Source: https://www.samuelson-law.com/and-you-assumed-that-escrow-moneys-were-bankruptcy-proof.html
Timestamp: 2019-04-21 20:13:55+00:00

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

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