Often-used real estate practice tied to alleged Ponzi scheme

The bankruptcy and multiple lawsuits related to Franconiabased Edmund & Wheeler Inc.’s alleged participation in a national Ponzi scheme raises a number of questions over the regulation of the real estate reinvestment tool known as a 1031 exchange.

A like-kind 1031 exchange, so named after Section 1031 of the Internal Revenue Code, allows individuals and entities that sell commercial property to delay paying capital gains tax by buying or investing in another similar property of equal or greater value.

The 1031 exchange isn’t a new tool — in fact, it has been around for exactly 100 years. But the future of these exchanges may be in doubt, since the Biden administration is looking to severely limit their use.

They are very common. Although data is hard to come by, one estimate in a study issued by the Real Estate Research Consortium indicates that like-kind exchanges are involved in 10% to 20% of commercial real estate transactions, resulting in nearly $10 billion in revenue loss to the government.

Fraud is rare, but it does occur regularly. And it usually involves a qualified intermediary — known as a QI — which the IRS requires but doesn’t really regulate.

Most investors — particularly those new to 1031 exchanges — think of QIs as a neutral party, holding their money in escrow. The law prevents them from holding it too long, since sellers have to meet strict deadlines to receive the tax break. They have 45 days from the closing of the sale to select a new property to reinvest in, and 180 days from closing to purchase that property.

The tight time frame can lead to pressure sales, particularly when the QI might have a conflict of interest.

The Florida Board of Realtors cited one Ponzi scheme in 2007 that involved QIs in Nevada and California, in which $95 million of customers’ proceeds were used to finance investments, including a breast implant manufacturing business.

In 2009, the CEO of a QI company in Virginia pleaded guilty to misappropriating $132 million of client funds to invest in her various companies and lavish lifestyle.

In 2012, the Federal Trade Commission reported that it was aware of 23 instances when investors lost a total of $250 million as a result of QI fraud.

In 2018, the SEC filed an emergency action against a California QI that used $24 million in a Ponzi scheme to pay off earlier investors and take over $2 million for herself.

‘Referral fees’

As reported in the Sept. 10-23 issue of NH Business Review (“NH investors entangled in real estate ‘Ponzi scheme’”), no one is charging John Hamrick, the head of Franconia-based Edmund & Wheeler, of simply absconding with investor funds.

Those Ponzi scheme allegations are more aimed at Noah Corporation and Rockwell Debt Free Properties for commingling investors’ money that was earmarked for a slice of a particular property and using it to pay the rents of investors in previous properties, until the whole enterprise collapsed into bankruptcy.

Instead, the lawsuits filed against Hamrick accuse him of steering people into this enterprise, even though he knew or should have known that they were on shaky ground, because they were receiving hefty commissions from Rockwell that were not disclosed to clients.

Instead, the clients allege they were told that all Edmund & Wheeler would receive was a small fee of $750 from the investor.

One New Hampshire investor, Stephen LaRosa, said he didn’t understand how Hamrick could make a living with so little compensation.

“‘That’s all we get. I just love doing my job,’” LaRosa said Rockwell told him. “And we found out that he is getting kickbacks from Rockwell.”

The multiple lawsuits claim he was getting around a 5% commission that he did not disclose to investors from Rockwell. The money actually went to Mary O’Toole, a partner in Edmund & Wheeler who is also Hamrick’s “life partner,” according to filings on both sides of the lawsuit.

“Hamrick created an arrangement with O’Toole Enterprises under which commissions due to E&W and Hamrick ... from Rockwell were paid to O’Toole Enterprises, thus manifesting Hamrick’s understanding that his dealings with Rockwell involved risks requiring a scheme to hide or transfer assets that might otherwise be available to claimants,” according to a complaint in the second Denver lawsuit.

Hamrick doesn’t call them kickbacks or commissions, but “referral fees,” and said that they were disclosed “every single time in the contract.” When he was asked to show one of those contracts, Hamrick declined. (O’Toole did not return a phone call left at her office.)

However, in another lawsuit, filed in Vermont, E&W disclosed in one consulting agreement it “can derive referral fees from certain providers of replacement real estate and will disclose those potential fees,” but the contract didn’t say what those fees were.

In a response, E&W lawyers said that when it came to discovery, “defendants will provide evidence that the referral fees were indeed disclosed.” However, even if they weren’t, the company did “not plausibly allege a breach that is causally related to their damages,” the lawyers said.

But every plaintiff that NH Business Review talked to said that the fees were not disclosed, and several said that it should be illegal for qualified intermediates to take referral fees — particularly those not disclosed.

There are no federal regulations governing fees, but 13 states have statutes mandating requirements for qualified intermediary licensing, skills required for management and standards for holding exchange funds, according to Lynn Harkin, executive director of the Federation of Exchange Accommodators. But, when asked which states they were, Harkin declined to answer.

Harkin did say that the FEA has a code of ethics that does not forbid referral fees but does require disclosure. When asked if any law required disclosure, she again declined to answer.

New Hampshire law

FEA’s lack of interest in talking about QI regulations might be understandable because right now, they and other business groups are fighting for the practice’s very life.

To help pay for his $3.5 trillion spending plan, President Biden includes a provision that would only allow a deferral of $500,000 in capital gains tax ($1 million for married couples). The proposal has created a storm of opposition from the real estate industry, which claims the change would result in the loss of hundreds of thousands of jobs tied to these deals.

Mackay, Caswell & Callahan, a tax and business law firm in New York, lists eight states that regulated exchange facilities in 2019, including New Hampshire, though it turns out the New Hampshire law — Senate Bill 483, passed in 2010 — was designed to make sure that such exchanges don’t run afoul of the Granite State’s unique tax structure and has nothing to do with QIs. Nevada appears to be the only state that licenses QIs, requiring that they put up a bond, but they don’t regulate fees and disclosure.

New Hampshire’s real estate commission doesn’t regulate 1031 exchanges.

And there is a question over whether the Securities Division can do anything about them as well. The industry — and E&W is no exception — insists that investors who are “Tenants in Common” are just purchasing pieces of real estate so that the commercial real estate bought the equal amount that was sold.

But in the cases like Noah/Rockwell, when funds are commingled and don’t actually go to a particular property, the SEC maintains that they are securities. Hamrick claims they are not, and that is one of the things the state Securities Division must determine during its investigation, since to sell securities you must be licensed to do so.

‘A complete sham’

This crevice in the law brings back memories of the Financial Resources Mortgage scandal that came to light in 2009, the biggest Ponzi scheme in New Hampshire history. While it didn’t involve 1031 exchanges, it did involve investors thinking they were buying real estate when they were actually just pouring money into a company that commingled funds and was eventually forced into bankruptcy.

Although the perpetrators went to prison, it was unclear exactly who regulated the activity, and there was much fingerpointing among the agencies involved:

Securities, Banking and the Attorney General’s office. The state Legislature felt some responsibility for the fiasco, since it set aside $10 million in this year’s budget to compensate victims.

Rep. Judith Spang, D-Durham, remembers that scandal, though she ended up opposing the funding, arguing that investors should swallow their losses, and the money should go for human needs.

“I don’t think the governor should pay for private business investments gone bad,” she said. “At the time I would say they were stupid, but now I know from my experience that they were not stupid, but I was deceived.”

That’s because Spang, too, was allegedly “sucked into” the Noah/Rockwell mess by Hamrick.

“Just like other investors, I thought it was going to a certain facility, and it was a complete sham.”

Spang didn’t join the lawsuit, because unlike most of the litigants, her property — in Southfield, Mich. — was built and used as an event venue. So, although she filed a claim in bankruptcy court (she said it was in the low six figures), she said the owners might get more by actually selling the property than through the court.

When asked to compare the FRM scandal to this, Spang said the Noah/Rockwell scheme is much bigger because it is national in scope. And when asked whether it might spark any legislation on her part, Spang, who mainly concentrates on environmental matters, said she would hope that some of her more financially astute colleagues might take up the matter.

“I don’t know a lot about such things,” she said. “That’s why I was fooled. I was an innocent.”

Bob Sanders can be reached at bsanders@nhbr.com.

Fraud usually involves a qualified intermediary, known as a QI, which the IRS requires but doesn’t really regulate.