Guaranteed Returns, Commingled Funds & Related Company Transactions

In 2002, an Internal Revenue Service ruling (Procedure 2002-22) set forth guidelines for purposes of determining where undivided fractional ownership interests in real estate could be treated as ownership of real estate. Under the ruling, if "essential elements" of the TIC arrangement are followed, TICs qualify for 1031 exchange deferral of taxes. The structure of a TIC can be beneficial to many investors tired of active daily real estate management. There are many solid TIC sponsors in the market today. However, this is the story of one that wasn't.

By 2005, TICs were a hot commodity. At one time, Boise, ID-based DBSI, which operated under names such as Spectrus Real Estate and For 1031 LLC, was riding near the top of the heap. The 29 year old company became one of the nation's biggest sponsors of Tenant In Common (TIC) ownership interests in commercial properties across the United States. By providing smaller investors with access to the institutional properties markets and, in some cases, a guarantee of investment returns (from 6.5% to 12% returns annually -- whether or not the property performed well), DBSI became one of the most well-known TIC sponsors in a rapidly growing industry. Guaranteed returns, regardless of performance....really?

But as the commercial market began slowing in 2007 and 2008, DBSI began reporting problems. By September 2008, the house of cards quickly began to crumble. In a letter to investors, DBSI indicated it was "temporarily" reducing or eliminating payments. Within six weeks, DBSI had declared Chapter 11 bankruptcy. With the bankruptcy, day-to-day management of its properties broke down.

In October 2008, bankruptcy court-appointed examiner Joshua R. Hochberg, former chief of the Justice Department's fraud section, began investigating claims of fraud. He was directed to investigate allegations that DBSI defrauded investors out of $500 million. DBSI founder and president Douglas Swenson was alleged to have taken somewhere in the neighborhood of $160 million ( (Swenson's counsel denies he did anything wrong).

Hochberg’s (preliminary report, released in June, indicates a tangled web of closely related companies primarily controlled by Swenson. Transactions within the company - including transfers among DBSI related companies, Swenson, and four other minority owners - were more numerous that previously believed. Instead of investing the money as promised, Hochberg declared that the company was "an elaborate shell game." Hotchberg's report seems to indicate that as the market cratered, and new cash infusions dramatically slowed, DBSI and its affiliates used new investor proceeds to continue their daily operations and pay off existing debts. His report also claims that Swenson, DBSI and several other executives exerted control over dozens of DBSI affiliates and essentially ran them as a unified business with commingled funds (where have we also heard this other major problem before?).

Hotchberg continues to investigate the demise of DBSI. A more complete, final report should be out soon. What will the report conclude? Based on the the initial report indicating commingled funds, closely-related transactions and guarantees of returns - three major flags in previous schemes - I'd say it, unfortunately doesn't look good for investors.