Is Your Qualified Intermediary a Thief?

           Someone once asked Jesse James why he robbed banks, to which he responded “because that’s where the money is!”  Recent events demonstrate that, like James, certain qualified intermediaries involved in so-called “1031 Exchanges” are unable to resist the temptation to rob investors.  The activities of these modern-day bank robbers are facilitated by the unregulated nature of the qualified intermediary industry.

            1031 Exchanges, named after the relevant section of the Internal Revenue Code, allow persons selling residential or other types real estate to purchase fractional interests in commercial real estate, thereby deferring paying capital gains taxes if they invest the proceeds in “like kind” property within 180 days.  Because regulators regard these fractional tenants-in-common interests as investment contracts (and therefore securities), sale of  these interests typically are effected through registered broker-dealers.  The NASD has warned that in selling these interests, member firms should be aware of suitability, due diligence, concentration and other issues.  See NASD Notice to Members 05-18 (March 2005).

            To qualify for the tax benefit, proceeds from the sale of real estate must go into an account until they are used for the purchase of the new property.  Such accounts are typically handled by one of hundreds of qualified intermediaries located throughout the country, which are largely unregulated.   No licenses are required, and Nevada currently is the only state that imposes any regulation.  There are no laws governing what intermediaries do with funds under their control.  Intermediaries make money in several ways.  Most charge transaction fees, while others earn the spread between interest they gain on investors’ proceeds and the interest paid out to investors.  See Peter Lattman and Kemba Dunham, “Tax Strategy for Real Estate Hits Rocky Turf,” Wall Street Journal, May 26, 2007, at B1.   

            At least three qualified intermediaries have been accused of misappropriating client funds.  First, investors have accused Donald McGhan and his two companies, Henderson, Nevada-based Southwest Exchange, Inc. and Qualified Exchange Services, of operating a Ponzi scheme through which he misappropriated more than $95 million of customer proceeds to fund other business and personal activities. See Sorrel et al. v. Qualified Exchange Services, Inc. et al., No. 2:07-cv-02088-SJO-VBK (C.D. Cal. March 29, 2007) (amended complaint filed).  To illustrate the perils facing investors, McGhan was able to operate his business despite having been sued by the SEC in 2000, and enjoined by a federal court from violating the antifraud provisions of the federal securities laws in connection with accounting improprieties involving a publicly held company of which he was CEO. See SEC v. McGhan, No. 00CV00475 (D. Nevada March 8, 2000), litigation release available at http://www.sec.gov/litigation/litreleases/lr16466.htm.

            Further, court filings indicate that Edward Okun’s Miami-based company 1031 Tax Group LLC, owes $151 million to more than 300 investors.  This entity filed a voluntary petition under Chapter 11 of the U.S. Bankruptcy Code. The filings indicate that Okun “borrowed” money from Tax Group to finance real estate investments made by another company he controlled.  Court records indicate that federal prosecutors have begun a preliminary investigation in the case. See In re The1031 Tax Group, LLC, No. 07-11448-mg (U.S. Bank. S.D.N.Y. May 14, 2007) (petition filed).  the company acquired Denver-based Investment Exchange Group in 2006.  Finally, news articles indicate that Breckenridge, Colorado attorney and qualified intermediary “Scoop” Daniel misappropriated between $500,000 and $1 million before faking his disappearance.  Daniel’s law license has been suspended.  See Renee McGaw, “Once-Obscure 1031 Exchanges Now Under Spotlight,” Denver Business Journal, May 28, 2007.

            To protect themselves, investors and broker-dealers should use qualified intermediaries that are affiliated with regulated entities such as banks and brokerage firms.  Alternatively, they should use intermediaries that are members of the Federation of Exchange Accommodators, a trade organization that performs background checks of all members. A background check would provide some degree of assurance that a particular intermediary does not have a history of law violations. Moreover, investors should insist that intermediaries put their money into a segregated account and invest their funds in a safe, short-term, relatively liquid instrument such as a bank certificate of deposit, and find out whether the intermediary has insurance coverage.

            The theft of investor funds by intermediaries will increase the pressure for state and federal regulation. Industry participants would be well advised to seek greater self-regulation, or risk imposition of a legislative solution that may not be to their liking.