In every 1031 exchange, whether deferred or reverse, the Exchangor entrusts valuable assets to their Accommodator. In the case of a deferred exchange, the cash proceeds from the sale of the Old Property are held by the Accommodator until the purchase of a New Property is closed. In the case of a reverse exchange, the Accommodator holds legal title to either the Old or the New Property, depending on the form of the reverse exchange. Exchangors should be diligent in selecting an Accommodator that has basic security provisions in place.
If the exchange is a delayed exchange and the asset is cash, the Exchangor should verify that the cash is held in a regulated financial institution (e.g. a bank), that the funds are liquid, that the investment policy used for the funds has a risk profile that is acceptable to the Exchangor and that the process for disbursing funds requires, at a minimum, explicit authorization from the Exchangor.
Exchangors should also verify that a delayed exchange Accommodator has sufficient insurance to protect its clients from acts of dishonesty (a Fidelity bond) and errors in execution (An Errors and Omissions policy). When cash is held, both a Fidelity Bond and an E&O policy should be required. In simple terms, a Fidelity bond will provide protection if assets are stolen and E&O insurance provides protection if the Accommodator makes a mistake.
As an aside, the FEA currently sponsors a Fidelity bond program for its members. The amount of insurance each Accommodator buys is the maximum amount that the insurer will pay if there is a claim. This means, hypothetically, that if an Accommodator has a $10 million Fidelity bond and has more than $10 million in exchange deposits in the aggregate on deposit, then there may be exposure to the Exchangors if an act of fraud occurs. There are real examples of this in the works today. Exchangors should be fully aware of the risks resulting from an Accommodator having a Fidelity Bond that is too small (i.e. less than their aggregate exchange proceeds balance).
Finally, Exchangors should ensure that their Accommodator has protections in place in the case of bankruptcy or insolvency. The segregation of assets into qualified trust accounts or other similarly structured depository accounts is useful in this regard. Also, some diligence by Exchangors with regard to the financial condition of the Accommodator they are considering is certainly warranted given the current (April of 2008) economic conditions – a combination of collapsing interest rates and drastically reduced exchange activity related to changes in real estate markets around the US. In short, Exchangors should make sure their Accommodator is healthy and going to be around for the long-term.
If the exchange is a reverse exchange, the Exchangor should ensure that the parked asset is held by an LLC that has been formed specifically for their exchange and that no other assets have or will be held by that LLC. Exchangors should also ensure that 1) the documentation provided by the Accommodator provides assurance that Accommodator is legally obligated to return the asset to the control of the Exchangor at the successful conclusion of the exchange or the expiration of the exchange period. In addition, the Exchangor should be granted a 100% security interest in the LLC and, if requested, a Deed of Trust for the parked asset.
LLCs provide some level of bankruptcy remote-ness by definition. However, additional provisions should be made to ensure that a bankruptcy of the member of an LLC in a reverse exchange (typically the Accommodator) does not entangle the LLC and its assets needlessly for a lengthy period of time.
ES Group does not perform deferred exchanges and therefore does not hold cash exchange proceeds. Our documents provide the highest level of security and protection for our Exchangors’ assets and the certainty that assets will be returned when required can easily be verified by examining the documents. We provide three levels of bankruptcy protection. The first level entails a 2-tiered LLC structure combined with a large personal guarantee of the parent Accommodator. Two additional levels involve the formation of LLCs that have operating agreements customized to restrict the ability of the Accommodator to voluntarily enter into a bankruptcy.
Lastly, on a pragmatic note, potential Exchangors should understand that the temptations and risks associated with cash simply do not translate to parked properties. The various provisions described above would make it nearly impossible for even the most devious of Accommodators to liquidate an asset without the Exchangor knowing it and being able to intercede. Without being able to liquidate an asset, there really is no motivation for mischief. We prefer to hold assets for the minimum time possible to complete an exchange. ES Group does not inflict “carrying charges” on its clients.
Reverse exchanges provide, therefore, a level of security for Exchangors that deferred exchanges simply cannot provide because 1) there is no cash and far, far less risk of mischief, 2) there are binding agreements that stipulate the return of the parked assets and 3) there is far greater protection from bankruptcy when separate and properly constructed LLCs are used.