Bankruptcy Court Ruling: 1031 Sub-Accounts Available to Creditors

In a ruling handed down on April 15, 2009, the Court in the LandAmerica Exchange Services (or “LES”) case ruled that exchange proceeds held in sub-accounts were assets available to all creditors.

LES was the 1031 exchange arm of LandAmerica Title Company – one of the largest title companies in the country. LES had about $300 million in a commingled, or “pooled,” account which held the exchange funds for about 400 clients. They also had about $100 million in separate sub-accounts for about 50 clients.

The entire pooled account was invested in auction rate securities until February, 2008 when that market froze, making the account illiquid, which made LES unable to complete 1031 exchanges for clients whose money was locked in that account. This ultimately brought down the entire company (not just LES, but the title company as well).

...They used to say, “we’re too big to fail”–we’ve come to learn no company can say that...

The clients whose funds were in separate sub-accounts argued that their accounts should not be included in the bankruptcy because their funds were parked in separate accounts. The clients who were in the pooled account disputed this, of course, because if the sub-account money was added to the bankruptcy pool it meant immediate liquidity of about 25 cents for each dollar they had frozen. In this landmark ruling the bankruptcy court ruled that the sub-accounts were indeed part of the larger bankruptcy and added the sub-account clients’ money to the bankruptcy pot.

Rather than set up a truly separate account for each client, most large exchange intermediaries use either a pooled account, or set up a “master account” with a banking facility, and then set up “sub-accounts” for each client. The master account is owned by the intermediary and is in the intermediaries name with the intermediary’s tax identification number.

The purpose of the master/sub-account structure is to allow the intermediary (who controls the master account) to invest the funds for the benefit of the intermediary because they are investing a large pot of money. Some of these intermediaries market these sub-accounts as being similar to, or the same as, a truly separate account in the client’s name. LandAmerica, in its filings with the SEC apparently referred to these accounts as “separate accounts.”

The court’s opinion doesn’t go into detail about how the sub-accounts were worded or how they were handled by LES. We don’t know if the bank was aware of what sub-accounts existed or whose funds were in them, but obviously the court wasn’t impressed with the sub-account structure.

There are a number of serious issues here which should make you worry about your intermediary. First, LES was part of, and ended up bringing down, one of the largest title companies in the country. The large title companies used to say, “we’re too big to fail” – and in the last couple of years we’ve come to learn that no company can say that. They also used to say that you don’t have to worry about your title company’s exchange division because they’re governed and/or insured by the state insurance commissioners. While this may be true about the actual title insurance function, the states involved in this case have made it very clear that 1031 functions fall outside their coverage and responsibilities.

Another thing that’s important here is that no money was stolen. LES wasn’t a theft problem like so many of the recent 1031 intermediary problems. The investment of the pooled account simply became illiquid. The securities (20 year bonds in this case) are still there, but there are no buyers for the bonds.

The thing I find most astounding about this case is that even though the investment in the auction rate securities froze in February, LES continued to do exchanges and accept exchange funds until they finally went bankrupt in November. In other words, exchange money coming in from February through November was used to cover the reinvestment requirements of prior clients. The participants in the pooled account in February, who were the ones who should have had the bankruptcy problem, all got their money back. The new clients who came in months after the account was frozen lost their money. So remember: when you place money with an intermediary in a pooled account or a sub-account, you become responsible for any of the prior sins of that intermediary.