And You Assumed That Escrow Moneys Were Bankruptcy-Proof . . .

April 15, 2009

DRAFTING 1031 ESCROW AGREEMENTS TO ADDRESS A POTENTIAL INSOLVENCY OF A QUALIFIED INTERMEDIARY; LESSONS FROM LANDAMERICA

Presented at the Annual Meeting of the American College of Real Estate Lawyers on October 31, 2009 in Washington, DC
8/15/09

The LandAmerica bankruptcies taught us that we cannot merely assume that third-party escrow arrangements are safe from unrelated third-party creditors. Now we know that the bankruptcy of the third-party intermediary, especially where the funds are not covered by deposit insurance and time deadlines are involved, can have profound implications far beyond the loss of the deposit itself. The following explores what happened in the LandAmerica case with respect ot Section 1031 escrow deposits and what drafting implications that has for future transactions.

I. THE PROBLEMS

In troubled times so severe that escrow agents start getting into trouble, 1031 escrow agreements are scrutinized closely, and, thus, can no longer be treated as minor form documents requiring little attention. 26 USC §1031 doesn’t specifically provide for what happens to the proceeds of sale in a forward exchange in which the subject taxpayer (the “the subject exchangor”) wants to take advantage of the 45- and 180- day deferrals allowed by the Code. Treas. Regulation §1.1031(k) -1 [26 CFR 1.1031(k)-1] provides “safe harbors” especially helpful for the situation in which a third party owns, and wants to sell, the property the subject exchangor wishes to buy. During the 180-day period, the subject exchangor needs to avoid being in actual or constructive receipt of funds or other non-like kind property before the subject exchangor actually receives the replacement property. Thus, for most purposes, that Regulation provides the governing law. It provides the subject exchangor with 4 options for the holding of the proceeds, from a forward exchange, pending the subject exchangor’s acquisition of the replacement property during the 180-day period. More than one such safe harbor may be used in the same transaction provided that the terms and conditions of each are separately satisfied. Those 4 safe harbors are:

Treas. Reg. §1.1031(k)-1(g)(2): to have the “transferee” (presumably including the buyer of the relinquished property) provide security or guaranties;
Treas. Reg. §1.1031(k)-1(g)(3)(i): to have the funds held in a “qualified escrow account”;
Treas. Reg. §1.1031(k)-1(g)(3)(ii): to have the funds held in a “qualified trust”; and/or
Treas. Reg. §1.1031(k)-1(g)(4): to have the funds held by a “qualified intermediary”.

The qualified intermediary approach was the easiest and cheapest, primarily because vendors prepackaged it into a very “formy” type of transactions that most clients don’t want to invest a lot of billable time in reviewing, it does not involve negotiating a separate agreement with a third party, and, it is often backed-up by fidelity bonds, guarantees, and/or professional liability insurance. Thus, it became the most prevalent approach.

However, then came the LandAmerica bankruptcies. In Millard Refrigerated Servs. v. LandAmerica 1031 Exch. Servs. (In re LandAmerica Fin. Group, Inc.), 2009 Bankr. LEXIS 940, 51 Bankr. Ct. Dec. (LRP) 148 (Bankr. E.D. Va. Apr. 15, 2009), (a) the subject Exchange Agreements provided that they were designed to effectuate an exchange in accordance with Treas. Reg. §1.1031(k)-1(g)(4) and the applicable provisions of that Regulation was incorporated therein; and (b) pursuant to the terms thereof, the subject funds were placed in separate sub-accounts of a master account (“Segregated Accounts”) that LandAmerica 1031 Exchange Services, Inc. (“LandAmerica’s Qualified Intermediary” or “LES”) held at Citibank. That sub-account was “associated with” Millard’s name and taxpayer identification number, the funds were placed by Citibank in that sub-account, and, those Segregated Accounts apparently, contained only the funds from the subject exchanges. Nevertheless, the Court held that the exchange agreements were worded to give LandAmerica’s Exchange Intermediary too much control over the funds. Specifically, the exchange agreements provided, in relevant part:

” . . . LES shall have sole and exclusive possession, dominion, control and use of all Exchange Funds, including interest, if any, earned on the Exchange Funds . . . This agreement i) expressly limits the Taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by the qualified intermediary, and ii) expressly limits the Taxpayer’s rights to receive interest or growth factor, all as provided in paragraph (g)(6) of Treas. Reg. 1.1031(k)-1. Taypayer shall have no right, title, or interest in or to the Exchange Funds or any earnings thereon and Taxpayer shall have no right, power, or option to demand, call for, receive, pledge or otherwise obtain the benefits of any of Exchange Funds, including interest earned on the Exchange Funds . . .” [the language underlined in the above quote is the only portion thereof that comes from Treas. Reg. §1.1031(k)-1(g)(4)(vi).]
In footnote 19, the Court in Millard held:

“Nothing in the Exchange Agreements, however, prohibited LES from investing the Exchange Funds that were placed into the Segregated Accounts (indeed LES was indemnified in the event it chose not to do so), from transferring the Exchange Funds out of the Segregated Accounts, from encumbering or pledging the Segregated Accounts for its own use, or from otherwise obtaining the benefits of the Exchange Funds. In fact, the funds in the Segregated Accounts were entirely and completely vulnerable to attachment and levy by third party creditor of LES.”

The Court treated the Segregated Accounts as being controlled only by LandAmerica’s Qualified Intermediary. Therefore, the Court held that LandAmerica’s Qualified Intermediary held more than just legal title to those funds and, thus they were property of the bankruptcy estate under §541(d) of the Bankruptcy Code [11 USCS §541(d)], and, thus, presumably available to all of the 450 exchangors (and probably also to all of the other creditors) involved in the case.

[There is some inconsistency in the Millard opinion as to whether LandAmerica's Qualified Intermediary's other creditors would also be able to make claims against the escrow funds. On the one hand, the Court in Millard stated:

"The Committees and the Debtor . . . argue that Millard should receive the same pro rata treatment as all of the other former exchange customers of LES [those "other former exchange customers of LES" presumably being the exchangers under the unsegregated or commingled §1031 account maintained by LandAmerica's Qualified Intermediary under other exchange agreements] 4 – 4 . . . To permit one group of exchangers to recover their exchange funds under a trust theory necessarily reduces the amount of liquid funds available for distribution to other exchange creditors and impacts all of the other exchange creditors adversely, whether similarly situated or otherwise.”

On the other hand, in footnote 19, the Court in Millard states, as quoted above:

“In fact, the funds in the Segregated Accounts were entirely and completely vulnerable to attachment and levy by third party creditors of LES.”

The author of this paper has difficulty seeing why any of the subject exchangors should be treated in a class different from that of other unsecured creditors generally, with respect to released escrow funds.]
See also Frontier Pepper’s Ferry, LLC v. LandAmerica 1031 Exch. Servs., Inc. (In re LandAmerica Financial Group, Inc.), No. 08-35994-KRH, 2009 WL 1269578 (Bankr. E.D. Va. May 7, 2009).

The damages from LandAmerica Qualified Intermediary’s bankruptcy far exceeded the amounts of the escrow deposits, even putting aside LandAmerica Qualified Intermediary’s investment losses while the funds were in the sub-accounts. The subject exchangers also suffered the loss of favorable treatment under §1031, breach of contract claims by the buyers of the relinquished properties where the subject exchangors had to hold over, and breach of contract claims by the sellers of the replacement properties where the subject exchangors couldn’t replace the amounts of the escrowed funds quickly enough for settlement.

II. DRAFTING IMPLICATIONS OF THE MILLARD AND FRONTIER OPINION
Whether Millard and Frontier are correct or contrary to precedent, or will be accepted by the IRS, most draftspersons will want to deal with them in such a way as to try to avoid any problems under them. However, there are limits upon how much drafting guidance we can attempt to draw from the Millard and the Frontier opinions:

A. Get the Protections Millard and Frontier Didn’t. The subject exchangor will want the funds placed in separate, non-commingled accounts with (1) strong restrictions upon acceptable investments; (2) the subject exchangor’s having the ability to trace the funds; and (3) the exchange intermediary’s having no power to remove, encumber or pledge any monies or properties from those accounts except in connection with such permitted investments. The account should be titled as an escrow account with the subject exchangor’s name and tax identification number. Consider using qualified intermediaries who are financially strong themselves and who are backed up by fidelity bonds, guarantees, and/or professional liability insurance. Some states, such as California (see Deering’s California Codes Annotated, Division 20.5, §§51000 et. seq.) have enacted or are considering laws regulating qualified intermediaries operating in their respective states and providing protection, for the escrow funds they hold, as against certain creditors. Consider using qualified intermediaries located in those states; however, note that the protections provided may not be sufficient to cover large transactions.

B. Millard and Frontier are Limited to Cases under Federal Bankruptcy Law. The debtor in those cases is LandAmerica’s Qualified Intermediary, which itself is not a domestic insurance company. §§109(b) and (d) of the Bankruptcy Code [11 USCS §109(b) and (d)] do not allow domestic insurance companies to become debtors under Chapter 7 or 11. [For unexplained reasons, the parent company, LandAmerica Financial Group, Inc. was removed, by stipulation of the parties, from Millard; and was never included in Frontier.] Thus, Millard and Frontier may be limited to companies that hold §1031 escrows other than domestic insurance companies; such non-domestic companies may include holding companies (such as the publicly held parent companies that, in this case, issue insured closing letters and guarantees), separate §1031 exchange companies (such as LandAmerica’s Qualified Intermediary), foreign insurance companies, and title agencies. Domestic insurance companies are regulated by state agencies. Those agencies, or the courts they use for enforcement purposes, may view the applicable state laws differently from how Millard interpreted Virginia property law. Therefore, exchange agreements may be able to give exchange intermediaries much more power when the Bankruptcy Code is not applicable.

C. Millard and Frontier are Also Limited to Trusts and Resulting Trusts under Virginia Law. The Court cited the language, of the exchange agreements, that granted the debtor, LandAmerica’s Qualified Intermediary, extensive control over the monies in the escrow accounts. The Court found that:

“As LES maintained the exchange funds in bank accounts in its name and under its control, the money is presumably property of the LES bankruptcy estate. . . .

To rebut this presumption that the funds are the property of the bankruptcy estate of LES, Millard must show that it retained some right to the funds. Any such right to the funds must be established as an interest in property recognized under state law. [Citation omitted]”

The Court then held that Virginia law is the applicable law and proceeded to determine whether a trust or a resulting trust had been created for the funds under Virginia law. See the same analysis in Frontier. The Court then found that no such trust had been created. As part of its analysis, the Court considered it important that the exchange agreements expressly relied upon the “qualified intermediary” language of Treas. Reg. §1.1031(k)-1(g)(4), not the “qualified trust” language of Treas. Reg. §1.1031(k)-1(g)(3)(ii). The Court also thought it important whether the applicable documents involve fiduciary duties that “create a special relationship of trust and good faith that goes beyond that goes beyond the duties set forth in an ordinary contract between commercial parties.” The property laws of other states may have less stringent requirements for establishing trusts or resulting trusts. Therefore, if the draftsman wants to take advantage of the qualified escrow account safe harbor or the qualified trust safe harbor, say to back-up a qualified intermediary safe harbor [which the parties are permitted to do under Treas. Reg. §1.1031(k)-1(g)(1)], it is, obviously, safer (1) to draft ;an express trust or escrow agreement; (2) if possible, to structure to elect, and to elect, as the governing law, a state with favorable laws; and (3) to incorporate the applicable state requirements for creating an escrow agreement or trust.

D. The Court Did Not Consider Grounds – Other than Trust and Resulting Trust – Even under Virginia Law, for Excluding the Funds from the Bankruptcy Estate. In footnotes 16 and 20 of Frontier, the Court noted that it is not yet considering the issue of whether it should impose a constructive trust. The opinion in Millard also does not consider the question of imposing a constructive trust. The subject exchangors in both cases have alleged other grounds for relief and sought the imposition of constructive trusts. The Court has not, apparently, gotten to those other grounds. However, imposing a constructive trust is subject to judicial discretion, in equity, and the other grounds have their own issues; therefore, the draftsperson should not rely upon them.

E. Is it Possible to Draft a Qualified Intermediary Agreement that Keeps the Escrowed Assets Out of the Bankruptcy Estate? The Court indicated that it is indeed possible to word the exchange agreement in such a manner that the bankruptcy of the qualified intermediately will not make the escrowed funds part of the qualified intermediary’s bankruptcy estate. Footnote 6 of Millard states:

“The treasury regulations governing 1031 Exchanges make clear that the taxpayer must abrogate all control over the exchange funds until the exchange is completed. “If the taxpayer actually or constructively receives money or property in the full amount of the consideration for the relinquished property before the taxpayer actually receives like-kind replacement property, the transaction will constitute a sale and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.” Treas. Reg. §1.1031(k)-1(f). However, the abrogation of control required by the treasury regulations does not require the taxpayer to relinquish all right, title and interest to the exchange funds as the parties to these Exchange Agreements (as hereinafter defined) contracted for Millard to do. See DeGroot v. Exchanged Titles, Inc. (In re Exchanged Titles, Inc.), 159 B.R. 303, 306 (Bankr. C.D. Cal. March 27, 1993) (“for the purpose of the exchange . . . there was no need for [the accommodator] to acquire ‘real’ interest in the . . . property . . . to make the exchange qualify under the statute . . .’”) (citation omitted); Cook v. Garcia, No. 96-55285, 1997 U.S. App. LEXIS 5980, 1997 WL 143827, at *1 (9th Cir. 1997) (“A taxpayer need not abandon all equitable interests in proceeds . . . for a transaction to qualify as a non-taxable event under section 1031.”). This negates Millard’s argument that the disclaimers contained in Section 2 of the Exchange Agreements were included only because the treasury regulations require them to be included.”

The problem in Millard and Frontier seems to be that, under the subject exchange agreements, the subject exchangors gave the qualified intermediary far more power and control than is required by Treas. Reg. §1.1031(k)-1(g)(4). Treas. Reg. §1.1031(k)-1(g)(4)(vi) requires the subject exchangor to give up the:

” . . . immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary.”

F. Under Millard and Frontier, is either a Qualified Escrow Account or a Qualified Trust Preferable, to the Qualified Intermediary, to Keep the Escrowed Assets Out of the Bankruptcy Estate. Should the Exchange have both a Qualified Intermediary and either a Qualified Escrow Account or a Qualified Trust? In one of the LandAmerica bankruptcy cases, Health Care REIT, Inc v. LandAmerica 1031 Exch. Servs. (In re LandAmerica Fin. Group, Inc.), case number 08-03149-KRH, the parties entered into both an exchange agreement and a qualified escrow agreement in which (1) LandAmerica’s Qualified Intermediary served as the qualified intermediary; (2) to secure the performance of LandAmerica’s Qualified Intermediary’s obligations, Centennial Bank served as the “Escrow Holder”; and (3) Centennial deposited all of the escrow funds in a segregated sub-account at Citibank “associated with” the subject exchangor’s tax identification number and titled in the name of the Escrow Holder as escrow holder for the subject exchangor and LandAmerica’s Qualified Intermediary. The amended exchange agreement and the qualified escrow agreements cited both Treas. Reg. §1.1031(k)-1(g)(3)(ii) for the “qualified trust” portion and Treas. Reg. §1.1031(k)-1(g)(4) for the “qualified intermediary” portion of the exchange. However, they also contained the same broad transfer of control, by the subject exchangor, language that the Court found objectionable in Frontier and Millard. The parties settled that litigation and, thus, we have no ruling from the Court with respect to whether the escrow agreement would have been sufficient to moot the problem with the exchange agreement. Since the definitions in the Regulations and the case law are meager and a trip-up could have such dire consequences, obviously the safest (albeit most costly, although the costs should diminish as the procedure becomes more routine) approach seems to be to use a qualified intermediary exchange agreement, together with a qualified escrow account agreement as was used in Health Care REIT, Inc., supra or a similar qualified trust – but (a) without the extra concessions, by the subject exchangor to the intermediary, that the Millard and Frontier court found so objectionable for purposes of seeking exclusion from the bankruptcy estate of the qualified intermediary; and, on the other hand (b) not reserving such powers and control in the subject exchangor that the subject exchangor appears to be in constructive receipt of the funds during the 180-day period for §1031 purposes.