- One thing mortgagees most often cannot do is fore- tously rise well past expectations of the uninitiated. close and pursue the monetary obligation simultane- ously. New York, like most states, has a one-action rule Receiverships in Foreclosure or an election-of-remedies statute that prohibits such an Notwithstanding that mortgagee’s counsel is armed oppressive dual assault.25 with all the techniques to solve the early problems in a foreclosure, a mortgagor could choose nevertheless to How Much Is Due the Lender? litigate. This situation can then be exacerbated by phys- The quantum of peril to those liable for the mortgage ical deterioration of the property, resulting in diminu- debt is a critical item in the process. Of course, the debt tion of the mortgage security to the point where the consists of principal and interest. Interest is generally a mortgagee will sustain a loss. more momentous category than might first appear. If a A permutation of this idea relates to a commercial mortgage is silent on the subject, upon default the prin- property, for example, a shopping center or an apart- cipal bears interest at the contract or note rate—which is ment building. The mortgagor subjected to a foreclo- in essence the expected rate of return. If, however, the sure, knowing the case will ultimately be lost, embarks mortgage provides for some other rate to apply on de- on a course of action to “bleed” the property. He collects fault, that different and almost inevitably higher per- all the rents and profits but neglects repairs, payment of centage will apply. That might be 15%, or 20%, or 24% taxes, insurance and every other possible cost. This or, as is so in New York, any rate of interest. Because in- turns a handsome profit for the mortgagor and funds a terest on default is deemed neither to be a loan nor a for- protracted defense to the foreclosure. Under these cir- bearance, it cannot run afoul of usury proscriptions.26 cumstances, one need not expound at length upon the But there is still more to it, some of consequence, expected deteriorated value of the mortgaged property some of less importance. Typically, a lender is entitled to at the conclusion of the foreclosure. recoup sums in a number of categories. Disbursements In response to this very real dilemma, the mortgagee is one. Actual out-of-pocket expenditures in the foreclo- has a great asset in the ability to appoint a receiver.29 In sure process—e.g., index number, process service, fore- a foreclosure action, when the lender believes that the closure search, legal advertising, referee’s fees—can be property may decline in value during the progress of added to the foreclosure judgment. So too can late the case or that the mortgagor or some occupant may charges, but only up to the time the mortgage balance allow the property to depreciate or be vandalized, the

Journal | July/August 2001 23 appointment of a receiver is available to preserve the 5. See 1 Bergman § 4.03. premises for the ultimate benefit of the mortgagee. 6. See Default and Acceleration, in 1 Bergman ch. 4. The receiver stands in the shoes of the owner. Once 7. See 1 Bergman § 1.10. appointed and qualified, the receiver has the right to 8. See Ordering and Analyzing the Foreclosure Search, in collect all rent due or to become due arising out of the 1 Bergman ch. 11. Who precisely those parties are to be is premises. The receiver collects the income, maintains in- another major topic, for which reference is invited to Par- ties to the Foreclosure Action, in 1 Bergman ch. 12. surance, pays taxes and makes repairs. The property is, 9. There is, of course, much to preparation of the complaint therefore, preserved. In addition, any excess income is in a mortgage foreclosure action. For details, see The Fore- applied to reduce the mortgage debt, and consequently closure Complaint, in 2 Bergman ch. 16. a twofold purpose is served. Still further, the mort- 10. For a complete discussion of this subject, see Responses to gagor’s interest in delaying the foreclosure is greatly di- the Complaint: Law and Strategies for Plaintiffs and Defen- minished, if not entirely eliminated. dants, in 2 Bergman ch. 19. 11. See Role of the Referee, in 2 Bergman ch. 20. The Prickly Ref- Conclusion eree’s Hearing—If You Stumble, N.Y. Real Prop. L.J. Vol. 24, How does one adequately sum up a subject as ex- No. 1 at 36 (Winter 1996). pansive as mortgage foreclosure? The ready answer is 12. As a practical matter, a motion for summary judgment in that it is not achievable. Even a delineation of but a few the foreclosure case would also seek the appointment of a of the topics excluded exposes the futility of the en- referee. deavor: settlement strategies and devices, defenses to 13. See 2 Bergman § 20.03. foreclosure, parties to the foreclosure action, venue of 14. See 2 Bergman § 20.06. the case, deed in lieu of foreclosure, partial foreclosure, 15. See Judgment of Foreclosure and Sale, in 2 Bergman ch. 27; strict foreclosure, the upset price, foreclosure sale proce- Foreclosure Sales—Unlocking The Bidding ‘Mystery’: There Shouldn’t Even Be One, N.Y.L.J., Nov. 29, 1995, p. 5, col. 2. dures and infirmities, condominium issues, co-op fore- closures and after foreclosure. 16. See The Foreclosure Sale—Process and Elements, in 3 Bergman ch. 30. Living with foreclosure every day, however, reveals 17. See The Foreclosure Closing and Distribution of Sale Proceeds, that it is much like every other area of the law—when it in 3 Bergman ch. 31. is understood viscerally, it is not so mysterious. Maybe 18. See CPLR article 65; Notice of Pendency in the Foreclosure this will serve as a beginning. Case, in 1 Bergman ch. 15. 19. RPAPL § 1331. 1. How, in turn, a junior mortgagee assesses and protects its 20. For a discussion of practice tips relating to the filing of a position is in itself a worthy subject. For a further review, lis pendens, see 1 Bergman, § 15.08[1]. see 1 Bergman on New York Mortgage Foreclosures § 2.16, (Matthew Bender & Co., Inc. 2001) (hereinafter 21. CPLR 6501; 1 Bergman § 15.02. “Bergman”). See also, Foreclosure of the Second Mortgage— 22. For a full discussion of surplus monies in the foreclosure The Nuances of Default on a Second Mortgage are Worthy of case, see Surplus Money Proceeding, in 3 Bergman ch. 35. Note, 11 Servicing Mgmt., 32 (Dec. 1999); Are You Really Junior?—It Sure Matters!, Equity, Oct., 1998, at 24; Assault 23. See generally Deficiency Judgments, in 3 Bergman ch. 34. On The Second Mortgage, 7 Servicing Mgmt., 15 (Mar. 24. See 1 Bergman § 7.13. 1996); So, What’s Your Position, Junior?, 6 Servicing Mgmt., 25. See Election of Remedies, in 1 Bergman ch. 7. 68 (Feb. 1995); A New Look at RPAPL Section 1351 Relief— A Treat for Lenders, N.Y. St. B. Ass’n Real Prop. L. Sec. 26. See 1 Bergman § 6.02[3][g]. Newsl. Vol. 19, No. 4 at 7 (Oct. 1991). 27. See 1 Bergman § 1.10. Confirmed at Last—Yes, Virginia, 2. What represents an actionable mortgage default is an ex- There are Late Charges, and in New York Too, N.Y.L.J., Jan. pansive subject. For a lengthier analysis, see Default and 26, 1994, p. 5, col. 2. Acceleration, in 1 Bergman ch. 4. 28. See Legal Fees, in 2 Bergman ch. 26. 3. See generally Overview and Guide to the Basics of Mortgage 29. For more on this subject, see No Scamming This Time— Foreclosure Concepts and Strategies, in 1 Bergman ch. 2. Protecting Receiver and Foreclosing Plaintiff from Deception, 4. Non-judicial foreclosure—actually “power of sale” fore- N.Y.L.J., Sept. 25, 1996, p. 5 col. 2; The 5 Percent Question— closure in New York—became effective on July 7, 1998 Receiver’s Commission: Confusion Reigns Over “How Much,” with creation of a new RPAPL article 14. It sunset on July N.Y.L.J., May 24, 1995, p. 5 col. 2; Appointing and Paying 1, 2001 with the reasonable prediction, however, that it Receivers in the Mortgage Foreclosure Action, N.Y. St. B.J. would be extended. While designed to reach a sale Vol. 62, No. 1, at 34 (Jan. 1990); Receiverships in the Foreclo- within about three months of initiating the procedure, it sure Action, in 1 Bergman ch. 10. is confined essentially to non-residential , does sometimes require court intervention, and has a number of infirmities which diminish its efficacy. For a further discussion, see Non-Judicial Actions—Statutory Ambiguities Could Cause Delays in Default Cases, N.Y.L.J., Feb. 10, 1999, p. 5, col. 2; Non-Judicial Foreclosure, in 1 Bergman ch. 8.

24 Journal | July/August 2001 Confusury Unraveled: New York Lenders Face Usury Risks In Atypical or Small Transactions

BY JOSHUA STEIN

ew York’s usury law consists of a scrambled col- roads lead to rectangles, representing conclusions. Some lection of statutes, most of which appear in the of these rectangles represent incomplete conclusions. In NNew York General Obligations Law.1 Combined those cases, the rectangle has a second path leading out with federal preemption in certain areas described of it, and the analysis continues down that path because below, these statutes exempt most substantial commer- one must ask more questions. cial lending transactions from any usury restrictions.2 Most boxes on the flowchart contain small reference “Usury” remains a potential trap only for the unwary number(s). Each such number refers to a footnote in the loan shark (who probably does not care, because the ju- following discussion, directing the reader to the text and dicial system is not highly relevant to his activities any- footnotes where a discussion of the particular issue be- way) and participants in a few other atypical or small gins. That discussion contains citations, details, qualifi- lending transactions.3 cations, and more information to consider. The flow- In the occasional weird case where usury restrictions chart should be considered only in the context of this do apply, a violation can invalidate the entire loan and article as a whole. constitute a felony.4 A practitioner must be alert to this Do not take this flowchart too literally. It merely sum- risk whenever considering any loan transaction that is marizes information in a way that many people find small or involves a borrower other than a corporation or practical and interesting. An attorney considering a par- limited liability company.5 ticular set of facts may find that by using some other As in any other area, the practitioner should always order or approach instead, the attorney will achieve the refer to the most current version of the applicable best possible result and the most appropriate analytical statutes and other law before rendering any advice on basis for it. New York usury law. Maximum Rate The following discussion of New York usury law In the rare factual circumstance where New York’s does not cover any loan restrictions beyond usury and usury ceiling actually applies and federal law does not compound interest, such as prepayment, attorneys’ fees, preempt it, a lender usually cannot charge interest discount points, prepaid interest, and late charges. Ad- higher than 16% per annum.8 The Banking Law contains justable-rate residential mortgages are subject to their similar provisions.9 “Interest” includes certain other own interacting federal and state limitations and disclo- charges payable to the lender on account of the loan. sure requirements, which are beyond the scope of this article.6 Exemptions for broker-dealer loans are also not 7 addressed. For ordinary mortgage loan transactions, JOSHUA STEIN is a real estate and fi- the most common escape hatches from usury include nance partner in the New York office those discussed below. of Latham & Watkins (e-mail The flowchart accompanying this article is designed [email protected]). A member of to summarize New York’s usury maze. The flowchart the American College of Real Estate analysis begins on page 28, with the oval marked Lawyers, he serves as chair of the “START.” It continues down the page. Lines indicate the Practising Law Institute annual semi- sequence of issues to consider. Diamond boxes indicate nar on commercial real estate financ- ing. This article will be a chapter in decision points, each with a question that can be an- the author’s forthcoming book, New York Commercial swered “YES” or “NO.” Depending on the answer, the Mortgage Transactions (Aspen Law & Business). The au- analysis continues down one path or the other. thor is a graduate of the University of California at The paths of analysis sometimes lead to more dia- Berkeley and received his J.D. from Columbia University. mond boxes, each another decision point. Eventually, all

Journal | July/August 2001 25 The usury ceiling rises by 150 basis points to 17.5% per the lender must still confront another old friend, the annum for loans secured by cooperative apartments.10 mortgage recording tax. If the loan documents provide, Floating-rate loans and loans that contemplate future or the parties ever agree, that unpaid interest shall be advances create a few special complications of their added to principal (for example, as part of a workout), own, which are beyond the scope of this article.11 then the loan thereby incurs additional mortgage The courts have established some rules for calculat- recording tax on the resulting new “principal indebted- ing just how much interest a lender is actually collecting ness.” Moreover, the Department of Taxation and Fi- on a loan (such as the effect of prepayment of interest). nance takes the view that as soon as interest starts to ac- These rules can be crucial in close cases but are outside crue on previously accrued interest, the previously the scope of the present discussion. accrued interest becomes principal and hence itself sub- ject to mortgage recording tax.18 Compound Interest Independent of the usury restrictions, New York lim- Penalties for Usury 19 its a lender’s ability to collect compound interest. Even If a loan is usurious, it becomes wholly void. The 20 if a loan is not usurious, the lender may be barred from lender forfeits all principal and interest (the loan be- charging interest on the borrower’s unpaid interest. In comes a gift) and the borrower can also recover the usu- 21 general, New York prohibits compound interest on any rious portion of the interest previously paid. If the loan of $250,000 or less, except in the following cases: lender is “a savings bank, a savings and loan association • Certain Business Loans. Business loans of $100,000 or or a federal savings and loan association” or within cer- more secured under the Uniform Commercial Code tain other categories of institutional lender, the statute with a rate at or below prime plus 8% percent per provides a different penalty: the lender forfeits all inter- annum;12 est (not just the usurious part of the interest), but not principal, and may also be required to repay the bor- • Certain UCC Loans. Demand loans of $5,000 or more 22 secured by certain Uniform Commercial Code docu- rower twice the interest actually paid. 13 ments; and Criminal Usury • Other. Statutory exceptions enacted for particular in- New York has a separate criminal usury ceiling of 14 dustries. 25% per annum on nonexempt loans. Any lender that New York prohibits compound interest on any loan, knowingly collects criminally usurious interest commits regardless of amount, secured by a “one or two family a felony.23 The criminal usury ceiling applies to some owner-occupied residence,” including a cooperative loans that are not subject to civil usury restrictions at all: apartment.15 loans of $250,000 or more; and certain secured loans of If a lender illegally charges compound interest and $5,000 or more that are payable on demand. the net effective interest rate after compounding is at or In these cases, however, New York law does not ap- below the usury ceiling, he or she must refund the pear to give the victim of usury any express civil rem- “compounded” part of the interest but not the other in- edy against the lender.24 A few cases say that banking in- terest already paid. In that case, the lender faces no stitutions are exempt from criminal liability for usury.25 other forfeiture risk. If the effective interest rate, after The only penalty available against them would thus ap- compounding, exceeds the usury ceiling, then the se- pear to be forfeiture. vere penalties for regular “usury” will apply.16 Until 1989, New York courts had, for almost two cen- Federal Preemption for Residential turies, invalidated compound interest in a number of First-Mortgage Loans cases, as if interest payable on unpaid dollars of “inter- Federal law preempts all state interest-rate restric- est” was something completely different from interest tions, presumably both “usury” and “compound inter- payable on unpaid dollars of “principal.” Although in est” restrictions, for residential first-mortgage loans (in- recent years courts have sometimes apparently strug- cluding first-lien co-op loans) made to any borrower by gled to find exceptions to the general New York rules any federally insured institution, federally regulated against compound interest, New York has retained its lender, federal government agency, lender approved by common law rule against compound interest. The Leg- the Federal Home Loan Mortgage Corporation (Freddie islature solved the problem in 1989 primarily at the urg- Mac), any other lender that regularly makes residential ing of Martin E. Gold, formerly director of corporate mortgage loans totaling more than $1,000,000 a year, or law in the New York City Law Department and now a number of other lenders regulated by or connected with Sidley Austin Brown & Wood in Manhattan.17 with the federal government. If a mortgage loan that provides for “compound” in- Although Congress allowed the states to override the terest does not run afoul of New York’s rules in this area, federal usury preemption for residential first-mortgage

26 Journal | July/August 2001 loans, New York did not. To the contrary, New York af- even as an affirmative claim. A New York corporate or firmed the federal override.26 As a result, virtually all LLC borrower can still assert the invalidity of com- residential first mortgages27 are exempt from New York pound interest on loans of $250,000 or less.39 The usury usury restrictions.28 Federal law also supersedes state exemption for loans made to a corporate or LLC bor- usury restrictions for certain other categories of loans, rower does not apply to entities formed to own a one- or but these miscellaneous exemptions generally will have two-family dwelling.40 Finally, a corporate loan remains no practical effect given the other exemptions and pre- potentially subject to criminal usury restrictions, as de- emptions available and today’s rate environment.29 scribed elsewhere in this article, although these restric- tions are enforceable solely by the state. Junior Mortgages; Other Institutional A commentator on New York usury law recently de- Lender Exemptions scribed the remaining usury restrictions on corporate A New York state-chartered bank or trust company loans as being much like “the appendix in humans and or licensed mortgage banker may make junior mortgage wings on flightless birds,” and as an economic matter loans to individual borrowers at whatever interest rate “not only useless, but unsound as well.”41 is “agreed to by the [lender] and the borrower.”30 By im- plication these loans are exempt from the usury ceiling Loans of $250,000 or More in the New York General Obligations Law.31 Any loan of $250,000 or more not “secured primarily Similar exemptions-by-implication would probably by an interest in real property improved by a one or two apply to certain “personal loans” made by a state bank family residence” is treated the same as any loan of or trust company, foreign bank, or other licensed $2,500,000 or more, except that criminal usury restric- lenders.32 Other state banking-related statutes may per- tions still apply.42 mit specific regulated lenders to charge interest above Various additional statutory exemptions sometimes the usury ceiling. also come into play.43 Loans of $2,500,000 or More Usury Savings Clauses Any loan of $2,500,000 or more (including obligatory Lenders will often include in their documents “usury future advances) is exempt from all usury restrictions, savings clauses,” language saying that if the loan turns including criminal usury.33 This simple provision of out to be usurious, then any payments by the borrower New York law basically solves the usury problem for all above the allowable rate shall be retroactively recharac- substantial commercial loans and is a major part of the terized as repayments of principal. In the few cases that reason that multistate loan transactions are often gov- have considered the validity and effectiveness of such erned by New York law. clauses, the results were not encouraging for lenders. If, however, the loan is secured by a “one or two fam- The decision in Federal Home Loan Mortgage Corp. v. 44 ily owner-occupied residence,” including a cooperative 333 Neptune Avenue Limited Partnership offers an inter- 45 apartment,34 the lender still cannot collect compound in- esting, though typically unilluminating, example. terest.35 For most residential first mortgages, however, There, a bankruptcy court applying New York law ini- as previously described, federal law would preempt tially found that the loan, although usurious, was saved even the restriction on compound interest. by the “usury savings” clause. The District Court for the Eastern District of New York rejected that reasoning, Limited Liability Company and Corporate concluding instead that the “‘usury-avoidance’ provi- Borrowers sion does not save the otherwise usurious loan. Since A limited liability company (LLC) or corporate bor- the loan is usurious, it is void.”46 The court followed by rower cannot “interpose the defense of usury in any ac- analogy an old and well-established line of New York tion,”36 nor can a guarantor of a corporation’s debt.37 cases holding that a lender cannot cure an otherwise The same logic would suggest that a guarantor of a lim- usurious loan by simply returning to the borrower (or ited liability company’s obligations should also not be alternatively, allowing credit for) interest payments able to raise a usury defense. The courts do not seem, above the usury cap.47 however, in any reported case to date to have addressed On appeal of the 333 Neptune Avenue case, the Second the implications for a guarantor. Circuit explicitly refused to adjudicate the issue, saying Some very old cases suggest that a corporation also that the “usury savings” provision raises “knotty and cannot affirmatively commence an action to invalidate a undecided questions of New York state law that are best usurious obligation.38 No recent New York case has con- avoided by federal courts.”48 The appellate court va- sidered this question. The courts’ general attitude in this cated and remanded the decision of the District Court. area would indicate, however, that a corporation (pre- No published opinion was available at the time of this sumably also an LLC) probably could not assert usury research.

Journal | July/August 2001 27 FLOW CHART

12-17

8-9

26-29

12-17 10 30-32

12-17

33-35

19-22

OR LLC 12 36-41 12

19-22 19-22

12

42-43

23-25

COMPOUNDING 12-17 13 23-25 12-17

The numbers in the ovals indicate the endnote references where these topics are covered in the text.

A few years earlier, the Appellate Division in a mem- The court cited its own 1965 decision, Durst v. orandum decision ignored a “usury savings” provision. Abrash,50 where it had concluded that even if the parties Although the loan documents in that case said that if the agree to arbitrate any disputes over the interest rate, the interest rate were found to be usurious it would drop to courts can still examine whether a loan is usurious and the legal rate, the court decided this was not enough to impose appropriate remedies.51 Over a dissent that im- make the loan nonusurious.49 plied the usury statutes may be second- or third-class

28 Journal | July/August 2001 52 citizens in the statute books, the Durst majority con- 1. For more on New York usury law, see Bruce J. Bergman, 1 cluded that usury statutes are to be taken seriously and Bergman on New York Mortgage Foreclosures, § 6.01, the parties should not be able to sidestep them.53 By cit- (Matthew Bender & Co., Inc. 2001). ing the Durst case in its 1994 case on usury savings 2. Although this work generally disregards residential transactions, they must be taken into account to provide clauses, the court suggested that it regards usury sav- a reasonable summary of New York usury law. ings clauses as the functional equivalent of using arbi- 3. This article is based in substantial part on the author’s tration to avoid usury issues. previous article on New York usury law. See Joshua Stein, The question of the enforceability of usury savings Confusury Unraveled: A Road Map of New York’s Usury Law, N.Y. St. B. Ass’n Real Prop. L. Sec. Newsl., Vol. 21, No. 4, clauses has not been resolved by the New York Court of at 17 (Fall 1993). That article was extensively updated Appeals. The reported cases to date suggest serious and expanded for this republication. skepticism regarding such clauses, though they would 4. See N.Y. Penal Law §§ 190.40, 190.42 (hereinafter “Penal appear to do no harm. Law”). 5. Thus New York, which prides itself on being more practi- In contrast, it is the author’s sense that practitioners cal and business-like than California, ends up with a in this area do place some weight on usury savings usury law functionally the same as California’s, which clauses. Practitioners may assume that usury savings one article described as follows: clauses work, based perhaps on the general theories that [U]sury law [in California] does not seriously in- convenience most lenders and offers very little pro- (a) the courts don’t like usury law very much; and tection to most borrowers. The law in this area has (b) words in a document usually mean what they say. a loud bark but rarely bites. However, its rare bite The preceding discussion demonstrates, however, that can be painful indeed. This may be good politics, neither assumption is necessarily correct in the area of but it makes for complex law. usury savings clauses. Practitioners should place little E. Rabin & R. Brownlie, Usury Law in California: A Guide Through the Maze, 20 U.C. Davis L. Rev. 397, 440 (1987). or no reliance on usury savings clauses. In particular, if 6. See 12 U.S.C. § 3803(c) (1998); 12 C.F.R. § 226.19 (1999); counsel is asked to opine that a loan is not usurious, N.Y. Banking Law §§ 6-f, 6-g (hereinafter “Banking Law”). counsel should reach that conclusion based on some- 7. See N.Y. General Obligations Law § 5-525 (hereinafter thing other than a usury savings clause. “GOL”). 8. See GOL § 5-501(1) (maximum usury rate 6% unless oth- Usury Summary and Conclusion erwise provided in Banking Law § 14-a); Banking Law Considered as a whole, the usury exemptions and § 14-a(1) (16% maximum usury rate for purposes of GOL § 5-501). GOL § 5-501(3)(b) sets special rules for most res- preemptions summarized above virtually assure that idential loans where the annual interest rate exceeds 6%. any significant commercial loan, and almost every resi- In these cases, the borrower has the statutory right to pre- dential mortgage loan, will be exempt from New York pay at any time. The lender cannot collect a prepayment fee unless the prepayment occurs in the first year and the usury restrictions. Aside from the exemptions and pre- documents expressly provide for such a fee. See GOL emptions discussed above, particular factual situations § 5-501(3)(b). This statute expressly provides for federal may suggest other usury defenses and definitional ex- preemption. clusions found in the cases but not discussed here. 9. See Banking Law § 14-a(1); see also, e.g., Banking Law §§ 108(1) (state bank or trust company), 173(1) (private Common escape hatches from usury include: (1) in- bankers), 202(1) (foreign banks), 510-a (investment com- terest after default or after maturity; (2) deferred pur- panies); Comp. Codes R. & Regs. tit. 3, § 4.1 (hereinafter chase price;54 (3) waiver; (4) burdens of proof; (5) stand- “N.Y.C.R.R.”). ing (the usury defense is available only to the original 10. Banking Law §§ 103(5), 235(8-a), 380(2-a). borrower); (6) application of another state’s law; 11. GOL § 5-501(4), (4-a); Banking Law § 14-a(1)-(2); 3 N.Y.C.R.R. §§ 4.1, 4.2 (regulations adopted by Banking (7) estoppel (including the borrower’s delivery of an Board). 55 estoppel certificate ); and (8) other equitable defenses. 12. GOL § 5-526. The prime rate means “the average prime Does title insurance solve any possible usury prob- rate on short term business loans which is published by the board of governors of the federal reserve system for lem? No. The American Land Title Association 1992 the most recent week which was publicly available from standard loan policy of title insurance expressly ex- the board of governors of the federal reserve system on cludes any coverage for usury.56 And the New York title the previous business day.” GOL § 5-526(4). insurance industry’s rate manual does not allow title in- 13. GOL § 5-523. surance companies to insure against usury risks, such as 14. See, e.g., N.Y. Insurance Law § 3203(a)(8)(G); Martin E. Gold, New York Approves Law Legalizing Compound Interest, by issuing a usury endorsement. N.Y. St. B. J., Vol. 62, No. 6, at 26 (Oct. 1990) (citing other Given how easy it is to steer clear of usury problems industry-specific statutory exceptions). in New York commercial transactions, however, the lack 15. See GOL § 5-527(2). The statute defines “residence” to of title insurance protection against New York usury “include” a cooperative apartment, but says nothing about condominiums. A court would probably say “resi- rarely causes much concern in this area of practice. dence” also includes a condominium apartment.

Journal | July/August 2001 29 16. Giventer v. Arnow, 37 N.Y.2d 305, 372 N.Y.S.2d 63 (1975). which just replicates the principal indebtedness secured 17. The history of compound interest in New York and the by the old underlying mortgage. The borrower makes 1989 legislation are described in two articles by Mr. Gold: payments only to the holder of the “wraparound,” who is Compound Interest: Legalization Wins Approval, N.Y.L.J., June supposed to pay the “underlying” mortgage. Typically 15, 1989, p. 1; and New York Approves Law Legalizing Com- the holder of the wraparound mortgage benefits from the pound Interest, N.Y. St. B. J., Vol. 62, No. 6, at 26 (Oct. 1990). difference between a low interest rate on the underlying mortgage and a higher rate on the entire wraparound 18. See Op. N.Y. State Dep’t of Taxation & Fin., Ticor Title mortgage. These transactions are less common today than Guarantee Company, N.Y. St. Tax Rptr. (CCH) & 401-177 at they once were, for several reasons. First, interest rates 46,171 (June 25, 1993) (mortgage recording tax imposed are relatively low. Second, most existing mortgages cate- on capitalized interest “as if the interest had been actually gorically prohibit any further mortgages. Third, wrap- paid to the mortgagee and the mortgagee then loaned the around mortgages create substantial risks for all parties same amount back to the mortgagor”). Goldberg asks except the holder of the wraparound—risks that were not whether the parties might avoid this result by recharac- adequately identified, analyzed, and dealt with during terizing the “compound interest” as simple interest calcu- the last wave of wraparound financing. Finally, those lated using a different formula. risks created unique problems for cooperative apartment If interest has become due, and the lender then corporations, which were often left as potential baghold- agrees to defer payment of that interest in return for ers in the early 1990s when a sponsor took back a wrap- the borrower’s agreement to pay interest on the de- around mortgage, assigned it to “Wrap, Inc.” (literally, in ferred interest, or if the borrower exercises an op- at least one case), then defaulted on maintenance pay- tion to capitalize interest, then it would seem that ments for the unsold apartments, yet continued to collect the deferred interest has become principal. How- payments on the wraparound mortgage. The “wrap- ever, if the initial loan agreement provided that in- around mortgage” structure is not highly favored today, terest would be compounded, then it would seem, but is still occasionally seen. although this is not the present state of the law, that 28. Common exceptions include mortgages involving un- the compounding is merely the means of calculat- usual lenders and careless lenders taking a mortgage on a ing the cost of borrowing the original principal. “residential manufactured home” that fail to comply with David M. Goldberg, Transfer and Mortgage Recording certain consumer protection requirements. See 12 U.S.C. Taxes in New York Title Closings § 6-13(a) (Lexis Law § 1735f-7a(c), (d), (e)(4); Quiller v. Barclays American/Credit Publishing). In Cosmopolitan Broad. Corp. v. State Tax Inc., 764 F.2d 1400 (11th Cir. 1985) (construing the transac- Comm’n, 78 A.D.2d 475, 435 N.Y.S.2d 804 (3d Dep’t 1981), tion as nevertheless complying with federal regulations the court required payment of mortgage recording tax on because language allowing borrower a right to cure im- the total amount of principal indebtedness when the doc- plied borrower would receive notice of default), aff’g en uments failed to distinguish between principal and inter- banc 727 F.2d 1067, 1072 (11th Cir. 1984) (denying protec- est. If unpaid interest is added to principal, the logical ex- tion of federal preemption because a contract term al- tension of this case would require payment of mortgage lowed lender to commence foreclosure without notice recording tax on the additional principal indebtedness. upon default); 12 C.F.R. § 590.1-4 (implementing regula- 19. GOL § 5-511(1) (unless lender is a savings bank, savings tions for consumer protection). and loan association, or federal savings and loan associa- 29. See, e.g., 12 U.S.C. § 1735f-7a (loans insured under Titles I tion). See Eikenberry v. Adirondack Spring Water Co., 65 and II of National Housing Act); 38 U.S.C. § 3728 (Veter- N.Y.2d 125, 126, 490 N.Y.S.2d 484 (1985). ans Administration guaranteed loans); 12 U.S.C. § 85 (na- 20. GOL § 5-511. tional banks not subject to states’ discriminatory rate caps 21. GOL §§ 5-511, 5-513. But see GOL § 5-519 (granting par- or caps below discount rate plus 1%); 12 U.S.C. § 1831d tial relief if lender repays excess interest). (preempting state usury ceilings below discount rate plus 1%); Depository Institutions Deregulation and Monetary 22. GOL §§ 5-511(1), 5-513; see, e.g., Banking Law §§ 108(6), Control Act of 1980, Pub. L. No. 96-221, § 511(a), 94 Stat. 202(7), 235-b, 380-e, 510-(a)(1). 132 (certain business and agricultural loans made be- 23. Penal Law §§ 190.40, 190.42. tween 1980 and 1983); GOL § 5-501(5) (loans insured by 24. See American Express Co. v. Brown, 392 F. Supp. 235, 238 “federal housing commissioner” or pursuant to “Service- (S.D.N.Y. 1975) (discussing the inability of the victim “to men’s Readjustment Act of 1944”). The foregoing does personally enforce the criminal usury law of the state”) not purport to list all banking-related statutes that could (dictum). preempt New York usury laws. 25. See Flushing Nat’l Bank v. Pinetop Bldg. Corp., 54 A.D.2d 30. See Banking Law §§ 103(4-a) (state bank or trust com- 555, 387 N.Y.S.2d 8 (2d Dep’t 1976) (citing Franklin Nat’l pany), 591-a(1) (licensed mortgage bankers, limiting secu- Bank of Long Island v. DeGiacomo, 20 A.D.2d 797, 248 rity to residential real property on mortgage that is not a N.Y.S.2d 586 (2d Dep’t 1964); Reisman v. Hartman & Sons, first lien). Inc., 51 Misc. 2d 393, 273 N.Y.S.2d 295 (Sup. Ct., Queens 31. See Novelty Textile Mills, Inc. v. Hopkins, 145 Misc. 2d 583, Co. 1966). See also Tides Edge Corp. v. Central Fed. Sav., 547 N.Y.S.2d 516, 517 (Sup. Ct., Bronx Co. 1989). F.S.B., 151 A.D.2d 741, 542 N.Y.S.2d 763 (2d Dep’t 1989). 32. See Banking Law §§ 108(4)(b), (5)(b), 202(4)(b), 352(a). 26. Banking Law § 14-a(7). These “exemptions-by-implication” might not avoid 27. The term “first mortgage” would probably not include a criminal usury problems. wraparound mortgage. See Mitchell v. Trustees of U.S. Mut. 33. See GOL § 5-501(6)(b). Real Estate Inv. Trust, 375 N.W.2d 424, 430 (Mich. Ct. App. 34. The statute does not expressly refer to condominium 1985). This type of mortgage arises where the parties apartments. One would expect a court to treat condo- want to preserve an existing mortgage, probably with a minium apartments the same as cooperative apartments, below-market interest rate. The borrower signs a new as they would seem to be functionally equivalent at least mortgage, part of which is “new money” and part of for purposes of usury and consumer protection.

30 Journal | July/August 2001 35. See GOL § 5-527(2). 50. 22 A.D.2d 39, 253 N.Y.S.2d 351 (1st Dep’t), aff’d, 17 N.Y.2d 36. GOL § 5-521(1); N.Y. Ltd. Limited Liability Company 445, 266 N.Y.S.2d 806 (1965). Law § 1104. 51. Id. at 44 (“[If] usurious agreements could be made en- 37. See First Nat’l Bank of Amenia v. Mountain Food Enter., Inc., forceable by the simple device of employing arbitration 159 A.D.2d 900, 553 N.Y.S.2d 233, 234 (3d Dep’t 1990). clauses the courts would be surrendering their control The documents in this case were vague about whether over public policy in a way in which the Court of Ap- the corporation or the individual guarantor was the true peals . . . made very clear could not happen.”). borrower. The court decided that the availability of the 52. This is a characterization with which the author would usury defense hinged on “whether the loan was made to agree, at least in the world of commercial mortgage loans. repay personal obligations or to further a profit-oriented 53. Durst, 253 N.Y.S.2d at 356 (“The welter of legislation in enterprise.” Id. at 235. If the latter, then neither borrower this area makes clear that the concern is one of grave nor guarantor could raise a usury defense. public interest and not merely a regulation with respect 38. See, e.g., Atlantic Trust Co. v. Proceeds of the Vigilancia, 68 F. to which the immediate parties may contract freely.”) 781, 782 (S.D.N.Y. 1895) (stating that the usury statute is, 54. See, e.g., Mandelino v. Fribourg, 23 N.Y.2d 145, 295 N.Y.S.2d in effect, repealed as to corporations, citing Merchants 654 (1968); Christopher v. Gurrieri, 238 A.D.2d 299, 655 Exch. Nat’l Bank v. Commercial Warehouse Co., 49 N.Y. 635 N.Y.S.2d 654, 655 (2d Dep’t 1997) (mem.) (where promis- (1872); Rosa v. Butterfield, 33 N.Y. 665 (1865); Curtis v. Leav- sory note arose from purchase of business, it “was neither itt, 15 N.Y. 9 (1857)). a loan nor a forbearance . . . but was in the nature of a 39. Although loans to a borrower of this type remain subject purchase money mortgage which is not subject to the to “criminal usury” limits, that statute is a criminal one usury laws”). Compare C&M Air Sys., Inc. v. Custom Land enforceable only by the state. Dev. Group II, 262 A.D.2d 440, 692 N.Y.S.2d 146 (2d Dep’t 40. See GOL § 5-521(2). 1999) (upholding an interest rate defined in the docu- 41. Paul Golden, Evolution of Corporate Usury Laws Has Left ments as “the highest rate of interest permitted,” without Vestigial Statutes That Hinder Business Transactions, N.Y. St. deciding whether the transaction was an exempt pur- B. Ass’n J., Vol. 73, No. 4, at 20 (May 2001). Mr. Golden is chase money loan). The usury exemption for deferred right on all counts. purchase price may also be available to a third-party lender that finances an acquisition. Dallas v. Dallas, 182 42. See GOL § 5-501(6)(a). A.D.2d 1039, 582 N.Y.S.2d 835, 836 (3d Dep’t 1992) (“[a] 43. These include the following: Any loan of $5,000 or more, mortgage given to secure money, borrowed for the pur- payable on demand, secured by a pledge of documents of pose of purchasing real property, is generally held to be a title or negotiable instruments under Article 3, 7, or 8 of purchase-money mortgage, notwithstanding that the the Uniform Commercial Code, is exempt from all restric- mortgage was given to a person other than the seller,” cit- tions on interest rates and interest compounding, except ing Barone v. Frie, 99 A.D.2d 129, 472 N.Y.S.2d 119, 121 (2d criminal usury. See GOL § 5-523. The Banking Law con- Dep’t 1984)). But see Bruce J. Bergman, Usury and the Pur- tains similar provisions. See, e.g., Banking Law § 510-a(2) chase Money Mortgage—An Appellate Division Faux (loans by investment companies). In general, no usury re- Pas(?)(!), N.Y. St. B. Ass’n Real Prop. L. Sec. Newsl., Vol. strictions apply, not even criminal usury, when a corpora- 21, No. 1, at 4 (Jan. 1993) (describing Dallas case as “man- tion borrows $100,000 or more (not including future dis- ifestly incorrect”). There is no reason to think that New cretionary advances) for business purposes, at a rate of York’s usury exemption for purchase-money mortgages up to prime plus 8% per annum, granting a UCC security applies only to first mortgages, although the author is not interest as security. See GOL § 5-526. aware of any authority on point. 44. 1999 WL 390837 (E.D.N.Y. 1999). 55. In Hammelburger v. Foursome Inn Corp., 54 N.Y.2d 580, 584, 45. The usury savings clause at issue stated in relevant part: 446 N.Y.S.2d 917, 919 (1981), the Court of Appeals con- Under no circumstances shall Mortgagor be cluded that, based on delivery of an estoppel certificate charged under the note or this Mortgage, more than in connection with an assignment of the loan, the mort- the highest rate of interest which lawfully may be gagor “will be estopped from asserting the defense of charged by the holder of this Note and paid by the criminal usury” unless the assignee knew about the prob- Mortgagor on the indebtedness secured hereby. . . . lem or knew that the estoppel certificate was obtained Should any amount be paid to Mortgagee in excess under duress. If criminal usury arises whenever the rate of such legal rate, such excess shall be deemed to exceeds 25% per annum, how could an assignee claim ig- have been paid in reduction of the principal balance norance of the criminal usury problem? Answer: the rate of the Note. in the documents might have been 24%, but if the origi- Federal Home Loan Mortgage Corp. v. 333 Neptune Ave. L.P., nal lender had extracted a 10% loan fee, not mentioned in 201 F.3d 431 (2d Cir. 1999) (as quoted in an unpublished the documents, this would probably bring the effective Second Circuit opinion). interest rate above 25%, depending on the term of the loan. Such a loan might be criminally usurious, but the 46. 333 Neptune Avenue, 1999 U.S. App. LEXIS 32056, at *5. assignee might not know it. If an estoppel certificate can 47. See Babcock v. Berlin, 123 Misc. 2d 1030, 475 N.Y.S.2d 212 immunize an otherwise usurious loan, can the original (Sup. Ct., Suffolk Co. 1984); Bowery Sav. Bank v. Nirenstein, holder use this principle protectively, such as by requir- 269 N.Y. 259 (1935). See also Yakutsk v. Alfino, 43 A.D.2d ing the borrower to deliver an estoppel certificate either 552, 349 N.Y.S.2d 718 (1st Dep’t 1973) (giving credit for at the closing or shortly thereafter to induce the holder to excess interest will not cure a usurious loan). agree to some modification of the loan? Can the original 48. 201 F.3d 431 (2d Cir. 1999). holder rely on such an estoppel certificate? 49. See Simsbury Fund, Inc. v. New St. Louis Assocs., 204 56. See ALTA 1992 Loan Policy “Exclusion from Coverage” A.D.2d 182, 611 N.Y.S.2d 557 (1st Dep’t 1994). No. 5.

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Call to Order 1-800-582-2452 Source Code: CL1390 8/2001 Wall Street Remains a Key Player In Commercial Real Estate Financing Despite Capital Market Fluctuations

BY JOSEPH PHILIP FORTE

o better understand the context of real estate fi- not have to be structured to minimize the credit risks in- nance as we head into the 21st century, it is in- herent in real estate finance transactions. Tstructive to understand where we have been, The development of conventional or Private Label where we are now, and where we are headed. MBS residential transactions was, however, hampered Historically, real estate finance business was con- by credit risk concerns. While some isolated Private ducted within local markets. The traditional sources of Label MBS issuance occurred in the late 1970s, non-GSE real estate financing for acquisition, development and securitization of whole loans did not gain momentum construction have been the institutional lenders that do until the thrift industry crises in the high interest rate business in that local “Main Street” market—the com- environment of the early 1980s. Based on its good expe- mercial banks, thrifts, and insurance companies. rience with GSE-issued MBS, Wall Street saw a unique Until recently, primary market lenders generally did opportunity to profit from the thrift crisis by proffering not approach the capital, or “Wall Street,” market for the securitization exit strategy as the solution to the funding. Likewise, Wall Street rarely made forays into thrifts’ residential portfolio dilemma. Real estate assets, the local real estate finance markets; when it did, it was such as mortgages, are inherently illiquid and are not as to serve an existing investment banking client with cor- freely transferable as securities. If the real estate assets porate real estate needs. Thus, while Main Street lenders serve as a basis for the issuance of securities, however, focused primarily on the individual real estate project, greater liquidity can be attained through a vehicle sepa- Wall Street’s focus in real estate finance was limited to rate from the real estate assets. corporate client relationships. In recent years, however, Without a GSE issuer and the credit enhancement Wall Street has expanded its real estate focus to become from a government guarantee, the Wall Street market another source of real estate financing. would not consider a Private Label MBS to be equiva- lent to a GSE-issued MBS. With a Private Label MBS, an Background investor would need to be concerned with the credit of Residential Mortgage-Backed Securities (MBS) the issuer as well as with the usual credit risks associ- Wall Street’s orientation began to shift when Govern- ated with real estate assets. To assure the market of ment Sponsored Entities (GSEs) entered the residential timely payments on the securities, it became necessary 1 real estate finance markets nationwide in the 1970s. to structure the Private Label transactions to provide Wall Street discovered and quickly exploited the oppor- credit support.4 This credit support can be provided by tunity to profit from the inefficiency of the fragmented residential real estate finance market. Although residential mortgage-backed securities JOSEPH PHILIP FORTE is a partner at (MBS)2 issued by the Federal National Mortgage Asso- Thacher Proffitt & Wood in New York ciation (FNMA) and the Federal Home Loan Mortgage City and a member of the Steering Committee of the Capital Consortium. Corporation (FHLMC) were not backed by the full faith He is a past president of the Commer- and credit of the United States, as GNMA’s MBS were, cial Mortgage Securities Association the government sponsorship of the GSEs created an im- and the publisher of its quarterly mag- 3 plicit government guarantee in the perception of capi- azine, CMBS World. He is also the co- tal markets. This shadow guarantee, coupled with some chair of the Real Estate Financing and Federal Housing Administration and Veteran’s Admin- Liens Committee of the NYSBA Real Sec- istration (FHA/VA) Loan pools, was the equivalent of a tion. He is a graduate of St. Francis College and received two-tier credit enhancement. Without the usual capital his J.D. degree from St. John’s University School of Law. markets credit concerns, the MBS issued by GSEs did

34 Journal | July/August 2001 third party or issuer credit enhancement or by the struc- ture of the transaction.5 While mortgage loan sellers in the secondary market typically make representations Impetus to Changes in and warranties concerning their mortgage loans and are Real Estate Markets generally obligated to repurchase the related mortgages in the event of a default, representations and warranties In August of 1998, real estate borrowers were by a seller are not considered to be credit enhancement 6 shocked to discover that the collapse of an Asian cur- for a structured transaction in the capital markets. rency and a Russian bond default adversely affected In determining whether to purchase a particular class their ability to seek simple real estate financing in of securities, capital markets investors generally place hometown America. As a result of developments in enormous reliance upon the investment grade rating as- the early 1990s, commercial real estate financing be- signed to the issuance by one or more of the national came an integral part of the capital markets. “Con- 7 credit rating agencies. Credit enhancement makes the duits” had replaced savings and loan associations as Private Label MBS more acceptable to capital markets the source of capital and liquidity for many borrow- investors and substantially increases the possible base ers. of investors because it enables an issuer to obtain an in- This access to the capital markets was both “good vestment grade credit rating for its MBS issuance. In- news” and “bad news” for the traditional borrower vestment grade ratings, therefore, become the key to and the traditional real estate lender. Local real estate success in the capital markets by allowing investors to was suddenly being affected by events in the world dispense with the in-depth review of the real estate that financial markets with an immediacy far different a primary market lender would undertake in its normal 8 from the traditional real estate lag in a falling econ- underwriting process. omy. Real estate borrowers now had access to capital Commercial Mortgage-Backed Securities (CMBS) markets, but also had to cope with the consequences Although the Wall Street investor (albeit wrongly) of their fluctuation. views the real estate collateral pooled for a residential After August 1998, some commentators have MBS as homogeneous and similar in certain respects to questioned whether resecuritization was a financing corporate bonds, an investor cannot make the same as- “fad” or the wave of the future for commercial real sumptions in the face of the unique and diverse nature 9 estate. As the accompanying article suggests, there of commercial real estate. The securitization of com- “ain’t no goin’ back.” mercial mortgages had a slower and more deliberate growth than the securitization of residential mort- gages.10 gages acquired in the liquidations of the failed savings Although several MBS transactions involving pools and loan associations.13 The RTC’s activity had several of commercial mortgages or a single large CMBS were profound effects on the CMBS market—it significantly closed from 1984 to 1985, the strong resurgence of inter- increased investor awareness and knowledge of CMBS; est by traditional Main Street lenders in commercial it expanded the base of CMBS investors; and it legit- mortgages in the mid-1980s stalled any further develop- imized the CMBS market. With the increased pressure ment of a CMBS market beyond some occasional iso- on the management of traditional real estate lenders to lated transactions.11 The oversupply of traditional Main tailor their investment portfolios for credit rating agen- Street capital, unfettered by market restraints, crowded cies, their government regulators, and the financial mar- out the capital markets investors, but the cycle quickly kets, CMBS began offering a viable solution for risk ran its course. A series of events, including the savings management and reallocation of institutional assets.14 and loan crisis and the stiffening commercial bank reg- ulatory environment in the late 1980s, led to a national The Capital Consortium real estate depression in 1990 that effectively strangled The converging interests of Main Street and Wall the flow of Main Street capital to commercial real estate. Street lenders in the CMBS market created a unique op- The credit crunch severely affected not only real estate portunity for the real estate industry to organize a uni- 12 and real estate investors, but also lenders and owners. fied effort to respond to the effects of the credit crunch. In the early 1990s Wall Street again seized the oppor- To successfully join commercial real estate finance and tunity to provide a counter-cyclical funding source for capital markets, however, it was necessary for Main commercial real estate finance transactions. The task of Street lenders to appreciate and respond to the specific developing a CMBS market was eased by the Resolution concerns of Wall Street in the CMBS structures and for Trust Corporation’s (RTC) mandated sell-off of mort- Wall Street to understand Main Street lender issues.

Journal | July/August 2001 35 With the existing residential MBS market as a model ment of CMBS or portions of loan portfolios sold to oth- of liquidity for single-family properties, three national ers to avoid over-reserving for federally regulated real estate trade associations joined forces as the Capital banks; and (4) to create a class exemption in the Em- Consortium, to pursue the common goal of developing ployee Retirement Income Security Act’s (ERISA) “par- a viable CMBS market to create a secondary market for ties in interest” and prohibited transactions” limitations commercial mortgages. The Capital Consortium is a for CMBS.16 confederation of the Mortgage Bankers Association of The NRC’s Creating the Instrument Working Group17 America (MBA), the National spent more than three years Association of Realtors® developing a mortgage tem- (NAR) and the Real Estate The CMM uses “borrower” plate that could be readily Roundtable ((RER) formerly and predictably underwrit- known as the National Re- instead of “mortgagor,” ten, originated, rated, and alty Committee), as its origi- pooled for CMBS transac- nal members, as well as the “lender” instead of “mortgagee,” tions.18 The group chose a Commercial Mortgage Secu- and “security instrument” mortgage document devel- rities Corporation (CMSA) oped by Thacher Proffitt & and the Bond Market Associ- instead of “mortgage.” Wood, a law firm with a sig- ation. nificant real estate finance To expedite and focus its and capital markets practice, efforts, the Consortium initially identified certain pri- as its initial discussion draft for the ratable mortgage mary obstacles to the development of the CMBS market template. The firm’s mortgage template had been cre- that had not hampered development of residential ated 13 years earlier for a national residential lender that MBS—lack of standard documentation, inconsistency in regularly pooled its residential loans for securitization. availability and scope of data on commercial mortgages, The lender was contemplating a national commercial and a generally unfavorable regulatory and legislative and multifamily lending program that failed to go for- environment for CMBS investment. The Consortium’s ward. Since that time, the form had been used by nu- goals were to provide greater liquidity to the commer- merous traditional real estate and Wall Street lenders in cial secondary mortgage market, to bring enhanced the primary and secondary markets, including the first market discipline and stability to the commercial mort- commercial mortgage conduit. gage market through efficient secondary market pric- Over time, the firm had substantially revised and ex- ing, and to create known rating implications for com- panded the form to reflect the current market issues and mercial mortgage portfolios. reorganized the mortgage from its historical accretion The Working Groups Adhering to the Consortium’s format into a corporate document format with the arti- objectives, the MBA-sponsored Making the Market cles and sections grouped by subject matter. The revised Working Group developed data elements to establish form had been used for years by several commercial information reporting guidelines for loans intended for mortgage conduit programs, which subsequently securitization or for sale in the secondary market. To en- pooled and securitized the multifamily and commercial hance market liquidity and to create efficient pricing, loans based on it.19 The revised form had also been used the Consortium promulgated the Data Elements Guide- in many large single or affiliated borrower pools and in lines, which seek to provide “a comprehensive, uniform many property-specific single-asset transactions.20 As a data framework for originators issuers, investment model, it therefore had the benefit of extensive primary bankers, trustees, loan servicers and investors to better market usage and capital markets exposure. manage information at the security, class, pool, loan, The Working Group delegated the drafting of the property and tenant levels.”15 mortgage template to a Documents Task Force repre- The Clearing the Barriers Working Group, headed by senting the diverse constituencies within the RER, in- the RER, made tremendous progress toward removing cluding owners, advisors, builders, investors, lenders, regulatory and legislative barriers to commercial mort- and managers of commercial real estate investments. gage securitization. At the outset, the Consortium iden- The Task Force decided to produce a complete form of a tified the following legislative and regulatory goals: generic mortgage, rather than a skeletal template.21 (1) to amend the “five or fewer” rule of the U.S. Tax After the Task Force completed its final draft of the Code governing real estate investment trusts (REITs); mortgage template, it was delivered to a Principal (2) to encourage federal preemption of state securities Working Group, composed primarily of the non-lender laws with regard to merit review and limitations on in- constituency of the RER, for its review and feedback. vestment in CMBS; (3) to change the regulatory treat- After nine months of negotiations, the Principal Work-

36 Journal | July/August 2001 ing Group obtained certain concessions and modifica- disclosed to the investors, and (3) the structure must tions to the final work product of the Task Force.22 The disallow or must compensate for the repayment of any CMM was then submitted to the three trade association principal before its scheduled repayment, whether in in- members of the Consortium for their review and ap- stallments or at maturity. These elementary principles proval. The Consortium approved the CMM and pub- drive many of the structural considerations that often lished it on June 25, 1996, as part of its Capital Markets baffle the Main Street lender, the lender’s counsel, the Initiatives.23 borrower, and the borrower’s counsel in looking at a The Capital Markets Mortgage (CMM) To ensure commercial mortgage loan that is being originated for structural consistency and ease of use, the finished securitization. Knowledge of these basic principles of product, the Capital Markets Mortgage (CMM), con- structured finance provides the real estate lawyer with a tains a detailed table of contents that enables a docu- better grasp of the perspective of Wall Street, specifically ment draftsman or due diligence reviewer to locate investment bankers, credit rating agencies, and capital specific provisions more easily.24 The CMM also incor- markets investors. porates a list of definitions for greater consistency in ne- Access to and disclosure of information in the capital gotiating and documenting transactions. It is organized markets is critical to the securitization process.31 A by subject matter with numbered articles and sections growing appetite for property and borrower-specific that are captioned to proffer a more modern documen- information spawned by the losses accrued in the last 25 tary presentation. national real estate depression, coupled with the contin- To allow the use of consistent terms throughout vari- uing development of sophisticated computer data col- ous loan documents such as promissory notes or as- lection and retrieval systems in loan servicing, has fu- signments of and rents, the CMM uses “bor- eled a feeding frenzy for information in commercial real rower” instead of “mortgagor,” “lender” instead of estate finance.32 “mortgagee,” and “security instrument” instead of The development of the CMBS market has further ac- “mortgage.” Consistent terminology permits easier sub- celerated the process of modernizing the information in- stitution of clauses between documents, especially be- frastructure with respect to the quantity, quality, scope, tween real estate security instruments in multistate and type of information requested.33 The increased transactions. availability of such information has caused the number The material provisions within the CMM are in stan- of parties gathering and reviewing information to grow. dard locations for ease of drafting, modification, or due In addition to the traditional participants, credit rating diligence review.26 It also contains certain legal and eco- agencies, secondary market investors (senior, mezza- nomic concepts universal to all real estate secured nine and subordinate), trustees and custodians, due dili- loans27 and identifies certain substantive sections and gence contractors and their respective attorneys, ac- clauses that may be added or deleted as appropriate in countants and other agents are involved in various particular transactions, such as transactions based on stages of the process, whether the transaction deals with property type or borrower entity.28 A Special Covenants a whole loan, bulk sale, or sale of CMBS in a public of- article provides for the insertion of special transaction- specific provisions without any disruption of the stan- fering or a private placement. dard provisions’ placement.29 A separate Local Law ar- Non-investment grade investors, especially holders 34 ticle allows modification of the generic template for of the first loss position (the “B” piece buyer ), will state-specific law provisions.30 have an even greater need for critical information re- 35 Substantively, the Documents Task Force considered garding borrowers and properties. Without the com- the then-recent experience of real estate lenders (from fort of an investment grade rating, non-investment Main Street as well as Wall Street) in the primary and grade investors or their due diligence agents are com- secondary mortgage markets, the current requirements pelled to review the borrower’s credit and collateral to of the various credit rating agencies in pool and as sin- assure themselves that their investments are prudent. gle asset CMBS transactions, and certain issues of par- Because of the inherent risk of the subordinate creditor ticular importance to capital markets investors. position, the due diligence that they undertake may be To appreciate the capital markets, it is helpful to keep greater than that of a primary mortgage market lender in mind the three elements essential for any securitiza- and similar to that of a junior mortgagee. This need for tion structure to be ratable and, therefore, marketable: information does not cease after the loan is initially un- (1) the structure must not permit any interruption of the derwritten, closed and funded. A CMBS, by definition, cash flow from the property to the ultimate investor, is designed to trade both the senior (the “A” piece (2) all information regarding the borrower, principals of buyer) and the B piece buyer. Current information is the borrower, the property, and the mortgage must be critical for prudent trading to occur.

Journal | July/August 2001 37 Regardless of whether commercial mortgages are investors, and the risk of governmental intervention in sold as whole loans or publicly or privately as securi- the market.41 tized pools, representations and warranties must be As the lingering specter of the last real estate credit provided to potential investors; it is the custom of the crunch recedes from the institutional memory of the marketplace. The nature and Main Street lenders, the type of the representations early reports of the demise and warranties may have an Wall Street and Main Street can of Main Street real estate fi- effect on the pricing of the nance and the triumph of transaction. For the average coexist and mutually profit from Wall Street CMBS may have capital markets investor, the real estate finance, and the real been greatly exaggerated. warranties may serve as an With the return of the Main initial disclosure device or, estate industry may be the primary Street lender to real estate fi- in some cases, a substitute beneficiary with access to a larger nance,42 the increased com- for due diligence.36 How- petition for a limited number ever, as a backup to the rep- source of financing. of financing opportunities resentations and warranties may wreak havoc on Wall it must make or pass Street’s plans to have con- through to the capital market, the seller-issuer into the duits43 replace traditional lenders as the principal source capital market can ultimately look to the representa- of real estate capital.44 Nonetheless, with the actual de- tions and warranties of the borrower contained in the crease in the number of traditional real estate lenders in mortgage and of any prior seller contained in the mort- the Main Street market through liquidation and consol- gage purchase and sale agreement.37 idation and the periodic reduction in appetite of Main The CMM is a ratable mortgage, which allows the Street lenders for commercial mortgages in real estate lender and the borrower to weigh the cost and the ben- downcycles, Wall Street and the CMBS market will have efit of each variation of a transaction provision from the a legitimate place in the commercial real estate market ratable template. When lender and borrower know the as a counter-cyclical source of real estate finance and as cost of a variation from the ratable template, the lender an exit strategy for primary market lenders, as well as has an enhanced understanding of its pricing and the for commercial mortgage portfolio investors.45 capital markets value of the loan asset it is creating, and Today, many money center banks are exclusively se- the borrower has an improved understanding of the rate curitized lenders into CMBS pools and hold no signifi- and proceeds the lender is offering. cant mortgage portfolios. More life insurance compa- The CMM is not intended as a standard mortgage for nies have slowly migrated to using securitization as an use in all transactions.38 It may be modified based on exit strategy. Whether a business (investment and com- differences in property type, lender requirements, bor- mercial banks) or a disposition alternative (insurance rower characteristics, market considerations, and other companies), commercial mortgage securitization is and factors. It is an evolving document that will be modified will continue to be an integral as well as critical factor in occasionally by the Consortium to reflect its acceptance real estate finance. One nationally recognized real estate and usage in the market and in response to develop- report has noted: 39 ments in the CMBS markets generally. Investors need to keep in mind that real estate’s linkage Conclusion to the fixed-income universe through CMBS means short-term capital availability will be closely aligned to The effects of the CMBS market on the primary mort- 40 the overall capital markets. A non-real-estate-related gage market will be considerable. The benefits should disruption like the 1998 credit crunch would be felt im- include increased liquidity; avoidance of cyclical credit mediately in the real estate world, impacting liquidity crunches; increased geographic, borrower, and collat- without regard to property market fundamentals. Most eral diversification; evolving market standardization of . . . agree that short-term shocks are tolerable in return underwriting; servicing and documentation; and the re- for the contribution of public-market efficiencies sulting stabilization of commercial property values. The in helping to smooth out the boom-bust cycles of the past.46 disadvantages could include the risk that lenders may leave the real estate finance market or consolidate, the Securitized lending now accounts for almost 20% of risk of poor underwriting and servicing, the loss of all outstanding commercial and multifamily mortgages portfolio lender discipline, the loss of the personal in the United States with a substantially larger percent- lender/borrower relationship, the unresponsiveness of age originated for securitization each year.47 In 1999, a

38 Journal | July/August 2001 majority of all commercial mortgages were originated to subordinate class of securities to absorb losses first before be deposited in CMBS pools.48 the more senior classes take any loss. Wall Street and Main Street can coexist and mutually 6. Eric M. Schwartz, Representations and Warranties in Com- mercial Mortgage-Backed Securities: Going . . . Going . . . profit from real estate finance, and the real estate indus- Gone?, Structured Finance Special Report (Moody’s In- try may be the primary beneficiary with access to a vestor Services, Inc., New York, N.Y.), Nov. 3, 1995, at 2 larger source of financing than has been tapped before.49 (hereinafter “Schwartz”). The mutual education of the markets to the critical is- 7. The three credit rating agencies are Standard & Poor’s, sues confronting them will help assure the successful Moody’s Investors Service, Inc., and Fitch Research, Inc. development of a CMBS market. Each company has developed its own criteria and methodology for rating commercial MBS (CMBS) transac- tions. This criteria is available on their respective Web 1. In the early 1970s, the Government National Mortgage sites. Association (GNMA) guaranteed pass-through certifi- 8. Investors will rely on a rating because a credit rating cates for pools of Federal Housing Administration in- agency will perform its own “stress test” of the mortgage sured and Veteran’s Administration guaranteed loans pool to determine the rating to assign, using a variety of (FHA/VA Loans) issued by GNMA-approved issuers. disparate factors such as debt service coverage, loan-to- The pass-through certificate represented an undivided value ratios and loan seasoning, balloons or negative ownership interest in the whole loan pool. Like the ear- amortization, exposure to borrower concentration, geo- lier guaranteed mortgage certificates, the issuers under- graphic diversity and economic risks, pool service experi- took to pass-through the investors’ pro rata share of the ence and creditworthiness, and deal structure and credit monthly principal and interest payments due on the enhancement. The credit rating agency will determine the whole loan pool, after deduction for servicing and man- likelihood of timely repayment using historical loan ex- agement fees, regardless of whether the underlying mort- perience for the collateral type and its own statistical gages were in default. GNMA’s guarantee of full and database concerning probability of default and severity of timely payment was backed by the full faith and credit the loss. Rating agencies will also consider the physical of the United States. and environmental condition of the mortgaged property, Federal National Mortgage Association (FNMA) and Fed- as well as the tax structure, loan servicing, administration eral Home Loan Mortgage Corporation (FHLMC) fol- issues, and the mortgage document provisions to deter- lowed GNMA into the capital markets in the late 1970s mine the rating. Commercial Mortgage Stress Test, Struc- and early 1980s and issued pass-through certificates rep- tured Finance Special Report (Fitch Research, Inc., New resenting pools of residential whole loans. In 1983, York, N.Y.), Jun. 8, 1992, at 1. FHLMC issued the first collateralized mortgage obliga- 9. Residential and commercial real estate loans differ in tion. This obligation provided for the distribution of cash many ways. For example, commercial real estate loans flow not to individuals on a pro rata basis, but to specific have different income property underwriting and ap- classes designed to meet specific investor concerns re- praisal methods, lack standard underwriting and loan garding timing of receipt of principal due to mortgage documents; lack FNMA/FHLMC loan programs and prepayments. Thereafter, a vast array of product varia- market guidance; involve different legal and regulatory tions developed in direct response to investor needs. issues of investment authority, borrower structure and 2. Briefly stated, the process of mortgage securitization in- credit, and property ; depend on income-produc- volves the creation of a new financial instrument that ing leases and tenants as well as other interested third represents an ownership interest (a pass-through certifi- parties; and have differing insurance requirements and a cate) in, or an obligation secured (a pay-through bond) variety of different permissible prepayment risks. Joseph by, a pool of mortgage loans. Acquisition of these instru- P. Forte, Commercial Mortgages in the Secondary Market, ments can be structured either as a sale, with the issuer Mortgage Banking, Oct. 1985, at 37. Of course, multifam- selling certificates that represent an undivided fractional ily property is residential as well as income producing. ownership interest in the issuer’s mortgage pool, or as fi- 10. In the 1920s, approximately 20 companies issued their nancing, with the issuer issuing debt instruments secured own “guaranteed mortgage certificates” to acquire in- by the issuer’s mortgage pool as collateral. vestment capital. Guaranteed mortgage certificates were 3. The GSE MBS were very attractive to Wall Street because fractional shares of mortgage loans sold to small (as small they minimized the credit risk inherent in conventional as $500) as well as large denomination buyers by the real estate finance. lenders who originated the loans. “Guaranteed” referred to the seller’s guarantee of the investor’s receipt of its pro 4. Hence, MBS are referred to as structured transactions. rata share of the monthly mortgage payments due from 5. Credit support can be provided by: (1) a third party the borrowers. This newly developing market collapsed credit enhancer issuing a standby letter of credit, a surety with the real estate failures that occurred in the wake of bond, a pool insurance policy, or a corporate guarantee; the Great Depression. Many guarantors were unable to (2) over-collateralization of a mortgage-backed bond; cover their guarantee payments to investors without the (3) creating separate senior and subordinated classes of cash flow of borrower payments, and the New York In- securities; or (4) establishing reserves or cash collateral surance Department, which regulated these companies, accounts. (Reserve accounts are generally created with placed all of the issuing companies into rehabilitation. In equity, cash flow holdbacks, or sales proceeds, while a the 1960s, the development of private mortgage insur- cash collateral account is financed by an institutional ance in New York was hampered by the memories of the loan. These accounts are pledged to the trustee for the earlier “guarantor” failures. Louis Perlstein, What the benefit of the investors.) The senior/subordinated struc- 1920s Tell Us About Mortgage-Backed Securities Today, Prop. ture is a variation on a second mortgage allowing the & Prop., Jan.-Feb. 1987, at 19.

Journal | July/August 2001 39 11. See Forte, supra note 9. FNMA/FHLMC Mortgage documents, all references to “articles” and “sections” are to the CMM. 12. “This dearth of capital resulted in a drop in property val- ues, dampened investment returns, increased delinquen- 18. Consortium, supra note 12, at 5. The Working Group was cies and foreclosures, as well as industry layoffs. In turn, also responsible for due diligence and terminology. It has this resulted in an erosion in state and local tax bases, promulgated the Due Diligence Checklist to assist in which adversely impacted community services.” The Cap- identifying in a uniform way the documents and infor- ital Consortium, Capital Markets Initiatives, Jun. 25, 1996, at mation contained in each loan file. The terminology pro- 1 (hereinafter “Consortium”). ject was incorporated into the mortgage template defini- tions. Consortium, supra note 12, at 61. 13. Since 1991, the RTC has issued over $17.8 billion in CMBS with a peak CMBS issuance of approximately $9 19. See generally Michael W. Davis, Conduits: Market Overview billion in 1992. 1995/1996 Commercial Backed Securitization and Rating Process, Series on CMBS Issues (Duff & Phelps, Survey, Trends and Developments (The E&Y Leventhal Credit Rating Co., Chicago, Ill.), Jul. 1995, at 2 (here- Real Estate Group, Los Angeles, Cal.), 1996, at 1, 6 (here- inafter “Davis”) (describing requirements for conduit inafter “Securitization Survey”). market securities). 14. Securitization allows real estate investors to 20. See generally Rating Single-Borrower Commercial Mortgage Transactions, Structured Finance Special Report (Fitch Re- move assets off their balance sheets, lessen their risk search, Inc., New York, N.Y.), Oct. 3, 1994, at 1 (address- based capital requirements, and/or redeploy their ing issues concerning single-borrower mortgage transac- capital in ways more in alignment with their strate- tions). gic plans. The institution can still generate income from the portfolio by remaining the servicer of the 21. The Capital Consortium Capital Markets Mortgage, Feb. 27, pool of mortgages underlying the CMBS. For buy- 1996, (hereinafter “CMM”) (A draft of the CMM is ers of the securities, the tranche structure of most printed in 31 Real Prop. Prob. & Tr. J. 523 (1996)). A securitizations allows investors to pick an invest- generic deed of trust and a deed to secure debt template ment that suits their risk and reward criteria, as well with terms identical to the CMM have also been devel- as the investment timeframe which facilitates oped. The Task Force intended that the mortgage and matching their assets and liabilities. deed of trust may be modified to reflect state-specific changes. The Documents Task Force intends to develop a Argante Cappelli & Michael Wirth, The Securitization of Promissory Note and Assignment of Leases and Rents Real Estate Assets, Real Estate Strategies (Deloitte & that will correspond to the CMM. Touche LLP, New York, N.Y.), Summer 1996, at 2. The Pri- vate Label CMBS market developed significantly from 22. The principal obstacle to consensus was a requested con- $1.6 billion in 1990 (before any RTC issuance) to about fidentiality provision that was sought as a substitute for $30 billion in 1996, with more than $100 billion outstand- the delivery of information contemplated by § 18.1. The ing in total. See Securitization Survey, supra note 13, at 1 changes that were incorporated focused on the sections (discussing statistics regarding market development); concerning insurance, leasing, defaults, and restoration. Commercial Mortgage Alert, Dec. 23, 1996, at 9. CMM, supra note 21. 15. Consortium, supra note 12, at 3. 23. A copy of the Capital Markets Initiatives, which includes the Executive Summary, the CMM, the Due Diligence 16. “The Omnibus Budget Reconciliation Act of 1993 re- Checklist, and the Legislative Initiatives is available from moved the bias against domestic pension funds’ capital the RER. See Consortium, supra note 12. investment in REITs. The Riegle Community Develop- ment and Regulatory Improvement Act of 1994 autho- 24. CMM, supra note 21, at i-iv. rized Federal preemption of state securities laws, subject 25. CMM, supra note 21, at v-vii. For example, all of the to promulgation of regulations by the Office of the grants of security are contained in article 1 including the Comptroller of the Currency and amended the risk-based property mortgaged, an assignment of leases and rents, a capital treatment of CMBS to avoid over-reserving. The security agreement, and a pledge of monies held. In def- Consortium submitted an initial application for exemp- erence to the past, article 1 also contains the historical tive relief under ERISA for investment grade CMBS in habendum and defeasance clauses. In the FNMA/ March 1995 which was subsequently updated.” Consor- FHLMC Mortgage, the grant of security interest is at tium, supra note 12, at 3-4. least as extensive as the CMM. 17. Samples of new FNMA and FHLMC revised uniform 26. CMM, supra note 21, at i-iv. The standard locations will forms of multifamily note, mortgage, and guaranty were correspond to identical provisions in the generic deed of released at the MBA’s Commercial Real Estate Finance/ trust and the deed to secure debt. The deed of trust tem- Multifamily Housing Conference in February 1997. The plate will, of course, contain a generic “Trustee” article, new documents are typewritten, rather than pre-printed, which can be modified by state-specific law requirements and the new mortgage is approximately 40 pages. FNMA in the “Local Law” article. and FHLMC will have slightly different versions of their 27. See CMM, supra note 21, at art. 2 (aggregating and delin- uniform documents regarding the yield maintenance for- eating the debt and other obligations secured by the mula, transfers of interest of non-managing general part- CMM and providing for the method of payment). ners under the Due-on-Sale Clause, and the conditions for and mechanics of a loan assumption. For purposes of 28. See, e.g., CMM, supra note 21, at § 3.3 (discussing “Insur- comparison to the CMM, the FNMA and FHLMC docu- ance” subsection (e) concerning blanket policies or (f) re- ments hereinafter will be referred to as FNMA/FHLMC garding policy layering, which may be added or deleted Mortgage/Note/Guaranty, and the FNMA/FHLMC sec- as necessary). tions will be referred to as they appear in these revised 29. See CMM, supra note 21, at art. 4 (discussing various spe- documents. Unless the context indicates a reference to the cial covenant provisions).

40 Journal | July/August 2001 30. 31 See CMM, supra note 21, at art. 22 (containing a repre- will frequently result in a lower rating to make up for un- sentative New York Local Law section for illustrative known risk. Cappelli & Wirth, supra note 14, at 2. purposes). 36. Exhibit B: Representations and Warranties, The Rating of 31. M. Cathy Anderson, Divulging Data, Institutional Investor Commercial Mortgage-Backed Securities (Duff & Phelps, (1995), at 211. Credit Rating Co., Chicago, Ill.) (1994) at 51; Standards, supra note 32, at 66; Schwartz, supra note 6, at 2. 32. As CMBS issuance and secondary trades continue to de- velop and expand in the capital markets, investors are 37. In the capital markets, typical mortgage purchase and only constrained by an industry infrastructure which is sale agreements contain seller representations and war- outdated and has not developed as quickly as the ap- ranties that are a contractual derogation of the “nonre- petite of the market. The CMBS industry clearly recog- course” endorsement and assignment of the mortgage nizes these shortcomings and is addressing the informa- loans transferred under the agreement for the purposes tion crisis in several ways. Several national trade of a seller-required cure or buy back upon a breach of associations, such as the Public Securities Association any representation of warranty. (now known as the Bond Market Association or “BMA”), 38. The CMM was published with the following Preface: the Real Estate Capital Resource Association (RECRA), MBA, the Commercial Real Estate Secondary Market and The capital markets mortgage . . . [is] a generic tem- Securitization Association (now known as the Commer- plate to be used in commercial and multifamily real cial Mortgage Securities Association or “CMSA”), and the estate transactions to be sold or financed in the cap- Capital Consortium have each established special work- ital markets. They should, however, only be used ing groups to deal with the several different facets of this with legal counsel and modified to conform to the information revolution. RECRA formed a Disclosure requirements of the states where the property is lo- Committee with respect to the release of non-public in- cated as well as the credit and risk requirements of formation. That committee issued Disclosure Guidelines the contemplated transaction . . . [and] is not in- for Commercial Mortgage Backed Securities on December tended for use in large or complex commercial real 15, 1995. The CMSA has developed a draft “Minimum estate transactions for which traditionally negoti- Reporting Requirements” for post-CMBS issuance infor- ated documents, specifically tailored to the individ- mation, which recommends, among other things, quar- ual characteristics of the type of loan, the property, terly reporting of the following actual property perfor- the borrower and the lender, will continue to be mance information: gross revenue by quarter, last full more appropriate. year’s expenses, net operating income, occupancy rates at Consortium, supra note 12. the end of the quarter, actual capital expenditures in the Notwithstanding the caveat in the Preface, the CMM can previous quarter, lease roll-over schedule, and a list of be used in negotiated transactions because it is readily major tenants (greater than 20% of space). In November susceptible to modification. Moreover, from the perspec- 1996, CMSA issued standards to “create a market mecha- tive of the credit rating agencies and investors, especially nism to facilitate a sufficient level of ongoing information B-piece buyers, some of the documentary as well as bor- to support a fully functional securities trading market.” rower organizational requirements will be more, not less, Commercial Real Estate Secondary Market and Securiti- restrictive for larger loans in pools, affiliated borrower zation Ass’n, Standards for the Dissemination of Information loan pools, and Property-Specific Transactions. on New Commercial Mortgage-Backed Security Issues (Nov. 39. Consortium, supra note 12, at 7. 11, 1996) (hereinafter “Standards”) (unpublished manu- script on file with CMSA (now known as the “CMSA In- 40. See Joseph B. Rubin, A Thriving Securities Market, Mort- vestor Reporting Package”)). The BMA has formed a spe- gage Banking, Jul. 1996; Gregory A. White, Someone Else’s cial committee to examine the liability issues of borrower Money, Real Est. Fin. J. (Fall 1996). and property-specific loan data and the release of such 41. For a further analysis of the benefits and disadvantages, data to third parties. In July 1995, a task force was formed see Brian Olason, Commercial Mortgage Securitization: Capi- by the National Council of Real Estate Investment Fidu- tal Markets Fill A Void, Real Est. Rev., Summer 1994, at 18. ciaries, the Pension Real Estate Association, and the Na- The Securities and Exchange Commission is considering tional Association of Real Estate Investment Managers to proposing formal rules on the disclosures of information review existing information reporting practices of the real in the public offering of CMBS. CMBS—SEC Mulls Disclo- estate industry issued standards for establishing informa- sure Rules, Commercial Mortgage Alert, Sept. 9, 1996, at 3. tion reporting criteria. 42. Traditional Lenders Re-enter Commercial Real Estate Lending 33. In 1993, FNMA/FHLMC expanded their requirements Marketplace, Special Report (Duff & Phelps Credit Rating for delivery of financial information in their new multi- Co., New York, N.Y.) (Oct. 1995). family mortgage rider. Those rider provisions have been 43. A conduit is a process that connects the Main Street and incorporated into the FNMA/FHLMC Mortgage. Wall Street markets. A financial intermediary that spon- FNMA/FHLMC Mortgage, supra note 17, at § 31. sors the conduit (originally, the investment banks, and 34. As distinguished from the “B” rating. See What Do “B” now more likely a commercial bank) makes or purchases Ratings Mean?, Structured Finance Special Report (Fitch loans from third-party correspondents on standardized Research, Inc., New York, N.Y.), Aug. 5, 1995. terms, underwriting, documents, and pools those loans for sale to investors in the CMBS market. See Davis, supra 35. Beneficial rating can be achieved in large part through in- note 19. formation. Rating agencies have no choice but to rate is- 44. Michael Higgins, Banks and Real Estate Securitization: The sues based on the information available to them. Better Time Is Now, Mortgage Banking, Jan./Feb. 1997, at 34. information usually equates to a better rating because more credit, collateral, borrower and interest rate risks 45. Jun Han, To Securitize or Not to Securitize? The Future of are identified, qualified and quantified. Less information Commercial Real Estate Debt Markets, Real Est. Fin. J., Sum-

Journal | July/August 2001 41 mer 1966, at 71. One super regional commercial bank has PRESIDENT’S MESSAGE announced that “[u]nder the new policy, all view com- CONTINUED FROM PAGE 6 mercial mortgages are being underwritten to standards that will make them acceptable for securitization.” Sally “What is it, Bob?” Gordon, A Compelling Case for Commercial Real Estate Secu- “Well, I was just wondering how often formal ritization, Fixed Income Research Report (CS First Boston, Boston, Mass.), Sept. 7, 1994, at 8. By beginning with the charges are brought against lawyers that don’t result in CMM or a lender customized version, a primary market public discipline? You wouldn’t happen to know that, lender with a capital markets sensitive portfolio of com- would you?” mercial loans may enjoy greater liquidity with a more Effie pulled another booklet off one of the piles in marketable pool of assets. Standard & Poor’s announced at its June 1996 Real Estate Finance Conference that it is front of her. “Hot off the press, Bob. New York State Bar developing a system to rate whole loans secured by com- Association Committee on Professional Discipline, An- mercial real estate. nual Report for 2000. Of the cases that went to formal 46. Capital Flows: The New World Order, Emerging Trends in charges and were processed in the courts last year, 234 Real Estate, (Price Waterhouse Coopers LLP and Land resulted in public discipline. Only two resulted in pri- Lease Real Estate Investments (Oct. 2000)) at 28. vate censures and only three were dismissed.” 47. CMBS in 2000 - A Quiet Year, Commercial Mortgage “That’s only about 2% that didn’t get public disci- Backed Securitization Update 2000-2001, Ernst & Young (2000). pline. And that’s with them making their decisions re- garding formal charges on the assumption that it will all 48. CMBS in 1999 - CMBS Market Highlights, Commercial Mortgage Backed Securitization Update 1999-2000, Ernst be private until the court rules. I’d assume they’d be & Young (1999). even more careful if they’re deciding on allowing 49. Barbara Rubin et al., Public Versus Private Markets: Com- charges to proceed in the context of public proceed- paring CMBS and Commercial Whole-Loan Yields, Real Est. ings.” Fin. J., Fall 1996, at 39. Steven Bergman, Banks Pump Life “You’re not as dumb as you look, Bob.” Into the Market for Commercial Mortgage Conduits, Barron’s, Jun. 12, 1995, at 48. See Tamara L. Adler, Senior Housing. “Thanks, Effie.” Alternatives and Implications, Real Est. Fin. J., Fall 1996, The sun gradually dimmed and sank over the fallow at 68. fields. Somewhere along the way Bob’s soap operas made way for the early evening news, although Bob was never quite sure where the borderline was. By six, Bob and Effie Gunderson were at the dinner table, dis- There are millions of cussing the events of the day. After a few moments, Effie reasons to do Pro Bono. lay down her fork and prepared to speak. All indica- tions were that she planned on saying something signif- (Here are two.) icant. “Bob?” Each year, in communities across “Yes, Effie.” New York State, indigent people “Did you know there are no lawyers in Winston?” face more than three million civil legal matters without assistance. “There are only 85 people in Winston, Effie.” Women seek protection from an “And not one of them a lawyer.” abusive spouse...children are de- nied public benefits...families are “So?” faced with losing their homes – all Effie walked into the next room and returned with a without the benefit of legal coun- manila folder. “You know, tuition at the North Dakota sel. They need help. We need vol- law school is pretty reasonable.” unteers. Bob nodded and smiled. At that moment he knew If every attorney volunteered just 20 that there would soon be a lawyer in the Gunderson hours a year, and made a financial contri- family after all. bution to a legal services or pro bono or- ganization, we could make a difference in millions of cases. Give your time. Share your talent. Contact your local pro bono program or call the New York State Bar Association at 518-487-5641 today.

Sponsored by the New York State Bar Association

42 Journal | July/August 2001 Businesses Considering Renting In Commercial Condominiums Face Unique Contractual Issues

BY MATTHEW J. LEEDS

n a growing number of circumstances, commercial sirable large commercial tenant would identify. Never- developments involving both horizontal and high- theless, in any situation, an understanding of the situa- Irise properties are being presented in the form of con- tion the tenant would be stepping into is necessary for dominium ownership. There are many reasons for this, the tenant to make a business decision on whether to including critical matters of financing.1 Although the tolerate the risk if all of its concerns are not addressed condominium form of ownership generally involves fee perfectly. ownership of real property, where the is a unit owner, the unique legal nature of this form of owner- Identifying Issues ship significantly affects the landlord-tenant relation- This article provides a survey of these considerations ship.2 by identifying the issues that would normally arise for a commercial tenant, suggesting some methods for per- As the broadest example, in a normal landlord-tenant forming due diligence to identify the special issues that situation, the landlord who owns and operates the might exist in a particular condominium, and describ- building can promise services and utilities to a tenant, ing some prospective methods of resolving competing but in the condominium form of ownership the imme- interests to address these issues. Again, although the diate landlord (who is the owner of the condominium focus of the discussion is on the point of view of a major unit) may not have dominion over such matters, which tenant who can command significant changes, it also re- are typically governed by the condominium’s board of flects the concerns of any commercial tenant in a condo- managers. Many other obvious and subtle issues arise minium. in these circumstances. Accordingly, a careful tenant would want to identify the issues in a particular com- Because condominiums are a creature of statute, state mercial condominium through the appropriate due dili- law must be reviewed for special considerations pecu- gence. liar to the jurisdiction, specifically the New York Con- dominium Act, article 9-B of the Real Property Law.3 In By definition, the owner of the condominium unit, dealing with terminology, the common New York for- who is the landlord, also needs to be sensitive to the mulation is to refer to the space that is actually owned concerns of prospective tenants and would engage in by an individual owner as a “condominium unit,” while similar examinations. Through negotiation, the tenant the entire development is referred to as the “condo- would like to obtain both assurances that it will be able minium.” (In some other jurisdictions these words have to get the benefits it bargains for and realistic mecha- somewhat different connotations.) nisms to enforce its rights against its landlord, or even against the condominium board and all of the unit owners. MATTHEW J. LEEDS is a member of A major tenant courted before the condominium is Robinson Silverman, Pearce Aronsohn established might have the best chance of actually gov- & Berman in Manhattan. He is second erning these matters. In such a situation, the tenant has vice president of the NYSBA Real the best opportunity to have its desired protections built Property Law Section and is past co- chair of its Condominiums and Coop- into the condominium documents. For a tenant, this is eratives Committee. He is a member an ideal situation, but the relative bargaining power of of the American College of Real Estate tenants will vary. In addition, especially once the con- Lawyers. A graduate of New York dominium is created, the ability to institute a tenant’s University, he received his J.D. from the State University wish list of protections might be diminished. However, of New York at Buffalo and his LL.M. from New York any tenant—large or small—would, theoretically, need University. to take into account all of the concerns that a highly de-

Journal | July/August 2001 43 This discussion also assumes that a property has element or taxes building services or facilities to a de- been fully given over to commercial use, as opposed to gree disproportionate to the common interest to be re- being a “mixed-use property,” which would present quired to pay a greater share of expenses related to that many of the same issues with more highly concentrated item. Sometimes the condominium documentation calls particulars. The normal paradigm involves a condo- for a specific allocation of expenses among the unit minium where the units are owned in fee simple own- owners in a manner different than common interests.8 In ership, as opposed to a condominium where the entire addition, some common elements may be allocated as condominium property is subject to a leasehold. Also “limited common elements” for the exclusive use of one covered here is a condominium that is subject to other or more units. Generally, the unit owner who has use of “umbrella” property owners associations in addition to a limited common element has greater responsibility for the condominium regime itself. the expenses and maintenance of those spaces than the unit owners who do not actually use them. The Condominium Form of Ownership It is always significant to note that the expenses of Like all other unit owners in the condominium form 4 operating of the condominium association do not nor- of ownership, the landlord in the situations referred to mally include two of the most significant expenses of in this article typically owns one or more of the various real property ownership: real estate taxes and the re- condominium units in the condominium. Each condo- payment of a mortgage. This is incidental to the fact that minium unit is a separate parcel of real estate,5 owned in 6 each condominium unit is itself a parcel of real estate, fee simple, and is its own separate tax lot. Each unit is and it is only the obligation of the unit owner affected fundamentally like a parcel of air space contained by the liens for mortgages and real estate taxes to pay within the inside surfaces of the walls and ceiling (or them. other boundaries) that usually describe a particular As security for the payment of a condominium unit space. owner’s common charges, it is usual that the association As a separate parcel of real estate, each condominium (by the board of managers or otherwise) has a lien unit may be burdened by a separate mortgage that will against each unit owner’s unit with respect to the pay- affect no other condominium units, without the consent ment of such common charges.9 In New York, this lien is 7 of those other unit owners. Inextricably entwined with generally subordinate to liens for real estate taxes and a the ownership of a condominium unit would be the first mortgage of record.10 However, the Condominium ownership of an undivided interest in what are referred Act does permit these priorities to be adjusted in a fully to as the “common elements” of the condominium, gen- non-residential condominium.11 erally the structural or shared areas of the condominium Those who are more familiar with residential condo- property. Typical common elements include the land on minium situations than with commercial condominium which the building is built, structural portions of the situations may be familiar with a common device by building, including the walls and the roof, and any com- which a condominium association can become involved mon lobbies, hallways and spaces, including those that in the sale or leasing of a unit. That is, many residential house building systems serving the condominium units. condominiums provide that, in order to permit some Each unit owner’s proportionate interest in the common common control over the unit owners or residents with- elements is frequently referred to as the “common inter- out flouting any common law restriction against unrea- est” allocable to that unit. The unit owners are thus in sonable restraints on alienation, many residential con- many respects like tenants-in-common with respect to dominiums require that a unit owner seeking to sell or the common elements. lease its property offer a right of first refusal to the con- The unit owners together constitute a kind of associ- dominium association. Not surprisingly, in commercial ation that is responsible for running the property. This condominiums, the business considerations dictate that association is managed by a board of managers elected a right of first refusal is not usually imposed on sales or by the unit owners. Although the board is responsible leases by unit owners. for running the association, it can separately hire pro- A property is subjected to the condominium form of fessional management to handle much of that function. ownership (i.e., divided into the separate condominium To pay the expenses of operating the property, the units, each as a separate parcel of real estate and the board normally assesses each unit owner a certain por- common elements and subjected to the governing pro- tion of these costs in what are called “common charges.” visions of the local condominium statute) by recording Although common charges are normally split up based or filing statutorily required documents. These materi- on the unit owners’ relative common interests, in com- als are normally in the nature of a “declaration of con- mercial condominiums it is not unusual for a particular dominium” and appropriate floor plan drawings indi- unit owner who uses a greater portion of some common cating the locations of the separate condominium units

44 Journal | July/August 2001 and the common elements. The declaration normally in- Documentation is rarely standard and is frequently corporates or is accompanied by the by-laws of the con- tailored to a particular circumstance. As with many sit- dominium, which typically govern management and uations, the lawyer can anticipate general categories, operation of the condominium.12 but does not know how they will be phrased in a par- In the area of consumer ticular instance, nor whether protection, such as real estate there will be any surprises. securities laws in New The expenses of operating the Thus, legal review will fre- York,13 states often require quently involve the following that sale of condominium condominium association do not documents, to be reviewed units be performed pursuant normally include two of the provision by provision to de- to an information statement termine how a particular con- or offering plan or memo- most significant expenses of real dominium structure might randa. In some of those jur- property ownership: real estate affect the client. Specifically, isdictions, information is the lawyer might be asked to merely maintained or com- taxes and the repayment of a review: piled by the association or • The Condominium Act. In a the developer. In New York, mortgage. profession of increasing spe- the offering statement is the cialization, even seasoned subject of a separate filing leasing lawyers may find it with a government agency, the New York State Depart- appropriate to engage colleagues who are more conver- ment of Law Real Estate Financing Bureau.14 That sant in condominium law and practice to review a lease agency reviews the materials to determine whether they of commercial space. If the property is located in an- are acceptable for filing. For some projects, when it is other state, consultation with local counsel is recom- deemed upon application that the requirement of an of- mended. fering plan does not fulfill a necessary statutory or pub- • Certificate of Occupancy. Although this would nor- lic purpose, the Department of Law has authority to mally be a part of the physical inspection conducted by issue a “no-action” or “no-jurisdiction” letter. It essen- the client and its other experts, there may be occasions tially states that, based on the application, a full filing is when required use issues or local statutes suggest that not required. Any offering materials would not nor- the lawyer review the certificate of occupancy as it per- mally be required to be provided to tenants, but, if avail- tains to the contemplated space. able, they might provide an interesting source of infor- • The Declaration of Condominium and the Condominium mation for a tenant renting a unit. By-laws. In most instances, an examination of these fun- The basics of the condominium structure suggest is- damental documents is the meat of the attorney’s due sues that can arise for tenants looking to rent a condo- diligence analysis. Together, these documents lay out minium unit. To identify which generic structures affect how the condominium unit is described, the services the particular condominium, however, and to flush out that will be provided to the unit, and the obligations any idiosyncratic issues that might exist with respect to that will fall on the unit owner. Critically, these docu- a particular condominium, a lawyer will normally en- ments indicate who is in charge of different aspects of gage in a certain amount of due diligence. condominium operations and whether the landlord will Due Diligence actually be able to deliver services and other promises made under the lease to the tenant. Even if the initial In any situation, a tenant will perform certain kinds documents indicate that the landlord will have full of physical and business examinations before deciding rights to perform for the tenant, the documents will also whether a particular property is appropriate. For exam- indicate whether the condominium can change its rules ple, a tenant and its experts (other than the lawyer) and operation in the future in a manner that could sub- would be expected to conduct a physical inspection of vert matters contemplated by the lease. the property, determine whether the building systems purportedly available are adequate to support the ten- In combination with a review of the condominium ant’s needs, investigate the reputation of the property statute, these documents will also indicate whether the and the developer (if relevant) and like matters. The landlord-owner of the condominium unit will be subject lawyer is normally asked to review any requested doc- to a lien on behalf of the board which, if foreclosed for umentation that might inform issues raised by the ten- nonpayment of common charges or other nonperfor- ant. Equally important is the lawyer’s review of appro- mance, could lead to a cancellation of the lease. priate documentation to suggest issues that the tenant • Rules and Regulations of the Condominium. The extent might have had no reason to expect. to which these rules affect the tenant, and the extent to

Journal | July/August 2001 45 which they could be changed by somebody (i.e., the office of the managing agent for the condominium. This other unit owners) other than the landlord (who is just opens a broad area, where the recital of incidental fact one of the unit owners), are important considerations could provide desired insight into a deal. For example, for any tenant. Actually, these concerns will often be an indication in financial statements of difficulties in dealt with by a review of the declaration and by-laws. collecting common charges from other major unit own- • The Offering Plan, if Any. These documents normally ers, or references to major work that needs to be per- recite a considerable amount of information. If the par- formed, could reflect an inadequacy in the physical ticular condominium has been created without an offer- plant or suggest a forthcoming additional assessment. ing plan because of an exemption or administrative At the same time, such due diligence frequently allows permission, it would be of an opportunity to speak with interest to document such the individuals actually in- consent. Certainly, it is al- Any provision allowing the volved in management to ask ways of interest to determine them generally about opera- whether the condominium escalation of real estate taxes tion of the property. Such was properly created (and should be reviewed to make sure casual interviews can some- therefore, among other times elicit interesting cur- things, that the landlord ac- that it reflects the appropriate rent information or a better tually owns what is being overview than would be leased to the tenant). measure of taxes against the available from the dry docu- • Condominium Floor Plans. units. ments themselves. Actually, a Although an examination of typical review of these mate- the floor plans is normally rials often yields much infor- considered in conjunction with the physical inspection mation that it is not necessary to describe separately to of the property, the condominium floor plans are often the client. On the other hand, it can reveal important the source of the description of the condominium units facts. themselves and the common elements. Regardless of the • Review of Unit Owner’s Mortgage and Other Due Dili- presentation by business people on behalf of a landlord gence. These are matters that would normally be con- or the understanding of the tenant’s experts, the condo- ducted with respect to certain leases. They include the minium documentation itself should be checked to availability of non-disturbance agreements (presumably make sure that it actually describes the demised in conjunction with subordination agreements) and premises as part of the condominium unit owned by the other matters that are routine for the experienced leas- landlord. In addition, an examination of the floor plans ing lawyer. will indicate whether building facilities exclusively allo- A lawyer’s normal review of due diligence materials cated to the tenant are actually within the control of the when the landlord has presented a proposed lease typi- landlord in its own unit, or are subject to control by the cally raises practical and legal issues. It is usually prof- board of managers or the other unit owners, as a com- itable to identify these ahead of time, particularly when mon element. the landlord has not anticipated the tenant’s concerns in • Title Insurance. The issue of title insurance is very the draft lease. The organization of negotiation between similar to the issue of whether a tenant in a conventional the parties might begin with a general meeting about landlord-tenant relationship is interested in title insur- these kinds of global concerns. Ideally, this might even ance, to support its own interests or for reassurance that precede any drafting exercise. Actually, in some devel- the landlord is the owner of the anticipated space. In ad- opment situations, a large tenant might be involved in dition, because the space to be leased out as a condo- planning the entire condominium, and so might have a minium unit is a separate parcel of real estate, issues re- say in the way the condominium documents are garding existing lienors and other aspects of the drafted. If not, many of the considerations will be the landlord’s status and well-being can be of great interest. same and the parties must seek to address the concerns in other ways (subject to bargaining power and other • Books and Records of the Condominium. These include practicalities). (1) financial statements of the condominium; (2) min- utes of meetings of the Board of Managers; (3) minutes Sample Concerns of meetings of unit owners; (4) accountant’s statements Due diligence and a general understanding of the such as certified financials; and (5) miscellaneous corre- condominium situation are likely to bring out a mix of spondence and statements included in the foregoing or generic issues and issues particular to a deal. maintained separately with the records. Frequently, ex- As an overall matter, it can be interesting throughout amination of most of these materials takes place in the a condominium lease review to keep in mind the simi-

46 Journal | July/August 2001 larities to a conventional sublease, where the subtenant • Lien for Non-Payment of Common Charges. Typical con- is not in privity with the person who has actual owner- dominium statutes and typical condominium docu- ship and control of the property.15 ments provide security for the payment of common Examples of typical concerns and some brief charges by establishing a lien against a unit owner’s thoughts on how they can be addressed include the fol- unit in favor of the board of managers. A tenant would lowing: be concerned that such a lien would be a superior right • Services, Use, Rules and Regulations. In the condo- to the lease and that foreclosure could wipe out the minium, the board of managers, acting as the represen- lease. tatives of all of the unit owners, governs the operation of • Insurance, Casualty and Condemnation. Because of the the property, tempered by the provisions of the condo- nature of a condominium, with the fundamental struc- minium documents. The tenant must be sure that its ture of the improvements being owned essentially in landlord can provide everything that is promised in the common by all unit owners, fundamental casualty in- lease. The tenant and the landlord, in turn, must deter- surance is obtained by the board of managers on behalf mine whether the landlord in the first instance has the of the unit owners. Although the general rule under the right to require the board to provide the services the Condominium Act is that the condominium will be ob- landlord has promised. These can be as direct as the pro- ligated to restore the property in the event of a major ca- vision of heating, ventilating and air conditioning, pro- sualty, this rule does not apply in catastrophic circum- vision of parking, use of loading facilities, maintenance stances. In fact, where loss involves 75% or more of the of signage on the exterior of the building and the like. property, 75% of the unit owners must agree to restore, One aspect of this examination involves determining or the property will be subject to a partition and, pre- 16 whether areas that must be accessible to the tenant are sumably, termination of the condominium. Such pro- actually technically part of the landlord’s condominium visions might contradict the provisions in a lease. In ad- unit, or whether they consist of common areas (such as dition, the parties should work to assure that insurance entrance ways and parking). It is often not enough for a obtained separately by a tenant would not conflict with tenant if the landlord has an obligation to provide ser- or be negated by a condominium policy. The parties vices, but the landlord cannot itself require that they be should determine from insurance experts the necessity provided. Rules of operation of the building, such as for mutual waivers of subrogation, defenses based on limits on hours or provisions or heat, or hours during acts of the insured, and the like. which a loading dock may be used, can significantly de- • Rent and Common Charges. Common charges do not tract from the rights that a tenant would normally re- necessarily represent the operating expenses that are quire in the lease. Another area of critical examination is strictly relevant to the tenant. A tenant should examine the permitted use of the property. In particular, a tenant the appropriate lease provisions to determine whether it whose lease is by its terms subject to the declarations is appropriate to tolerate a direct pass-through of com- and by-laws might be told by a landlord that the tenant mon charges. In particular, if the lease seeks to require a should have realized that the condominium might not tenant to assume a portion of increased expenses for the provide services for the unit owner-landlord, so the ten- entire property, it should be determined whether there ant is out of luck. is a way to account for such expenses properly and • Obligations of Tenants as Unit Owners. A typical draft- whether common charges actually serve as a measure of ing anomaly in many condominium documents sug- such operating expenses to be passed along. gests that, for the purposes of the condominium docu- • Real Estate Taxes. Any provision allowing the escala- ments, unit owners shall be deemed to mean not only tion of real estate taxes should be reviewed to make sure unit owners, but also their tenants, and sometimes their that it reflects the appropriate measure of taxes against licensees and guests. Presumably, such drafting was the units. Because the unit will have its own real estate meant to suggest that tenants would be subject to the tax bill, rather than a fixed percentage of the total tax bill same restrictions as unit owners, and to require unit for the entire project, the normal real estate tax escala- owners to police the behavior of their tenants. Unfortu- tion provision should be adjusted accordingly. In addi- nately, carrying such logic through a document would tion, condominium documents can provide that any mean that a tenant could be asserted to have all of the grievance of taxes would be coordinated by the board, obligations of a unit owner. This makes sense with re- but a tenant might want to resist such a unified effort, gard to day-to-day behavior at the property, but is not depending upon the circumstances and the jurisdiction. necessarily intended to suggest that a tenant has the • Ability to Finance the Lease. Concerns of potential unit owners’ fundamental obligations to pay common leasehold mortgagees should be considered, including charges or would be subject to a lien for such payment. concerns about whether the mortgagee would be enti-

Journal | July/August 2001 47 tled to copies of notices in the event of a unit owner’s of multiple ownership for the tenant suddenly occupy- default under its obligations to the condominium, and ing the property of more than one owner. would be extended possible rights to cure. • Termination of Condominium Ownership. Either by op- • Alterations and Work. The ability to perform work in eration of law or by a vote of unit owners, a condo- the space will be governed by limitations in the docu- minium can be terminated.17 In that situation, the land- mentation and rules and lord who previously owned regulations of the condo- a discrete parcel of real minium, including matters The most general principle property that was rented to pertaining to work that will a tenant no longer is the affect common areas or to be invoked is that a tenant would technical direct owner of building systems, insurance the premises. The tenant’s issues, and even questions like to know that it can require the position is somewhat un- of when work can be per- rights it bargained for in the lease sure, but it would appear formed. that all unit owners would • Consents. It is not un- can be implemented. become tenants-in-common usual for lease provisions to for the entire property. require that a tenant may • Amendments to Condo- perform a certain act (such as the performance of work minium Documents. Condominium documents are nor- on its space) with the consent of the landlord, with a fre- mally subject to amendment by a vote of unit owners quently modified position being that such consent can- (sometimes also requiring the vote of mortgagees of unit not be unreasonably withheld. Similar provisions occur owners). Naturally, if a tenant evaluated its position in a frequently in condominium documents, where such ac- condominium based upon the condominium docu- tivities can be performed by unit owners with consent of ments, its position could be changed by an act of the the board, provided that they are within certain reason- unit owners amending the provisions previously relied able bounds. Regardless of whether the “reasonable- upon for comfort. ness” standard modifies the issue of consent, any tenant Sample Drafting Mechanisms must recognize the potential problem of asking for con- The imagination of lawyers can suggest myriad ways sent from a landlord, who would otherwise give it but is to deal with these concerns. Regardless of how clever a then prohibited from giving such consent by the condo- strategy might be, its use might be limited by the bar- minium documents or by the board. Additional prob- gaining positions of parties, their energy and other prac- lems arise if the landlord cannot unreasonably withhold ticalities affecting a given situation. Still, it is appropri- consent but there is no similar standard of cooperation ate to suggest some sample approaches to concerns imposed on the board. Furthermore, even if both the raised above. landlord and the board are required to behave reason- The most general principle to be invoked is that a ably at their respective levels of involvement, there may tenant would like to know that it can require that the be instances where the board seeks to withhold its con- rights it bargained for in the lease can be implemented. sent for a consideration that is reasonable in the subjec- (That is, a tenant should not have a landlord make a hol- tive position of the board, but might not be reasonable low promise, which can only be redressed by an action in the different position of the landlord. There might for damages against the landlord). In some instances, also be an instance in which an owner of a building this would suggest an attempt to make sure that the would give consent, but the board might have some landlord-unit owner has a right as against the condo- special concerns because of the condominium form of minium to obtain the necessary services and rights. The ownership, such as the objective concerns of other ten- landlord would then agree in the lease to provide the ants or issues relating to common property. services and give rights to the tenant (thus permitting • Further Subdivision of the Unit. The landlord-unit the tenant recourse against the landlord for failure to owner might have a right under the condominium doc- provide such services). In other instances, a tenant uments to cause the unit that is the subject of the lease might seek assurance that the board and other unit own- to be split into one or more condominium units. Because ers would respect the rights of the tenant, and might this is just a matter of documentation, it does not neces- even seek more direct privity with them in the condo- sarily require physical work. However, the landlord minium documents or in separate agreements. Not sur- would then own multiple pieces of real property, all prisingly, experience has shown that in a major devel- subject to the lease. Presumably, each unit could end up opment where the presence of the tenant is a critical being owned by a different owner, thus creating issues component of the success of the project, a tenant might

48 Journal | July/August 2001 be able to arrange for condominium documents to re- would be required to give consent if a landlord who spect its interest. Such a tenant’s “wish list” can inform owned the entire property would be required to give any tenant’s negotiation. In such situations, techniques consent, independent of the condominium form of own- include: ership. • Deal with Specifics. If a tenant can identify matters that • Restrictions on Amendments. If specific rights of a ten- it needs to make sure are provided by the entire build- ant are protected in condominium documents, it can ing, the condominium documents can provide intensive only be meaningful if the documents cannot be detail on issues such as the provision of heat to the unit, amended by the unit owners in a way that would di- the number of parking spaces applicable to the unit, the minish those rights. Accordingly, the provisions in the hours of operation and the like. This might create a documents that permit amendments might be changed problem of flexibility in the future, however. In addi- so they would prohibit any amendment that would af- tion, it is important to make sure that the critical provi- fect the lease without the consent of either the tenant sions cannot be amended subsequently. It would always and/or the owner of the unit which contains the de- be worrisome if some specific matter had not been con- mised premises. sidered by the imagination of the business people and • Protection Against Board’s Lien for Common Charges. attorneys at the time of drafting the document, only to The documents themselves, or a separate agreement have it later become an important consideration. with the board, could provide recognition and non-dis- • “Subordination” of Condominium Documents to the turbance of the tenant in the event that the unit is fore- Lease. One shorthand approach to a tenant’s concerns closed upon by the board. In addition, the tenant, both would be to suggest that the operation of the condo- on behalf of itself and any mortgagee, might request minium and all condominium documents would be mortgagee-type protections of copies of the notices of subject to the rights of the tenant and the operation of unit owner’s default to the condominium and an op- the property as required pursuant to the lease. Some portunity to cure such defaults. Some commercial con- practitioners express the view that any lease existing be- dominium documents recognize the concern of tenants fore the condominium document is recorded would be with respect to the lien for common charges and actu- in this superior position. (This argument, in part, in- ally have been drafted by developers to provide the au- cludes a supposition that all unit owners succeed to the tomatic recognition, non-disturbance and attornment of interests and obligations of the original owner of the leases covering spaces in excess of a certain minimum property, who was the original landlord.) However, an size. explicit “catch all” statement to this effect in the condo- • Insurance. Tenants might seek provisions in condo- minium documents, specifically identifying a particular minium documents or separate agreements pursuant to lease, might express an important governing doctrine which the parties would agree that (1) any insurance of for the protection of a tenant. Further, a tenant might the tenant, the unit owner and of the board or other unit seek a provision in the condominium documents recog- owners would include appropriate provisions so that nizing not only the existence of the lease, but explicitly their insurance policies would not conflict and/or stating that the board and all unit owners recognize that (2) that the parties would enter into such side agree- the condominium would operate in such a way as to ments as would be necessary so as to keep the scheme of provide everything required under the lease to the ten- insurance in place (such as an agreement, if necessary, ant, and not to diminish such rights or to increase any not to sue each other in such a way as to negate a waiver obligations of the tenant. of a claim that a covered act was an act of the insured). • Issue of Consents. To address the concern of a landlord These might include waivers of subrogation, defenses not giving consent under a lease because the condo- for acts of the insured and the like. minium’s consent under the condominium documents • Restoration. A tenant would seek to have condo- was withheld, a tenant might seek to have the board minium documents recognize that the portion of the limit its rights of consent in certain matters, such as condominium property consisting of the demised (1) the Board’s consent being deemed given if the land- premises be restored in accordance with the obligations lord gives its consent (whether or not it could be rea- of the landlord under the lease with respect to casualty. sonably withheld); or (2) the landlord agreeing that it Where the law (on 75% destruction)18 or condominium would not be a reason for withholding consent that the documentation might require an affirmative resolution condominium did not give consent (thus giving a tenant of unit owners to restore, a tenant might seek a power of rights against the landlord, although the tenant might attorney and proxy from all unit owners in the event of still not be able to perform the act which was requested); such a vote (whether these run in favor of the tenant or or (3) having the board agree that in such a situation it in favor of the tenant’s landlord). The condominium

Journal | July/August 2001 49 documentation itself might provide for these powers of Conclusion attorney and proxies (presumably to attempt to bind all This survey of the concerns of tenants taking space in present and future owners). condominium units can only be read in light of the • Multiple Owners. If the premises are contained in specifics of a particular project. In addition, although a more than one unit, or if there is a prospect of an exist- major tenant in a development deal might have signifi- ing unit being further subdivided into more than one cant opportunity to negotiate its wish list of protections unit, a tenant might seek to require that there only be in condominium documents, many situations will not one party for the tenant to deal with. Otherwise, it allow a tenant to protect itself in this manner. would create difficult administrative problems, as well All the same, a discussion of these items raises the as the possibility of receiving different treatment with concerns that all tenants should consider. In fact, for a respect to different . One sample mechanism developer to be successful, the concerns of prospective would be for the landlord to agree that the owner of a tenants might be anticipated and addressed in forma- particular portion of the space would be deemed the tive condominium documents. To go full circle, it agent for all of the owners, and that the tenant would should be recognized that these deals only start at the only be required to give notice and deal with that one beginning of negotiations for such a lease with a state- agent, who would be authorized to speak in a binding ment of general principles and approaches derived from way on behalf of all of the landlord-unit owners. due diligence. • Termination. A tenant might seek a provision that, in the event of termination, not only would the lease be 1. David Clurman, The Business Condominium (1973). deemed to remain in place, the original landlord would 2. Matthew J. Leeds, Special Considerations of a Major Tenant be deemed to be the de facto owner of the portion of the Taking Space in a Commercial Condominium, The ACREL premises subject to the lease, and would be the agent for Papers, Fall, 1999. all of the other owners with respect to whom the tenant 3. N.Y. Real Property Law § 339 (hereinafter “RPL”). would deal. The tenant would also want all owners to 4. See, e.g., David Clurman & Edna Hebard, Condominiums be held responsible jointly and severally for the perfor- and Cooperatives (1970); Patrick Rohan & Melvin Raskin, Condominium Law and Practice (2001); William Jay mance of the landlord’s obligations under the lease. Lippman, Condominium and Co-op Closings: A Practical • Enforcement Rights. A tenant might seek not only for Guide to Residential and Commercial Properties, (3rd ed. the condominium documents to provide that its land- 2000); Matthew J. Leeds & Walter Goldsmith, New York Practice Guide: Cooperatives & Condominiums (1986). lord be the unit owner having a right to require the con- dominium to provide everything which has been nego- 5. RPL § 339-e. tiated in the lease but the tenant might also seek to have 6. RPL § 339-y. the condominium agree that the tenant, as a person 7. RPL § 339-l. named in the condominium documents, would have a 8. RPL § 339-m. right to claim such benefits. In addition, a tenant might 9. RPL § 339-z, 339-aa. seek to have both the lease and the condominium docu- 10. RPL § 339-z. ments recognize a right of the tenant to pursue enforce- 11. Id. ment of such rights directly against the board and other 12. RPL § 339-u. unit owners. To the extent that the condominium docu- 13. N.Y. General Business Law article 23-A (the “Martin ments and/or operation of the condominium is subject Act”) §§ 352-c - 352-k. to the lease, a tenant would like the board and the unit 14. See, e.g., N.Y. Comp. Codes R. & Regs. tit. 13, pt. 20, (Reg- owners to recognize their obligations to provide the ulations Governing Newly Constructed, Vacant or Non- landlord’s responsibilities to the tenant, although this Residentials.) might be taken as an extreme position in certain circum- 15. Andrew Herz & Russell Wohl, Subleases: The Same Things stances. In fact, in order to mollify other unit owners, it as Leases, Only Different, 35 Real Prop., Prob. & Tr. J. 667 might be appropriate in many situations for a tenant to (2000). agree that enforcement of its rights against other unit 16. RPL §§ 339-bb, 339-cc. owners would be limited to equitable remedies to make 17. RPL § 339-t. sure that appropriate services were obtained, at the 18. RPL §§ 339-bb, 339-cc. same time suggesting a limitation on damages which could be sought against the unit owners (but leaving the opportunity to pursue damages from the landlord-unit owner or an obstreperous board).

50 Journal | July/August 2001 Understanding Mechanic’s Liens Reveals Approaches to Thwart A Developer’s Improper Filing

BY BRIAN G. LUSTBADER

mechanic’s lien is as easy and inexpensive for a chanic’s lien on a private (or public) improvement is lienor to file as it is costly and time-consuming limited. Even so, if a property owner believes that a lien Afor the property owner to discharge. All that the against the property was wrongly filed, there are few prospective lienor need do is file a short (one page) form options available to discharge that lien. with the clerk of the county in which the subject prop- There are four basic methods. First, the owner may erty is located. No attorney is required and, until a re- “bond” the lien, that is, apply to the Supreme Court or cent amendment of the New York Lien Law, the lienor the County Court of the county in which the property is could keep his or her lien indefinitely by obtaining one- located to file a bond, in an amount set by the court, to year extensions each year after the initial filing.1 substitute as security for the debt allegedly owed in the Yet such a simple filing can and often does create sig- place of the property itself. Such a procedure is not ter- nificant title and loan problems for the owner of the ribly time-consuming (it can be accomplished in a few property subjected to the lien. Lenders often require that weeks) and is relatively inexpensive in terms of attor- the properties be kept “lien-free,” and, in addition, title ney’s fees and court costs. The problem is that the owner cannot be conveyed without discharging any liens that often must post collateral in the amount of the bond as exist. With this type of leverage available from such a set by the court (usually 110% of the amount of the lien), simple filing, a mechanic’s lien is a potent weapon in the and this collateral must remain in place until the lien is hands of an unscrupulous individual. For that reason, satisfied or litigated, which can take years. When a lien there clearly is great value to any method that enables a is inflated, this problem can be especially onerous for property owner to discharge a meritless lien without the owner, as additional collateral will be tied up for the waiting for a full-blown lien foreclosure proceeding. duration of that lien. However, this procedure is always This article describes the remedies available to the pri- available, regardless of how the owner utilizes any of vate property owner, and then focuses on liens asserted the other procedures described below. not by a contractor or a materialman, but by a developer. Another option available to the owner is to counter- Before analyzing the methods used to discharge a claim against the lienor for willful exaggeration of the lien, it is important to understand the purposes under- lien. If successful, the owner may be able to have the lien lying the Lien Law itself. The statutory scheme was not reduced to the proper amount, or even to have the lien designed to protect each and every person who per- dismissed in its entirety. In addition, the lienor may be formed a role in the improvement of real property. required to reimburse the owner for his or her costs in Rather—and undoubtedly in recognition of the cloud on obtaining such an order, including reasonable attorney’s title and the other adverse ramifications of a filing—the fees expended in the owner’s effort to establish the law’s protection was limited to the class of people who directly perform labor or furnish materials. These in-

clude contractors, subcontractors, suppliers, laborers RIAN USTBADER 2 B G. L is counsel to and the like. In recent years, that class has been ex- Mazur, Carp & Rubin, P.C. in Manhat- panded slightly to remedy perceived abuses against (or tan and a member of the Real Property simply to provide additional protections for) two addi- Law Section of the NYSBA. He liti- tional groups of individuals—architects and real estate gated the referenced case on behalf of brokers.3 the owner. A graduate of Massachu- setts Institute of Technology, he re- Methods for Discharging Liens ceived his J.D. from Columbia Univer- As the foregoing demonstrates, the class of compa- sity School of Law. nies or individuals who may legitimately assert a me-

Journal | July/August 2001 51 amount of the exaggeration.4 This option may have veloping,” have not been subject to extensive judicial some in terrorem effect on the lienor, that is, it may scrutiny. frighten the lienor into being reasonable with settlement As indicated above, few reported cases involve a lien demands, or even may encourage the lienor to with- that was stricken under Lien Law § 19(6), and none of draw the lien without further litigation. them involves a lien asserted by a developer. Therefore, However, if the lienor is not frightened off by the a decision last year by Justice Stanley L. Sklar of counterclaim,5 the owner must then either force the Supreme Court in New York County addressing this sit- commencement of a foreclo- uation is a welcome addition 9 sure (discussed below), or to the case law. The opinion wait until the lienor begins Few reported cases involve clarifies a number of issues the foreclosure action on his that can arise under Lien Law own—and the latter may not a lien that was stricken under § 19(6), including the type of occur until years after the fil- Lien Law § 19(6), and none of services for which a lien may ing (unless the willful exag- be filed, the class of claim- geration can be shown on a them involves a lien asserted ants permitted to file liens, summary judgment motion, by a developer. and the circumstances under a difficult task at best). which a lien may be dis- missed because of facial de- A third procedure pre- fects. vents the lienor from extending his or her lien for years, The case itself dealt with two liens filed by an indi- and allows the owner to obtain an adjudication of the vidual and his wholly-owned company, claiming that lien’s merits as rapidly as possible. This is simply a de- they acted as developers of two building renovation mand upon the lienor to initiate a foreclosure action projects in lower Manhattan. Each lien contained the fol- within 30 days; if the lienor does not comply, the lien lowing, identical description of the services allegedly will be discharged.6 The advantage of this demand, provided: “professional services rendered, as developer, other than the obvious acceleration of the foreclosure in connection with the coordination, supervision and di- proceeding (or, if the owner is fortunate, a lienor default rection of the development of the premises known as and the resultant lien discharge), is that it requires the and by the street address of . . .” lienor to incur significant and immediate expenses in By way of background, the owner had obtained a the form of attorney’s fees and the like. The disadvan- loan from a single lender to cover the renovation costs tage is that if the lienor does “pick up the gauntlet” the in both premises. The developer’s fees were recited as a owner must still await the entire legal process, including line-item cost to be paid each month on a proportional pre-trial document discovery, interrogatories, and depo- basis. A few months into construction, the owner de- sitions, plus a full trial, before resolution—all while in- faulted on the loan and construction ceased. The aggre- curring legal fees. gate value of both claimed liens exceeded $3.5 million. The only other option that allows immediate dis- This was the full amount of the development fees re- charge, without committing funds in the form of a lien cited in the loan documents, even though, as noted bond for discharge, is the rarely-used procedure of peti- above, the project had ceased after only a few months. tioning the court to dismiss a lien on its face.7 The rea- The lender then foreclosed against the owner on its son that this procedure is rarely used, and cases on the loan. In that proceeding, the developer, one of the vari- subject rarely published, is that it is typically available ous mechanic’s lienors named in the mortgage foreclo- only when there is a fatal defect that is apparent from sure action, asserted his lien claim. In response, the the face of the lien itself, e.g., an incorrectly named owner counterclaimed against the developer for willful owner, or a lien filed beyond the period of limitations exaggeration of the lien. New financing was obtained, set forth in the Lien Law.8 However, should a particular but because of the magnitude of the liens the owner was lien fall within category, the advantages of a Lien Law required to escrow funds well in excess of what was § 19(6) petition are obvious. In a relatively expedient, claimed in order to satisfy its subsequent lender. cost-effective fashion, an owner can be rid of a nettle- some lien soon after it is filed. Given the adverse impact the lienors were having on the projects, the owner chose to take aggressive action Denying a Developer the Right to Lien against the liens, and brought a Lien Law § 19(6) pro- The developer’s role is often central to the improve- ceeding independent of the mortgage foreclosure, as ment of real property, but his rights under the Lien Law, permitted by statute.10 The owner and initial lender ul- and those of the owner whose property he has been “de- timately settled the foreclosure action, and the owner

52 Journal | July/August 2001 and the developer were left to litigate between them- Lien Law § 19(6). Owners and developers must now be selves regarding the liens that had been filed. guided accordingly. Because there were no prior cases under New York’s Lien Law that dealt with the validity of liens filed by de- 1. Until recently, N.Y. Lien Law § 17 permitted unlimited velopers, the parties argued by analogy. The owner re- extensions of one-year duration, obtained by ex parte court order, for private improvements. Under Lien Law lied on cases that emphasized how the Lien Law’s pro- § 18, the limit of each extension for public improvements tections are limited to those who perform direct, on-site was six months. However Lien Law §§ 17 and 18 were services (or who furnish materials) that were actually amended by 2000 N.Y. Laws ch. 324, § 1, to provide that incorporated into the subject real property improve- effective January 1, 2001, lienors will be entitled to obtain 11 only two such additional one-year extensions for both ment, except where the Lien Law specifically permits a public and private improvements. claim for particular types of off-site services, e.g., archi- 2. “A contractor, subcontractor, laborer, materialman . . . 12 tectural or real estate brokerage services. In response, who performs labor or furnishes materials for the im- the developer pointed to the leading cases in which con- provement of real property . . . shall have a lien for the struction supervisors had been permitted to file liens for principal and interest, of the value, or the agreed price, 13 of such labor. . . .” Lien Law § 3. “The term ‘contractor,’ their services. when used in this chapter, means a person who enters Ironically, however, the cases cited by the developer into a contract with the owner of real property of the im- proved useful to the owner. Justice Sklar noted that provement thereof. . . .” Id., § 2(9). “The term ‘laborer,’ when used in this chapter, means any person who per- these decisions held that liens may not be filed for ser- forms labor or services upon such improvement.” Id., vices such as negotiation of subcontracts, coordinating § 2(11). contractors, etc.—in short, services that do not necessar- 3. See Robert Plan Corp. v. Greiner-Maltz Co., 229 A.D.2d 122, ily need to be performed at the construction site itself. 655 N.Y.S.2d 648 (2d Dep’t 1997) (real estate brokerage The court struck the liens. services). In granting petitioners’ application, Justice Sklar em- 4. Lien Law § 39 states: In any action or proceeding to enforce a mechanic’s phasized the requirement that the lienor have expended lien upon private or public improvement or in labor directly in improving the real property, citing Lien which the validity of the lien is an issue, if the court Law §§ 2(4) and 3, together with two cases decided shall find that a lienor has willfully exaggerated the thereunder.14 Because there was no New York authority amount for which his claims a lien as state in his no- tice of lien, his lien shall be declared to be void and directly on point, Justice Sklar also cited leading author- no recovery shall be had thereon. ities outside New York: the Supreme Court of Indiana Lien Law § 39-a states: and an intermediate appellate court in Illinois that had Where in any action or proceeding to enforce a me- ruled developers may not lien for their services.15 chanic’s lien upon private or public improvement Justice Sklar held that, “while supervisory services the court shall have declared said lien to be void on account of willful exaggeration the person filing may form the basis for a lien . . . [such supervision] must such notice of lien shall be liable in damages to the be of actual, on-site construction work . . . [and the] per- owner or contractor. The damages which said formance of collateral supervisory functions, such as the owner or contractor shall be entitled to recover, negotiation of contracts or the procurement of bids . . . shall include the amount of any premium for a 16 bond given to obtain the discharge of the lien, . . . constitute non-lienable work.” Justice Sklar indicated, reasonable attorney’s fees for services in securing however, that his decision did not affect the viability of the discharge of the lien, and an amount equal to any contract claim that the developer might have the difference by which the amount claimed to be against the owner, thereby negating any argument that due . . . as stated in the notice of lien exceeded the amount actually due . . . thereon. the developer was being denied an opportunity to pur- 17 5. Only a handful of such cases has resulted in any severe sue his claim in court. penalty, as it is very difficult to demonstrate that the lienor has acted “willfully.” Conclusion 6. Lien Law § 59 states: This ruling expressly confirms two important points. A mechanic’s lien notice of which has been filed on Developers cannot qualify as “contractors” within the real property . . . may be vacated and canceled . . . meaning of the Lien Law because they perform execu- by an order of a court of record. Before such order tive level services that are, by their nature, essentially shall be granted, a notice shall be served upon the lienor. . . . Such notice shall require the lienor to off-site and removed from the day-to-day work on the commence an action to enforce the lien, within a project. This remains true even if those services are ex- time specified in the notice, not less than thirty days tensive, such as arranging for financing, planning and from the time of service. . . . Proof of service and marketing the project, negotiation of contracts and sub- that the lienor has not commenced the action to foreclose such lien, as directed by the notice, shall contracts, and oversight of contractors. Further, liens for be made by affidavit, at the time of applying for such services are subject to immediate discharge under such order.

Journal | July/August 2001 53 7. Lien Law § 19(6) states: ment Corp., 85 Misc. 2d 304, 306, 379 N.Y.S.2d 994, 999 Where it appears from the face of the notice of lien (Sup. Ct., Queens Co. 1976). that the claimant has no valid lien by reason of the 14. In this connection the court cited West-Fair Electric Con- character of the labor or materials furnished and for tractors v. Aetna Casualty & Surety Co., 87 N.Y.2d 148, 638 which a lien is claimed, . . . the owner or any other N.Y.S.2d 394 (1995), and Chas. A. Sells, Inc. v. Chance Hills party in interest, may apply to the supreme court of Joint Venture, 163 Misc. 2d 814 (Sup. Ct., Westchester Co. this state, . . . for an order summarily discharging of 1995). record the alleged lien. . . . The application must be 15. Premier Investments v. Suites of America, Inc., 644 N.E.2d made upon a verified petition . . . and upon the ap- 124 (Sup. Ct., Ind. 1994); First Bank of Roscoe v. Rinaldi, 262 proval of the application by the court, . . . an order Ill. App. 3d 179, 199 Ill. Dec. 850, 634 N.E.2d 1204 (Ill. shall be made discharging the alleged lien of record. App. 2d Dist. 1994). 8. For example, in Atkinson v. Tiscione, 150 Misc. 2d 971, 972, 16. Citing Henry & John Assocs. v. Demilo Construction Corp., 571 N.Y.S.2d 189, 190 (Sup. Ct., Schenectady Co. 1991), 137 Misc. 2d 354, 520 N.Y.S.2d 340 (Sup. Ct., Queens Co. the court dismissed a lien for financial consultant ser- 1987); Goldberger-Raabin, 252 N.Y. 336; Carl A. Morse, 85 vices. See also FCZ Corp. v. Blais Deli, Inc., 135 A.D.2d 535, Misc. 2d 304. 536, 522 N.Y.S.2d 16, 17 (2d Dep’t 1987), (lien claim for wrongful termination of employment agreement sum- 17. A separate issue that was briefed by the parties, but only marily dismissed under Lien Law § 19(6)). indirectly decided by the Court, was whether extrinsic evidence could be submitted to defeat, or sustain, a lien 9. In re 110 Church LLC, et al., (Sup. Ct., N.Y. Co., Sklar, J.), that might otherwise be considered defective. See N.Y.L.J., 9/20/00, p. 27, col. 2. DiCamillo v. Navitsky, 90 Misc. 2d 923, 925, 396 N.Y.S.2d 10. See Lien Law § 19(6), quoted in note 7, supra. 585, 587 (Sup. Ct., Putnam Co. 1977) (lien summarily dis- 11. See the provisions of the Lien Law quoted in note 2 supra. charged and extrinsic evidence rejected where admitting the extrinsic evidence would serve “no useful purpose”). 12. See Lien Law § 2(4); see also Robert Plan Corp. v. Greiner- By reviewing the arguments raised by the parties in their Maltz Co., 229 A.D.2d 122, 655 N.Y.S.2d 648 (2d Dep’t supporting affidavits Justice Sklar implicitly ruled that 1997). such extrinsic evidence could be considered. 13. Goldberger-Raabin, Inc. v. 74 Second Avenue Corp., 252 N.Y. 336 (1929); Carl A. Morse, Inc. v. Rentor Industrial Develop-

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Journal | July/August 2001 55 omission of the vibrant contract and Rochester got the courthouse. You even environmental law practice, one have to watch those tricky footnotes. EDITOR’S thing we definitely agree upon is that David O. Boehm military counsel are highly motivated. Harris Beach & Wilcox MAILBOX Although service cultures may be Rochester, N.Y. different, the judge advocates serving President’s Message in the Army, Air Force, Navy and In addition to stirring fond memories Child Care in Courthouses Coast Guard around the globe in of my family’s cottage at Crescent Beach I read, with great interest, your Feb- places like Bosnia, Southwest Asia, at sea, and yes, even in Washington, D.C., in Ontario, I think that Paul Hassett’s ruary cover story “Construction Pro- President’s Message in the March/April all share a most noble service commit- gram Provides New Facilities.” My issue accurately portrays a new direc- ment, to provide their country and hope is that each of the new court- tion for the courts in New York State. houses and future courthouses to be their fellow service members the best The dedication of Chief Judge Ju- built around the state will provide legal advance they can. dith S. Kaye and the many other for- child care services for employees, ju- Lt. Col. Wayne Wisniewski, USAF ward-thinking jurists throughout our rors, for members of the bar, and for Peterson Air Force Base, Colo. Unified Court System is encouraging. others who must appear in court. Child The 18-B Experience Here at home under the energetic lead- care in municipal buildings/court- I was delighted to see the article in ership of Hon. Vincent E. Doyle, the houses is of great importance. It’s an the June issue of the Journal on 18-B Eighth Judicial District has taken a important convenience. This service and law guardian compensation. Cov- lead role in many pilot projects within also enables governments to attract the erage of this critical matter is long our courts. best employees – people who would overdue. The plight of the parties rep- Not unlike the resolution of the like to work near their children. The resented by underpaid counsel cannot Peace Bridge issue, our problem- lack of adequate child care in New York be overstated. The problem here is solving courts cannot be at their best is disappointing. Most child care facili- how to reach the general public and without community input and in- ties close after 6 p.m. Employees who the powers that be in the state govern- volvement. This includes the legal might otherwise be willing to work ment to underscore the need to im- community. Those of us who work longer hours have no choice but to prove the pay of those who represent within the courts and those of us in leave work shortly after 5 p.m., creat- the less fortunate among us. private practice would do well to keep ing productivity problems. Those who I hope the article has made some an open mind and to participate in are on waiting lists for child care pro- making problem-solving courts work. grams must rely on baby-sitters or nan- impact on the problem; it was an excel- The first graduation ceremony was nies who are not always very reliable. lent statement of the issue. held recently at the Jamestown Drug Child care makes sense in every Miriam Null Holliswood, N.Y. Court. In speaking about the gradu- courthouse and in every government ates, our district attorney and public building. Defending the Footnote defender sounded like the proud par- Paul Feiner As an emeritus member of the ents of a Little Leaguer who just hit Greenburgh Town Supervisor Fourth Department who was one of one out of the park. One notable grad- Military Law Cases those responsible for abolishing the uate who had 70 previous arrests is As a staff judge advocate serving on footnote in appellate briefs, I write in now drug-free and gainfully em- active duty in the U.S. Air Force, and a response to Paul F. McAloon’s interest- ployed. He is paying child support for New York State Bar member since ing defense of the “Lowly Footnote” in the first time. The mother of his child is 1984, I enjoy reading any article that the March/April issue. also a drug court graduate. brings the fascinating and diverse He is right in pointing out the foot- In addition to the apparent societal practice that is military law to the at- note’s literary value and its occasional benefits, there is this side bonus for the tention of others. By their article, “Mil- “pleasant relief” for both writer and bar. With every drug court graduate, itary Cases Present Diverse Array of reader. However, it can also lead to un- with every child who now has a fight- Vital Issues for Individuals and the intentional error, as in footnote 3 of his ing chance, we get to be the good guys. Government,” in the February issue, appealing exposition, where he refers The lawyers are not looked down attorneys Fidell and Sheldon have suc- to Buffalo as the place where the upon, but are seen as part of the solu- ceeded and done the bar a great ser- Fourth Department sits. Actually it tion to some of society’s worst ills. vice. While I differ with some of their sits, and always has, in Rochester, Kathleen Down Krauza characterizations, the “don’t ask, don’t which got the better of the bargain. Chief Clerk tell” policy for instance, and regret the Buffalo got the blizzards and Chautauqua County Courts

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Bicandi Martha A. Greenough Jon Eric Martino Ronen Sarraf Scott R. Worden Rachel S. Blumenfeld Mark D. Grimm Carlos Mastrapa Nitin S. Savur Iyad S. Zawaideh Daniel Matthew Boglioli Robert Grodd Edwin Matos Karen Theresa Schiele Victoria H. Zerjav Emily J. Boris David Guadagnoli Jill Heather McClure Robert Schirtzer Dehai Zhang Damien Matthew Bosco David V. Gubbini Frederick R. McGowen John Erik Schreiber Fathia Zouiyen Jason R. Boyarski Nicholas A. Gunia David Charles Mcgrail Jessica Mila Schutzman William Creighton Brashare Keith J. Hand Richard Brian Mcgrath Collin Schwartz SECOND DISTRICT Martin Burn Brent Hannafan Glenn Patrick Mcgrory Amy R. Sender Allie Aaron Shinina T. Butle Norman J. Hannawa Lauren Ann Mchugh Paul V. Seraganian Nicole M. Ajello Jan Osten Bystro Birch M. Harms Mary Alice Mclaughlin Andrew Shaffer Iddo I. Arad Elizabeth L. Capuan George Robert Hatzmann Vanessa Marika Meis Diana R. Shafter Justin Bloom Mary C. Cart Clara Elizabeth Henderson Jennifer Tabacchi Mitek Cheryl Leah Shammas Racquel Delsita Brown Christopher Joseph Carus Krisana Maria Hodges Robert Modica Stuart R. Shaw Robert E. Brown Antonio Celii Stephen B. Holden Curtis Lindberg Moner Umar A. Sheikh Marjory Cajoux Michele C. Cerullo Scott Walter Horlacher Kyle W.K. Mooney Morgan S. Sheinberg Caroline Campomanes Daniel H. Chakrin Jerome C. Huang Robert E. Moriber Nanci Ship Pei Pei Cheng Roy Lee Chan Irene Mary Hurtado Stuart Anthony Morrissy Andrea Kamala Shreeram Christine P. Claffey Guy Chayoun Amy K. Impellizzeri Joseph P. Morsellino Howard Frederick Sidman Adam Seth Cohen Betty Chen Nicole Ilyse Isacoff Marla Moskowitz Jennifer L. Siegal Bella Cohen Lisa Ann Chiarini Alon Israely William Denis Motherway Pearl Teng Ling Siew Michele D. Collins Daniel P. Chiplock Rachel L. Izower Matthew Francis Musselman Atul Singh Nia Cross Laura G. Ciabarra Yeon Wook Jeong Matthew Leo Mustokoff Deborah A. Sinnott Thea K. Davis Lauri Cohen Zheng Jiang Jason Abraham Nagi Paola Siracusa David W. Denton Christopher A. Colvin Megan E. Johnson Rajni A. Narasi Kurt A. Skeete Nadia I. Desyatnikova Christian B. Coppinger Matthew Farley Jones Roxanna D. Nazari Anna-Marie C. Slot Elliot M. Elo Gerald Coviello Gregory H. Kahn Bryan Nazor Jane Alexandra Small Keith D. Elrington Eric Dannheim T. Quinlan Kato Messeret Nega Eric James Smith Dawn Falco Anthony Lawrence Deluca David G. Katona Nahalel Alexander Nellis Jocelyn A. Smith Maryann Fede John Francis Desantis Noah Reid Katz Eric W. Nerenberg June H. Smith Marcel Florestal Malick Alioune Diop Kristen Margaret Keenan David Greg Neustein Nadine Smith Penelope J. Flynn Kevin Andrew Donohue Weslii V. Khahaifa Patricia M. Nunez Amy Jill Sobotkin Elsa M. Forbes Anne Bridget Doohan Freda M. Khan Colleen O’Loughlin Alan H. Sonnenklar Jamie A. Forman Daniel Dovdavany Sandra M. Kiersh Sarah Opatut Alexander Soric Spencer Brandt Freedman Nathy J. Dunleavy Taeman W. Kim Steven Howard Ornstein Victoria Prussen Spears Harold Gates Gerald Eichinger Thomas P. King Jeffrey E. Palker Caryn S. Stein Arthur Gershfeld Michael Q. English Gregory Anthony Kleva Laura Rose Palmer Joshua Adam Stein Jennie Getsin Franco Esposito Michael Korsinsky Peter Papagianakis Victor A. Grossman

Journal | July/August 2001 59 Kathleen Higgins FOURTH DISTRICT Nicole Marie Harris Avemaria Thompson Anyaibe Christopher W. Hoyt Margery C. Eddy Douglas Richard Henry William T. Toohey Olga King Arthars-Beskrone Richard Kipperman Robert R. Glynn Ian C. Hunter Arturo Torres Ann Ayers Jonathan Darrell Klein Scott R. Jones Rochelle Inger Darlene T. Treston Jeffrey J. Babcock George Kontogiannis Karl C. Kranz Yvette M. King Andromachi Tsoukalas Mauricia M.M. Baca Moshe Koplowitz Maureen Anne Mangan Claire Margaret Lapham Evanthia Voreadis Ronald W. Backes Michelle Lloydene Lawner John R. Mertz Louise A. Leduc Nathaniel T. Wallace Marie C. Baker Cheryl L. Lewis Glen F. Michaels Christopher N. Lewis Nikolaos Xylas Robert M. Baratta Danielle Librizzi Aaron W. O’Brien Lynne Mazin Andrew Zajac Scott C. Barnett Joseph Lopardo Daniel Salvin Andrew McLaughlin Kimberly T. Zuckerman F. Daniel Bell Marc A. Lowy Anthony R. Mole Relani Belous Elizabeth Elaina Malang FIFTH DISTRICT Kristin H. Neuman ELEVENTH DISTRICT Stephanie M. Belser Ian G. Merrill Kristen M. Benson Jeffrey Odefey Hector Alexiades Ronit Ben-Hur Jacques Elwin Michel Deborah I. Bice Jodi Ritter Camille Danielle Barnett Michael Paul Benedek Rebecca Morris David A. D’Agostino Elyssa C. Santos-Abrams Rosemarie P. Boyd Hector Benitez-Solivan Miriam Mosseri Julie L. Giruzzi Vincent Savino Rocco A. Cavaliere Kim Jean-Batiste Benjamin Derefim B. Neckles Christine M. Heppeler Brian T. Schmidt Allan G. Chambers Matthew Berkle Keith A. Nezowitz Amy S. Maloney Anuja Shah David Chan Laure Berthelot Esther C. Noe Rebecca Mandigo Mark A. Smith Blaise U. Chow Michael Bertrand Funmi Odegbami Elizabeth B. Snyder Tara E. Smith Wanda Doening Jessica Blatt Tara A. O’Rourke Michael D. Steinberg Amy Kendra Stoeberl Gwenevere Corlis Foster Glen E. Books Zvi Ostrin Annemarie E. Steward Adam D. Wadler Ethan David Ganc Jason Michael Borlinghaus Sean Patrick O’Sullivan Carissa L. Swavely Bruce J. Walker Gregory Lowell Gliedman Mary B. Boyle Tatiana Pahman Stacey A. Wiley Robert M. Weiner Carol L. Kegler Rebecca Brackley Svetlana M. Polyakova Galen D. Wilcox Jooyun Y. Kim William H. Brammer Sharmila Rampersaud SIXTH DISTRICT Thomas M. Wilentz Shawn Lan Stacey Michelle Brandenbury Joel S. Ray Edward E. Kopko Philip J. Wirzbicki Mayra Ivelisse Lopez Traci Vernita Bransford Paul J. Sagiv Paul Prasarn Sabrina Malpeli Gregg A. Brauneisen Howard J. Schain Jon J. Sarra TENTH DISTRICT Joseph F. McCabe Murry David Brochin Jennifer W. Shon Christopher Schulte Bruce A. Barket Carey C. Moore Mark Arthur Brown Steven N. Solomon Mary M. Tarantelli Meredith Diane Belkin Nicole Napolitano Keith C. Buell Inna Spector Andrew J. Welch William Bird Eslyn R. Persaud Erik J. Burgos Stacey E. Steinberg Margaret G. Blascetta Kaisur Rahman Thomas S. Burke Olga Suslova SEVENTH DISTRICT Dennis Buchanan Evelina Rubinoff Caleb Paul Burns Keith Taketo Tashima Margret Haining Cowles Jeffrey Philip Campisi Yana Ryzhik Deborah Ann Burns-Megarr Anna Tsirlina Elizabeth A. Davies Michele Capetola Rita Stark Christopher Robert Calabrese Yevgeny Tsyngauz Joseph S. Dressner Linda Caputo-Friedmann David R. Swarthout Silvio Cappellari Lizette Rios Vallsworth Eileen T. Duggan Lynnette S. Certain Hannah M. Tabbara David Cargille Thomas Karl Wittig Ellen P. Lynch Marilyn B. Chinitz Michael David Tarbutton Howard S. Caro Craig Edward Young Karen M. Petote Lauren Chite Hafiz Uddin James R. Carroll Peter L. Zanolin Melanie Sarkis Ricky Collura Tracy Kwai-lan Wong Thomas A. Carroll Jodie L. Sayers Diane Corrigan-Hancock Feng Xie Edward V. Cattell THIRD DISTRICT Shannon Lee Stockwell Shawn S. Cullinane Francis Y. B. Chew Edward Joseph Aluck Kevin Tompsett Richard D’Addario TWELFTH DISTRICT Denise Chim Mary Tracey Brooks Michael R. Denkovich Jennifer L. Budner Sang Bhee Choi Donna Cole-Paul EIGHTH DISTRICT Timothy Feil Rebecca Hanson Chenard Jodie Leith Chusid Jacqueline Conti Joseph A. Agro Thomas A. Gabriele Richard B. Demas Catherine M. Clark Thomas Henry Cragan Randy G. Attea Joseph T. Garcia Vadim Goldshteyn Adauto V. B. Conde John E. Daly Stephanie A. Cole Ross H. Gould Idina M. Holmes Catherine Conneely Rebecca Denue Troy Flascher Michelle L. Gross Sabrina Jiggetts Meredith R. Conway Denise M. DiPace Maureen Flynn Larry Inniss Richard P. Kearney Alicyn Beth Craig Michael J. Dutkowsky Kevin Graff Adrienne L. Lasaponara Alla Krupnik James Carman Crescitelli April A. Elkovitch Kelly Grear Adam J. Leemon Reagan Lambert Heather Daly Kirsten E. Fish Vincent A. Hemming John R. Lewis Nhu Phuoc-Anh Nguyen Paul S. Danner Jill Gruben Michael J. Hillery Anthony Michael Makrides Robert J. Reid Kelvin Scott Davis Stacy Harvey Anna M. Kobialka John F. McKinney Suzanne Marie Saia Stephen H. Dinolfo Kathleen S. Holland Elizabeth A. Mallory Latanya B. McPherson Peter A. Sell Dominick DiRocco Peng Jiang Cassandra J. Mann Maria S. Mitchell Hillary Shayne Springel Demetrius J. Djoulia Douglas R. Kemp Tiffany R. Martin Amy M. Monahan Licet Tineo John J. Donovan Denise M. Kim Daniel Morse Pranali M. Patel Tae-hoon Charles Won Priya Doraswamy Traci A. LaVallee David Polak Jeffrey I. Peskin Shana L. Douglas Karen McGrory Lisa D. Primerano Danielle M. Peterson OUT-OF-STATE Peter Francis Dow Leesa A. Naimo Aaron B. Sukert Vivien V. Ranada Lisa N. Abad Jonathan Jackson Doyle Candice Panichi Susan Fedor Surace James D. Reddy Christopher L. Abernathy Allen Arthur Drexel Yiselle Rodriguez Philip Witzling Kim M. Roesch Sae Ahn Peter Andrew Dub William Proctor Scott Beth L. Rogoff Yuki Akimoto Charlene D. Dukes Maura Patricia Walsh NINTH DISTRICT Gerald Rosenberg Maristella Aldana Marc S. Edrich Daniel Werner Debra A. Arena Leslie Rutledge John Anthony Ammiinato Kelly Eibs Ann Morris Willey Jennifer Ashare Jessica Grace Schubert Michael B. Anastasio Pia Manuela Eichberg Steven D. Wilson Christine Elizabeth Cervasio Harold A. Shapiro Timothy Andison Michael Eisenberg David C. Zegarelli William Wyman Cobb Beth Silver Chris Aniedobe Esteban J. Elias Richard H. Durben Heather J. Smith Kwadwo D. Anto Robert Epstein Elizabeth Sack Felber Steven Stern Valentine Chukwuemeka Diana S. Erickson Joseph A. Ferrigno Vincent Charles Tenety Rocco F. Errico

60 Journal | July/August 2001 Sarah R. Evans Laurie LaPalme Anne Mercedes Abdulcadir Farah Laura A. Lattal Schneiderman Christopher R. Fawcett Jason B. Lattimore Tania Scivetti Rory Z. Fazendeiro Chung-l Lee Geoffrey Louis Scowcroft In Barry Richard Feldman Donna M. Lee Stephanie A. Sechler Andrew Guthrie Ferguson Hyoung S. Lee Stefan Seel Memoriam Catherine M. Ferrara-Depp Moosang Lee Na Seon Joo Lori Ferraro Louis P.A. Lehot Kristi Lucile Toniann J. Ferreth Adrienne LePove Neel G. Shah Edward A. Baker Jonathan H. Ferry Yaniv Levinson Saleem A. Shareef Seaford, NY Tanya W. Fisher Yachun Lin Nilay Shastry Daniel P. Fitzgerald Jun Liu Imani Shele David Fleming Siew Luan Low Fincourt B. Shelton Gerard R. Boyce Oliver Fontana Chu-ching Lu Leon Shenker Franklin Lakes, NJ Siobhan M. Forde Wei-ming Lu John P. Sheridan John Freemyer Douglas F. MacLean Jek S. D. Sim Mitchell L. Dorf Stephen R. Froling Mutheu Maitha Edward J. Smeltzer Rahway, NJ Liam Ge Alia Malek Matthew A. Sokol Mindy Gensler Joseph A. Malfitano David Spielman Ekundayo B. George Zertasha Malik Gerd W. Stabbert Malcolm Fein Emmanuelle Victoria George Caryn D. Mark Joshua Randolph Stebbins Brooklyn, NY Daniel J. Gerkin Jennie L. Markowitz Marc Ethan Steinberg Sibylle Petra Christiane Matthew E. McGoey Roman C. Strutynski John D. LeSeur Gierschmann Gulmira McHale Laura A. Stutz Lathe Gill Geoffrey McLaughlin Eugene R. Sullivan Batavia, NY Christina Ann Gleason David Melnih Gilbert M. Swift Jane Y. Glezin David Melnik Tomoichiro Takayama Joseph E. Lynch John Golden Richard Steven Meyer Takashi Tanaka Auburn, NY William M. Goldman Geoffrey J. Michael Peter Daniel Tanski Jeffrey H. Goldsmith Frederick T. Miller Michael G. Tauber Rae Schupack Nathan Josephine Gonzalez Francisco J. Mirkow Andras Paul Teleki Gita Gorji Elizabeth Lynn Mitchell Edward N. Tobias Larchmont, NY Kenneth Charles Green Cheston David Mizel Jonathan Todres Brian F. Guzman Lokanath Mohapatra Saori Tomizawa Caryn L. M. Hargrave Alfonso E. Moreno Tommaso Tosi Timothy S. Hart Erik W. Mueller Maria Trabucchi Frank Hess Heidi E. Murdy Yoshiki Uchida Heidi E. Hilgendorff Satoshi Naganuma Derek S. Underwood Reiko Hiramatsu Toru Nakahara Saverio Valentino Lauren Thalia Hollander Deepak Damodaran Eline S. Van Der Vlist Sungkee Hong Nambisan Martha A. Vedder Takayuki Hori Irvin B. Nathan Manuel Vergan Robert Joseph Hudock Kimberly A. Neill Lucinda Mary Vette James T. Hunt Alicia Michele Nestor Roland Vogl Vanessa Ann Ignacio Jennifer M. Norton Michael John Wallace Masato Imaizumi Helena E. O’Neal James Walsh Shigeru Inada Olatunde Opaleye Justin J. Walsh Mehul R. Jani Wendoly Ortiz David R. Weaver Anne Marie Janiczek Thomas D. O’Shea I-lin Wei Jill L. Johnson Schroepfer Scott C. Pappas Miriam Nathalie Weisbecker Irena Jurasova Carletha Parkinson David Wesely Rachel Kagia Michele A. Peters Karen A. Westrick Vamsi K. Kakarla Leslie A. Pettenati Rebecca Moffat White Michael R. Kamen Glenn S. Pfeiffer John Williams Preeti Kapoor Carol M. Pieper Joshua Wong Constantina Katsigiannake Reza Pishva Richard Wong Dunniela Kaufman Stephen M. Plotnick Azizah Poy Yasin Amy Hillary Kay Vasiliki Plytas Brady Young Gavin M. Kearney Michael Steven Portnoy Becky Yu Kathleen Marie Kelly Martin Alexander Price Keisuke Yuzawa Melaine Mecka Kennedy Jeffrey C. Primiano Peter Wolf-Georg Zapf Allison D. Kiene Kristin Tansey Quick Andrew Paul Zarnowiecki Beth D. Kiesewetter Hector Virgicio Ramirez Hiroyuki Zetsu Jung-hong Kim Jay D. Raxenberg Stephanie M. Zlasney Ui-suk Kim Steven M. Reiness Honey L. Kober Jeri Elizabeth Reutenauer Hiroki Kodate Michael Rizzo David P. Kreppein Kim S. Rodriguez Ashlie Kropp Robert Paul Roesener Remzi Guvenc Kulen Melissa A. Rolland Maya Christine Kulycky Brian Ashley Rosenthal Ruchika Kumar Rosmini Roswijati John Joon-han Kwon Gary M. Rubman Charles J. LaDuca Bernadette Savage

Journal | July/August 2001 61 Jean E. Nelson II, Associate Director, Emil Zullo, Assistant Director, [email protected] [email protected] HEADQUARTERS Jean Marie Grout, Staff Attorney, Lawyer Assistance Program [email protected] Ray M. Lopez, Director, STAFF Leslie A. Fattorusso, Staff Attorney, [email protected] [email protected] Management Information Systems E-MAIL ADDRESSES Cheryl L. Wallingford, Program Manager, John M. Nicoletta, Director, [email protected] [email protected] Daniel J. McMahon, Assistant Director, Ajay Vohra, Technical Support Manager, Publications, [email protected] [email protected] Executive Staff Patricia B. Stockli, Research Attorney, Paul Wos, Data Systems and Telecommunications Patricia K. Bucklin, Executive Director, [email protected] Manager, [email protected] [email protected] Governmental Relations Margo J. Gunnarsson, Database Services John A. Williamson, Jr., Associate Executive C. Thomas Barletta, Director, Administrator, [email protected] Director, [email protected] [email protected] Marketing L. Beth Krueger, Director of Administrative Ronald F. Kennedy, Assistant Director, Richard Martin, Director, Services, [email protected] [email protected] [email protected] Kathleen R. Baxter, Counsel, Graphic Arts Media Services and Public Affairs [email protected] Roger Buchanan, Manager, Bradley G. Carr, Director, Lisa Bataille, Administrative Liaison, [email protected] [email protected] [email protected] William B. Faccioli, Production Manager, Frank J. Ciervo, Associate Director, Kathleen M. Heider, Director of Meetings, [email protected] [email protected] [email protected] Human Resources Amy Travison Jasiewicz, Editor, State Bar News, Accounting Richard V. Rossi, Director, [email protected] Kristin M. O’Brien, Director of Finance, [email protected] Membership [email protected] Law Office Economics and Management Patricia K. Wood, Director, Anthony M. Moscatiello, Controller, Stephen P. Gallagher, Director, [email protected] [email protected] [email protected] Pro Bono Affairs Continuing Legal Education Law, Youth and Citizenship Program Diane Burman, Director, Terry J. Brooks, Director, Gregory S. Wilsey, Director, [email protected] [email protected] [email protected]

THE NEW YORK JOURNAL BOARD BAR FOUNDATION MEMBERS EMERITI

s a tribute to their outstanding service to 2001-2002 OFFICERS DIRECTORS Aour Journal, we list here the names of Richard J. Bartlett John P. Bracken, Islandia each living editor emeritus of our Journal’s President Cristine Cioffi, Niskayuna Board. 1 Washington Street Angelo T. Cometa, New York City Richard J. Bartlett P.O. Box 2168 Maryann Saccomando Freedman, Buffalo Glens Falls, NY 12801-2963 Coleman Burke Robert L. Haig, New York City John C. Clark, III Emlyn I. Griffith Jules J. Haskel, Garden City Angelo T. Cometa Vice President Paul Michael Hassett, Buffalo Roger C. Cramton 225 North Washington Street John R. Horan, New York City Maryann Saccomando Freedman Rome, NY 13440-5724 Susan B. Lindenauer, New York City Emlyn I. Griffith Patricia K. Bucklin Robert L. Ostertag, Poughkeepsie H. Glen Hall Secretary Joshua M. Pruzansky, Smithtown Charles F. Krause One Elk Street, Albany, NY 12207 Philip H. Magner, Jr. Thomas O. Rice, Garden City Wallace J. McDonald Randolph F. Treece M. Catherine Richardson, Syracuse Treasurer J. Edward Meyer, III 375 State Street Hon. Shira A. Scheindlin, New York City Robert J. Smith Albany, NY 12210 Justin L. Vigdor, Rochester Lawrence E. Walsh

62 Journal | July/August 2001 Members of the House of Delegates 2001-2002 First District Eppers, Donald B. Alcott, Mark H. Third District Evanko, Ann E. OFFICERS Baker, Theresa J. Ayers, James B. Evans, Sue M. Barasch, Sheldon Bauman, Harold J. * Freedman, Maryann Saccomando Batra, Ravi Cloonan, William N. Gerstman, Sharon Stern † Bing, Jonathan L. Connolly, Thomas P. Gold, Michael A. Bonner, Thomas J. Dorsey, Richard J. Graber, Garry M. Brett, Barry J. Flink, Edward B. †* Hassett, Paul Michael Steven C. Krane, President Buckley, Hon. John T. Friedman, Michael P. McCarthy, Joseph V. Cashman, Richard Higgins, Patrick J. Mohun, Michael M. New York Chambers, Hon. Cheryl E. Kelly, Matthew J. O’Connor, Edward J. Christian, Catherine A. Klein, Frank O’Mara, Timothy M. Lorraine Power Tharp, President-Elect * Cometa, Angelo T. LaFave, Cynthia S. Palmer, Thomas A. Albany Cuyler, Renaye B. Leistensnider, Ruth E. Pfalzgraf, David R. Davis, Bonni G. Lester, Kelly Mooney Porcellio, Sharon M. Frank M. Headley, Jr., Treasurer Davis, Evan A. Maney, Hon. Gerard E. DeFritsch, Carol R. Miranda, David P. Ninth District Scarsdale Eisman, Clyde J. Murphy, Sean Aydelott, Judith A. A. Thomas Levin, Secretary Eppler, Klaus Netter, Miriam M. Fedorchak, James M. * Fales, Haliburton, 2d Pierro, Louis W. Gardella, Richard M. Mineola Farrell, Joseph H. Samel, Barbara J. Geoghegan, John A. Field, Arthur Norman † Tharp, Lorraine Power Golden, Richard Britt Finerty, Hon. Margaret J. Tippins, Timothy M. Goldenberg, Ira S. Fink, Rosalind S. Treece, Randolph F. Headley, Frank M., Jr. * Forger, Alexander D. * Williams, David S. Herold, Hon. J. Radley Freedman, Hon. Helen * Yanas, John J. Klein, David M. * Gillespie, S. Hazard Kranis, Michael D. Goldstein, M. Robert Fourth District Longo, Joseph F. Gross, Marjorie E. Cioffi, Cristine Manley, Mary Ellen Vice-Presidents Haig, Robert L. Clements, Thomas G. * Miller, Henry G. First District: Handlin, Joseph J. Doern, James E D Mosenson, Steven H. Mark A. Alcott, New York Harris, Martha W. FitzGerald, Peter D. O’Leary, Diane M. * Heming, Charles E. Harper, David A. * Ostertag, Robert L. Stephen D. Hoffman, New York Hirsch, Andrea G. Hoye, Polly A. Riley, James K. Second District: Hoffman, Stephen D. Keniry, Hon. William H. Stewart, H. Malcolm, III Edward S. Reich, Brooklyn Horowitz, Steven G. Russell, William E. Walker, Hon. Sam D. Jacoby, David E. Tishler, Nicholas E. Third District: Jaffe, Barbara Tenth District James B. Ayers, Albany Kilsch, Gunther H. Fifth District Abrams, Robert Fourth District: * King, Henry L. Doerr, Donald C. Asarch, Hon. Joel K. Kougasian, Peter M. Dwyer, James F. †* Bracken, John P. Peter D. FitzGerald, Glens Falls † Krane, Steven C. Fennell, Timothy J. Filiberto, Hon. Patricia M. Fifth District: Landy, Craig A. Fetter, Jeffrey M. Franchina, Emily F. James F. Dwyer, Syracuse Leber, Bernice K. Getnick, Michael E. Gutleber, Edward J. Lieberman, Ellen Gingold, Harlan B. Kramer, Lynne A. Sixth District: Lindenauer, Susan B. Klein, Michael A. Levin, A. Thomas Hon. Eugene E. Peckham, Binghamton * MacCrate, Robert Kogut, Barry R. Levy, Peter H. Seventh District: Mandell, Andrew Michaels, Joanne E. Meng, M. Kathryn Miller, Michael Priore, Nicholas S. Mihalick, Andrew J. C. Bruce Lawrence, Rochester Miller, Sonia E. Rahn, Darryl B. Monahan, Robert A. Eighth District: Minkowitz, Martin †* Richardson, M. Catherine Perlman, Irving Joseph V. McCarthy, Buffalo * Murray, Archibald R. Rizzo, James S. †* Pruzansky, Joshua M. Opotowsky, Barbara Berger Uebelhoer, Gail Nackley Purcell, A. Craig Ninth District: * Patterson, Hon. Robert P., Jr. Roach, George L. Joseph F. Longo, White Plains Paul, Gerald G. Sixth District Rothkopf, Leslie Tenth District: Pickholz, Hon. Ruth Beehm, Angelina Cutrona Spellman, Thomas J., Jr. Quattlebaum, Poppy B. Denton, Christopher Tully, Rosemarie A. Craig Purcell, Hauppauge Raubicheck, Charles J. Drinkwater, Clover M. Walsh, Owen B. Eleventh District: Rayhill, James W. Folmer, John B. Gary M. Darche, Flushing Rifkin, Richard Gacioch, James C. Eleventh District Robertson, Edwin D. Lewis, Richard C. Bohner, Robert J. Twelfth District: Roper, Eric R. Mayer, Rosanne Darche, Gary M. Lawrence R. Bailey, New York Rosner, Seth Peckham, Hon. Eugene E. Dietz, John R. Rubenstein, Joshua S. Reizes, Leslie N. Glover, Catherine R. Safer, Jay G. Wayland-Smith, Tina Nashak, George J., Jr. Scarborough, Robert H. Nizin, Leslie S. Schumacher, H. Richard Seventh District Terranova, Arthur N. Members-at-Large of the * Seymour, Whitney North, Jr. Bleakley, Paul Wendell Wimpfheimer, Steven Silkenat, James R. Buzard, A. Vincent Executive Committee Sloan, Pamela M. Castellano, June M. Twelfth District Sharon Stern Gerstman Souther, Eugene P. Clifford, Eugene T. Bailey, Lawrence R., Jr. Stenson, Lisa M. Dwyer, Michael C. Friedberg, Alan B. Michael E. Getnick Vitacco, Guy R., Sr. Grossman, James S. Kessler, Muriel S. Matthew J. Kelly Yates, Hon. James A. Harren, Michael T. Kessler, Steven L. Gunther H. Kilsch Heller, Cheryl A. Millon, Steven E. Second District Lawrence, C. Bruce †* Pfeifer, Maxwell S. Bernice K. Leber Cerchione, Gregory T. †* Moore, James C. Schwartz, Roy J. Susan B. Lindenauer Dollard, James A. * Palermo, Anthony R. Torrent, Damaris Esther Doyaga, David J. Reynolds, J. Thomas Torres, Austin Fisher, Andrew S. * Van Graafeiland, Hon. Ellsworth Hesterberg, Gregory X. * Vigdor, Justin L. Out-of-State Kamins, Barry Wallace, David G. Chakansky, Michael I. Lashley, Allen †* Witmer, G. Robert, Jr. * Walsh, Lawrence E. Morse, Andrea S. † Delegate to American Bar Association House of Delegates Reich, Edward S. Eighth District * Past President †* Rice, Thomas O. Attea, Frederick G. Sunshine, Nancy T. Doyle, Vincent E., III Terrelonge, Lynn R. Edmunds, David L., Jr.

Journal | July/August 2001 63 demician, who is responsible for the Answer: There are really two ques- assertion that two negatives cancel tions here. The first has to do with as- LANGUAGE each other, creating a positive, both in pect, whose grammatical meaning is mathematics and in language. That as- the use of verbs to denote the relation- TIPS sertion, of course, is nonsense. Nobody ship of one action to another, espe- would interpret the statement, “I did- cially their temporal relationship. With n’t do nothing,” to mean “I did some- respect to Sen. Schumer’s comment, to B Y G ERTRUDE B LOCK thing.” indicate that one action took place be- However, the current use of multi- fore the other he should have said, uestion: This query contains ple negatives would be unwise be- “That would have been one of the Sen- two questions: (1) is the word cause they have achieved notoriety, ate’s finest hours if the bill had been Qdisirregardless acceptable? En- now indicating a broader lack of gram- passed,” (or “had the bill been closed is a reputable journal article in matical structure and implying general passed”). That is, had the Senate which it is used instead of irregardless. substandard usage. That’s a substan- passed the bill (prior action), it would Which is correct? (2) TV and radio tial strike against anyone, implying have created a “finest hour” (later ac- commentators pronounce the adjective that ungrammatical English indicates tion). In legal writing the use of aspect long-lived like the verb live. Shouldn’t ignorance. Like licking your plate at is very important to indicate how ac- it be pronounced like the adjective the end of the meal, double negatives tions occurred temporally relative to alive? used to be acceptable, but no longer! each other. Answer: Both of these questions are The reader’s second question, The second question, about sub- relevant, given current misuse of both whether the vowel sound in the adjec- junctive, is not really pertinent here be- words. Take the “non-word” disirre- tive long-lived should rhyme with the cause in English the subjunctive mode gardless. To the noun regard three nega- noun life or with the vowel sound in in the past perfect tense is exactly like tives (less, ir- and dis-) have been the verb live, can be answered more the indicative mode. (As Ms. Buebel added to create this monstrosity. (The briefly. Pronounce the adjective with noted, Latin contained a much-ex- prefix -ir is really the negative prefix the “long” ‘i’ sound, as in life. The ad- panded subjunctive mode, and we in-, changed to ir- by assimilation with jective derived from the noun life, and should all be grateful that English does the following ‘r’ sound). Strike out the indicating that the subject has a long not.) So in the statement submitted, two unnecessary negatives and the life. The ‘f’ sound often changes to ‘v’ my substitution of “had been” for correct adjective, regardless, emerges. before a voiced ending, as in the ‘d’ “was” would be correct. Why did the drafter add two un- sound that follows. Compare the state- However, as Ms. Buebel correctly necessary prefixes? Probably to em- ment, “We bring you Joe Schmoe, live, noted, if the statement had been in the phasize his negative remark. It was from the scene of the fracas.” present tense, the subjunctive form common and correct in Old English It’s true that many commentators would be necessary because the state- (Anglo-Saxon) and in Middle English mispronounce the adjective long-lived, ment is “contrary to fact.” Thus, using to employ double and triple negatives but don’t assume they are authorita- the present tense, you would say, “If I for emphasis. Chaucer’s line in his tive. How many of these people also were a senator I would vote for the 14th-century poem, The Canterbury pronounce nuclear as if it were spelled bill.” (“I” am not a senator.) Tales: “For he that naught n’assaieth, nucular? naught n’achieveth” contains four neg- Question: Correspondent Felicia Gertrude Block is the writing special- atives, translating in modern English Buebel writes that she has just read the ist and a lecturer emeritus at Holland Law Center, University of Florida, to “For he that does not try nothing, column in the September 1999 Journal. Gainesville, FL 32611, and a consul- does not achieve nothing.” And She is curious about the use of the sub- tant on language matters. She is the Chaucer describes his Knight, whom junctive form in a quotation I used, al- author of Effective Legal Writing, fifth he greatly admires, by the use of three though my comment about the quota- edition (Foundation Press, July 1999), negatives: a man who “nevere yet no tion had to do with the use of “aspect.” and co-author of Judicial Opinion vileyne ne sayde.” That quotation, from a statement made Writing Manual (West Group for The modern rule that it is incorrect by Sen. Charles E. Schumer of New ABA, 1991). to use more than one negative was in- York, was, “That would have been one The author welcomes the submission troduced by 18th century grammari- of the Senate’s finest hours if the bill of questions to be answered in this ans who argued that English usage was passed.” Ms. Buebel asks whether column. Readers who do not object to should follow a mathematical model. Senator Schumer should have used the their names being mentioned should Among the most influential grammar- subjunctive form, “if the bill were state so in their letters. E-mail: ians was Bishop Robert, an Oxford aca- passed.” [email protected].

64 Journal | July/August 2001