BERNARD v. SCHARF (1997)

Orders entered September 26, 1995 and October 27, 1995 (Peter M. Wendt, J.) affirmed, with $10 costs.

This Housing Part proceeding concerns a six-story, 60-unit co-operative apartment building on West 142nd Street in Manhattan (the “Premises”) which was severely damaged and rendered uninhabitable by a fire on February 7, 1994.   Respondent 610 West 142nd Owners Corp. (the “Corporation”) owns the Premises.   Petitioners, who are both tenants and proprietary lessee shareholders who occupied the Premises, brought this proceeding under Title 27, Chapter 2 of the Administrative Code of the City of New York (the “Housing Maintenance Code” or “HMC”) and Section 110 of the Civil Court Act (“CCA”) to compel restoration of the Premises to habitable condition.   Appellants Leon and Morris Scharf, along with three other members of their family, sponsored the cooperative conversion in 1990 and hold approximately two-thirds of the Corporation shares.   Morris Scharf has been the registered managing agent for the Premises, is a partner in the Premises' management company and is the secretary of the Corporation.   Leon Scharf, Morris' father, is the Corporation president and “the person directly in control of the [P]remises.”  Bernard v. Scharf, 167 Misc.2d 502, 510, 634 N.Y.S.2d 919.

The Corporation's offering plan requires that the Premises be insured for full replacement cost, which was valued at $3 million when the Corporation was formed in 1990.   In September 1991, however, Leon Scharf, acting as president of the Board of Directors, reduced the Premises' insurance by replacing the original $3 million policy with a $2 million, 80% co-insurance policy.   He did not report the insurance reduction to the Corporation's Board of Directors until December 1991.

At the time of the fire, 18 apartments had been purchased by shareholders, 26 were rented as rent-stabilized or controlled apartments and the remainder were rented at unregulated market rates.   On February 8, 1994, the day after the fire, the Department of Buildings (“DOB”) issued a vacate order and the Premises were evacuated.   Thereafter, neither the Corporation nor the appellants took any action to demolish or restore the Premises;  from the date of the fire to approximately late November 1994, the Premises were left unsealed and unsecured from damage due to exposure to the elements and vandalism.   On or about August 16, 1994, the instant proceeding was commenced.   On September 23, 1994, the Corporation filed for reorganization under chapter 11 of the 1978 Bankruptcy Code (11 U.S.C. § 1101 et seq.), and on or after November 23, the DOB sealed the premises.

In the order appealed from, entered on September 25, 1995, the Court after trial directed appellants as well as the Corporation to restore the Premises “to safe and habitable condition”.   The Court also found that the Scharfs were “owners” under the HMC and personally responsible for making the necessary expenditures for repairs.   The bankrupt Corporation has not appealed from the subject order.   On their appeal, appellants Scharf contend that they cannot be ordered to restore the Premises to habitability because to do so would be economically infeasible.   They take issue with the lower court's determination that the defense of economic infeasibility is unavailable to appellants because:  (1) they presented no proof of the cost to them if the Premises is not restored, with respect to demolition charges, relocation costs for rent-stabilized tenants and liabilities to the tenant shareholders;  and (2) appellants are estopped from asserting the infeasibility defense because they brought it on themselves through their deliberate underinsurance of the Premises.   Joined by amicus curiae Pacific Legal Foundation, appellants also claim that the lower court's order to restore the Premises is an uncompensated “taking” that violates their due process rights under the 5th and 14th amendments to the United States Constitution.   Finally, appellants argue that the HMC is inapplicable to this proceeding because the fire-damaged Premises does not constitute “salvageable” housing within the meaning of the statute.

Appellants also appeal the denial, by order entered October 27, 1995, of their motion to renew on the ground that the Bankruptcy Court's appointment of a Trustee for the Corporation relieves appellants from responsibility under the HMC.

We affirm both orders.

Statutory Framework;  Applicability of the HMC

The Housing Part of the Civil Court of the City of New York is vested with original jurisdiction of “actions and proceedings involving the enforcement of state and local laws for the establishment and maintenance of housing standards, including ․ the multiple dwelling law and the [HMC] ․”.  CCA § 110[a].   The statute further provides that “[r]egardless of the relief originally sought by a party the court may recommend or employ any remedy, program, procedure or sanction authorized by law for the enforcement of housing standards, if it believes they will be more effective to accomplish compliance or to protect and promote the public interest ․”.  CCA § 110 [c].

The HMC, applicable to all residential dwellings, provides for “the sound enforcement of minimum housing standards” in order to “preserve decent housing ․ prevent adequate or salvageable housing from deteriorating to a point where it can no longer be reclaimed;  and ․ to bring about the basic decencies and minimal standards of healthful living in already deteriorated [buildings], which, although no longer salvageable, must serve as habitation until they can be replaced”.  (Administrative Code of City of New York § 27-2002).

 The HMC requires that “the owner of a multiple dwelling shall keep the premises in good repair ․ and be responsible for compliance with the requirements of this code ․”.  (Administrative Code § 27-2005[a], [c] ).  An “owner” is defined as, inter alia, the owner of the fee and “any other person, firm or corporation, directly and indirectly in control of a dwelling”.  (Administrative Code § 27-2004[45] ).   Injunctive relief is available against owners requiring them to abate or correct HMC violations.   (Administrative Code § 2121).   The HMC should be construed in order to advance its underlying legislative intent:  “to protect and preserve existing housing”.  (Fernandez v. Tsoumpas Bros. Co., 126 Misc.2d 430, 433, 481 N.Y.S.2d 948).   Accordingly, the courts have the power under the HMC to order repairs to buildings whose HMC violations arise from fire damage.  (Chan v. 60 Eldridge Corp., 129 Misc.2d 787, 494 N.Y.S.2d 284).

 Inasmuch as a fundamental purpose of the HMC is to correct any condition leading to the deterioration of salvageable housing, the statute applies here.   It is implicit in the trial court's findings of fact that the Premises is salvageable, although at considerable cost.   After hearing the testimony of several expert witnesses during a full trial, and after a personal inspection of the Premises, the court found that:

The floors and walls of the first five stories are solid.   The fifth story has severe damage, but also has solid walls and floors;  the ceiling, however, is almost completely destroyed.   The sixth [top] story is effectively gone for all practical purposes, except for the exterior walls, which have also sustained visible damage around the parapets.   The roof is a total loss.   However, most of the building exists, although in very poor condition.

Bernard v. Scharf, supra, at 506, 634 N.Y.S.2d 919.

Economic Infeasibility Defense

 Economic infeasibility is an affirmative, equitable defense for which the proponent has the burden of proof.  (Buchanan v. Toa Constr. Corp., NYLJ, May 31, 1989, at 21, col 1 [App Term, 1st Dept] ).   We are persuaded that, at trial, appellants failed to prove that restoring the Premises was economically infeasible for the reasons set forth by Judge Wendt (Bernard v. Scharf, supra, 167 Misc.2d at 510-11, 634 N.Y.S.2d 919).   We summarize here the lower court's well-reasoned analysis:

The court found that it was “evident from the expert testimony offered by both sides the cost of repairs would most likely exceed the market value of the restored [Premises]”.  (Id. at 506, 634 N.Y.S.2d 919.)   Appellants presented no proof, however, of the costs they would incur if the building is not restored.   Such proof is necessary for the sake of comparison.   If the Premises is not restored, it will have to be demolished or otherwise put in compliance with the applicable statutes;  appellants would bear the cost for this.   Likewise, appellants would bear the cost for relocating displaced rent-stabilized tenants.   Possible liabilities of the Corporation and the appellants to the tenant shareholders for the destruction of their proprietary leaseholds must also be considered.   The court concluded that appellants “have entirely failed to show the market value [of the restored Premises] will not equal the difference between the cost of restoration and the cost of demolishing the [Premises] along with all the other expenses ancillary to the cost of demolition, if the landlords comply with all their legal obligations.”  (Id. at 511, 634 N.Y.S.2d 919.)   The court further noted that no proof was presented that, once restored, the Premises would not generate enough income to recover the cost discrepancy in a reasonable time.

 The trial court also properly found the “marine rule”, which appellants invoke as a measure of the Premises' salvageability, inapplicable.   The marine rule was developed in marine insurance cases with respect to ships, but has been invoked in cases concerning commercial buildings.  (See, e.g., Corbett v. Spring Garden Ins. Co., 155 N.Y. 389, 50 N.E. 282).   The rule states that if the cost of restoration exceeds one-half the value of the building before the damage, then there is deemed a total destruction that does not require repair.   The trial court held that the marine rule is inapplicable to residential buildings, “especially in this case where there are protected tenancies and tenancies involving substantial financial investment (cooperative apartments)”.  (Bernard v. Scharf, supra, at 509, 634 N.Y.S.2d 919.)   To mechanically apply the marine rule to residential property would thwart the strong public policy that housing be maintained in safe and habitable condition.

 We also agree with the trial court that appellants are estopped from asserting an economic infeasibility defense by virtue of their deliberate underinsurance of the Premises.   If the Premises had been insured for its full replacement cost at the time of the fire, appellants would not have their present difficulties.  (See, Chan v. 60 Eldridge Corp., supra, 129 Misc.2d at 791, 494 N.Y.S.2d 284 [An owner's “unilateral decision on the amount of insurance it chose to carry cannot determine (the economic feasibility) of repairs.   Any other conclusion encourages underinsurance.”] ).   Appellants' alleged economic hardship is entirely self-created:  the lower court found after trial that “the other members of the cooperative board and the shareholders were not given any serious input into the significant reduction in insurance coverage” by appellant Leon Scharf, but were instead presented with a fait accompli.  (Bernard v. Scharf, supra, 167 Misc.2d at 512, 634 N.Y.S.2d 919).   Appellants' underinsurance of the Premises amounts to a bad business decision for whose consequences they are responsible.  (See, Department of Housing Preservation and Dev. v. Mill River Realty, Inc., 169 A.D.2d 665, 669, 565 N.Y.S.2d 44, aff'd, 82 N.Y.2d 794, 604 N.Y.S.2d 552, 624 N.E.2d 690 [economic infeasibility defense unavailable where hardship was “self-inflicted”] );  accord, Eyedent v. Vickers Management, 150 A.D.2d 202, 205, 541 N.Y.S.2d 210.

 The economic infeasibility defense is also unavailable to appellants because their underinsurance of the Premises breached both appellants' statutory duty and their contractual obligations to the petitioner proprietary lessees.   The Corporation's offering plan provided that the sponsors would carry at least $3 million in replacement cost insurance for the Premises.   Appellants never amended the offering plan to disclose the reduced coverage, in violation of 13 NYCRR § 18.3[w][11], which provides that the holder of unsold cooperative shares “shall amend the [offering] plan to provide current and accurate information about the offering ․ until the shares held as unsold shares have been sold to bona fide purchasers.”   Inasmuch as appellants and the other sponsors still held two-thirds of the shares and controlled the Corporation, appellants' failure to amend the offering plan to disclose the underinsurance breached a duty both to the proprietary lessees and the public at large.

The Order to Restore Does not Effect an Uncompensated Taking.

 The trial court's order to repair does not constitute an unconstitutional physical or regulatory taking.   The statutory requirement that a landlord keep residential property in good repair is a legitimate exercise of the police power (See Loretto v. Teleprompter Manhattan CATV Corp., 458 U.S. 419, 440, 102 S.Ct. 3164, 3178-79, 73 L.Ed.2d 868).   Appellants purchased the Premises and operated it as residential property subject to the HMC and other housing laws.   Accordingly, appellants cannot claim that the order to repair constitutes a physical taking;  as the Appellate Division, First Department has noted, “the Court of Appeals has drawn a sharp distinction with respect to the Takings Clause [of the Constitution] between regulation that protects the current tenant, which is generally permissible, and regulation that subjects the property to a use never intended, i.e., a landlord-tenant relationship, such as to constitute a physical taking.”   (Dawson v. Higgins, 197 A.D.2d 127, 135, 610 N.Y.S.2d 200).   The trial court's order to restore the Premises, which protects existing tenancies and leaseholds, falls into the former category.

 Nor does the trial court's order constitute a regulatory taking.   Government regulation may be deemed a regulatory taking “(1) if it denies an owner economically viable use of his property, or (2) if it does not substantially advance legitimate State interests.”  (Seawall Assocs. v. City of New York, 74 N.Y.2d 92, 107, 544 N.Y.S.2d 542, 542 N.E.2d 1059).   As previously noted, appellants made no showing at trial that the Premises, once restored, will not generate sufficient income to offset the restoration expenses over time.   Moreover, there can be no question that the State has a legitimate interest in keeping residential properties habitable, even after fire damage, and that the HMC and other statutes and regulations in question advance these interests.

Appellants are Liable as “Owners”

 The record abundantly supports the Civil Court's finding that appellants are “owners” under the HMC, inasmuch as they are “directly or indirectly in control of the premises.”   Along with other family members under their control, appellants were the majority shareholders of the Corporation's shares, controlled the board of directors and made and implemented all policy decisions, including the relinquishment of full replacement cost casualty insurance in 1991, thus causing the premises to be underinsured at the time of the fire.   They also acted as landlords to the non-shareholder tenants.   They caused the Corporation to seek the protection of the Bankruptcy Court.   Clearly, the Corporation was the alter ego of these appellants.   It is the intent of the HMC to pierce the corporate veil and hold true “owners” rather than the holders of title, responsible for violations(Housing & Dev. Admin. v. Johan Realty Co., 93 Misc.2d 698, 403 N.Y.S.2d 835).

 Appellants' claim that they cannot be held liable after their replacement at the helm of the bankrupt corporate debtor in possession by a Trustee lacks merit.   The Scharf family owns the majority of the Corporation's shares, and the evidence adduced at trial indicates that appellants are still de facto in control of it.   Accordingly, as “owners” of the Premises under the HMC, appellants are obligated to undertake and finance the restoration of the Premises under the lower court's order of September 26, 1995.

I respectfully dissent.

I disagree with the finding that the owners have not established economic infeasibility.   The Trial Court committed three errors.   First, it concluded that the cost of repairs exceeded the market value of the property after repairs but made no findings of fact as to either the dollar and cents cost of repairs or its market value.   Second, it held that the owners were required to prove the cost of not restoring the building but advanced no legal basis or appraisal methodology to support its position.   Third, it found that the failure of the owners to carry a higher limit insurance policy rendered it liable.   Insurance is not relevant to the issue of economic infeasibility.   The Majority opinion has adopted the Trial Court's decision.

Neither the Trial Court nor the Majority made findings of fact as to the cost of repairs and the market value of the property after the repairs.   The Trial Court decision refers to figures testified to by the experts, the cost of repairs and the market value, but it does not state which figures it adopts for the purpose of drawing conclusions of law.   Significantly it does state that “It has been proven that the market value of the building, once restored, would be less than the cost of repairs.”  (Bernard v. Scharf, 167 Misc.2d 502, 511, 634 N.Y.S.2d 919.)   Reference to “dollars and cents evidence” is necessary to appreciate the economic aspects of this case.  de St. Aubin, et al. v. Flacke, 68 N.Y.2d 66, 77, 505 N.Y.S.2d 859, 496 N.E.2d 879.

The building was purchased for $800,000 and comparable property on that street was shown to be in the same range.   A fire occurred with extensive damage, the degree is in dispute.   The tenants' expert testified that repairs would cost approximately $2.5 M.   The owners' three experts' figures for repair were $4.3 M, $4.8 M and $4.7 M respectively.   These figures differ somewhat from the Trial Court decision but they are generally more favorable to the tenants and are in line with the Department of Housing Preservation and Development (HPD) figures.   The experts who testified used the income and sales comparison methods of appraisal.   The $4.7 estimate was prepared by the appraiser for the insurance company insuring the loss.   The tenants' appraiser testified the building would have a market value of $2.25 M after repairs were completed.   The owners' two appraisers testified it would have a market value of $870,000 and $820,000.   It is undisputed that five years before the fire, Aetna Insurance Company refused to renew the insurance coverage unless the policy was increased to $4.5 M which they determined to be the replacement cost for the subject premises.

CPLR 4213(b) mandates that a Trial Court make findings of fact as to the essential elements of the case.   Since it did not make findings of fact as to the issues of market value and the cost of repairs, this Court does so based upon an independent examination of the record.

It is undisputed that five years prior to the fire, Aetna determined that the total replacement cost of the building was $4.5 M.   The Trial Court by inference found that the damage exceeded 50% by its consideration of the “marine rule.”   Therefore there can be no serious dispute that the replacement cost exceeded $2.25 M, since the tenants' experts testified to $2.5 M.   I accept the figure of the insurance adjuster who testified from a report he prepared for the insurer and not for trial purposes that the restoration cost would be in the $4.7 M range.   The $4.7 M restoration figure testified to and the minimal differential between the $4.7 and $4.5 M total replacement figure, reinforces the finding that the property is not reclaimable since almost totally destroyed.   I find based upon the testimony that the market value after restoration would be in the $1 M range.   Since the experts and the Trial Court all agree that the cost of repairs would exceed the market value after restoration, should we conclude that the property in its present condition has a minus market value?   The present market value is a reflection of the extent of damage and the reclaimability of the property.   Furthermore, since the replacement cost of the building is twice its market value if the tenants' valuation is accepted, five times its market value if the owners' valuation is accepted, and five times comparable property, the totality of these facts and conclusions establish an economic infeasibility defense.   Unlike Eyedent v. Vickers Management, et al, 150 A.D.2d 202, 541 N.Y.S.2d 210, the owners have established an economic basis for their defense.

The Trial Court decision required the owners to establish the difference between the cost of restoring and not restoring the building, but gives no authority for such methodology.   Appraisers for both sides testified in a lengthy trial as to the customary and accepted appraisal methodology of comparing repair costs to market value used in Eyedent v. Vickers Management, supra.   HPD does not adopt the tenants' argument on this point.   Insofar as the Trial Court referred to demolition and relocation costs it may have been treating this case as if it was brought under housing agency guidelines by an owner to voluntarily withdraw a housing accommodation from the market where the owner is required to pay demolition and relocation fees.   Clearly this is not a case of demolishing the building since neither side is seeking such relief.   There is an obvious difference between a situation where an owner seeks to withdraw sound housing from the market and where housing is destroyed by fire not caused by the owner.   In the former situation the owner must compensate the tenants, in the latter situation no compensation is required.   In any event, it is obvious the costs of tearing down the building are minimal in comparison to the cost of restoration.

While the parties argue the issue of insurance limits we must first decide if insurance is even an issue.   Is the financial ability or inability of the owners to do the renovation relevant in determining economic infeasibility?   No, because it is a different issue.   Economic infeasibility relates to the economic condition of the building and not of the owners.   Factors such as the cost of restoration and market value determine economic feasibility.   The owners' ability to pay is not a factor in reaching that determination.  Chan v. 60 Eldridge Corp., 129 Misc.2d 787, 791, 494 N.Y.S.2d 284.   Whether the owners have a $5 M insurance policy or a $1.6 M policy, or are solvent or insolvent, the result should be the same.

Apart from the fact that insurance is not relevant to an economic feasibility defense, the insurance argument has no validity.   There is no compulsory insurance coverage for property.   The exception relied upon by the cooperative tenants applies only to the eighteen shareholders.   The owners were required to budget $3 M fire insurance coverage for one year from the date of closing.  13 N.Y.C.R.R. Sec. 18.3(g)(3)(viii).   The year had expired at the time of the fire.   The legislating body set one year as the limit and we are asked to legislate by extending the period because a large number of unsold shares exist.   Since they are still unsold, where is the harm to the eighteen shareholders and furthermore there is no showing that they purchased after the one year period expired.   Accepting arguendo that the owner had continued the $3 M coverage, and that this proceeding was brought for the same relief, the owners could still argue that there is a $1.7 M shortfall between market value and the cost of restoration.   The proprietary lease required the owners to repair fire damage to the proprietary lessees' apartments or replace them.   This provision clearly does not require the owners to restore if the building was completely destroyed or damaged to the extent herein.   The remedy they may have, if any, for contractual monetary damages is not before this Court.

While not necessary to a finding that the economic infeasibility defense has been established, I disagree with the majority insofar as it finds that a regulatory taking has not been effected by the Housing Maintenance Code as applied.   The direction to restore the building at the cost required denies the owners an “economically viable use of his property.”  Seawall Assoc. v. City of New York, et al., 74 N.Y.2d 92, 107, 544 N.Y.S.2d 542, 542 N.E.2d 1059.

The brief by HPD requires comment to indicate why the arguments were considered but not accepted.   Initially HPD states that “economic feasibility” is determined by the objective criteria in the Rent Regulations citing New Year Realty Corp. v. Herman, 11 A.D.2d 643, 201 N.Y.S.2d 226.   This was an Article 78 proceeding reviewing a voluntary withdrawal from the housing market and the Court correctly found that the objective criteria in the Regulations must be established.   There are no regulations applicable here because this is not an agency proceeding to voluntarily withdraw the property from the market.   Treating this case as if it was brought under some Regulation, HPD disagrees with the appraisers for using subjective criteria rather than the objective criteria in the Regulations.   There are three general methods of valuation;  summation, market data and capitalization or income producing.   Using the objective criteria HPD has adopted the capitalization or projected income for the property seeking to establish economic feasibility.   The objective criteria under the Rent Regulations only allows certain expenses in calculating costs.   For example, the cost of plastering is not allowed but sheet rock is.   It appears that the economic test being used is whether the property can produce an 81/212% profit on the assessed valuation;  not on the owners' investment which would be almost $5 M.   HPD is using assessed valuation and not market value as a criterion.   The HPD methodology is neither applicable nor flexible enough to allow important factors such as comparable sales to be used in fixing valuation.   Noticeably both the tenants and HPD advance different criteria but both under Regulations which are inapplicable because this is not an agency proceeding and no statutory criteria are mandated.   The housing regulation which most nearly resembles this proceeding provides for withdrawal from the housing market by the owner when the cost of repairs equals or exceeds the assessed value of the building.  Rent Stabilization Code, Sec. 2524.5(a)(1)(ii).   This standard does not favor the tenants since it uses assessed value and not market value.   The Court of Appeals, in a different factual setting, has recently repeated that “the ultimate purpose of valuation ․ is to arrive at a fair and realistic value of the property involved.”  In the Matter of Commerce Holding Corp. v. Board of Assessors of the Town of Babylon, 88 N.Y.2d 724, 729, 649 N.Y.S.2d 932, 673 N.E.2d 127.

Summarizing this case, it is a question of economics, dollars and cents;  the economics of restoration and not the economic health of the owners.   A consideration of factors irrelevant to accepted appraisal methodology and insurance considerations confuses the issue of economic infeasibility.   While sympathetic to the plight of the tenants, the reality is that the owners who didn't cause the fire are being directed to expend almost $5 M ($21/212 M if the tenants' figures are adopted) for the shell of a building when a comparable building on the same street sells in the $1 M range.   This building will then be worth less than the cost of restoration.

The Judgment should be reversed and the petition dismissed.

PER CURIAM:

FREEDMAN and DAVIS, JJ., concur.