Lawyer disciplined for involvement in investment scheme

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The SEC is not “another jurisdiction” for the purpose of reciprocal discipline

On June 27, the South Carolina Supreme Court suspended a lawyer for eighteen months based on Securities and Exchange Commission (SEC) charges*. While this case has nothing to do with dirt law, I bring it to the attention of South Carolina lawyers because they often find themselves in the position of forming and representing limited liability companies (LLCs).

SECThe South Carolina lawyer, John Kern, helped form and served as general counsel for Ventures Trust II LLC and Face-Off Acquisitions, LLC, two of the LLCs used in a fraudulent investment scheme perpetrated by Craig Berkman. Berkman fraudulently raised around $13.2 million from approximately 120 investors by selling memberships in the LLCs he controlled. Unfortunately for these investors, Berkman was subject to a $23 million judgment in Oregon, in connection with another fraudulent investment scheme, and was also facing bankruptcy in Florida. Berkman began to use some of the funds from his new ventures to pay his bankruptcy obligations in Florida, and the SEC got involved.

In 2014, Kern signed an offer of settlement and consented to an entry by the SEC of an order imposing sanctions against him. SEC findings included that (1) Kern willfully aided and abetted the fraudulent conduct of Berkman; (2) Kern was ordered to disgorge fees of around $235,000 and to pay a fine of $100,000; (3) Kern was barred from associating with brokers and investment advisors; and (4) Kern consented to being denied the privilege of practicing law before the SEC.

South Carolina’s Office of Disciplinary Counsel (ODC) filed formal charges in 2016 and argued that the SEC is “another jurisdiction” under the Rule 29(e), which deals with conclusiveness of misconduct adjudications against lawyers in other jurisdictions. The Supreme Court found that the SEC is not a jurisdiction for the purposes of reciprocal discipline, but found that Kern was guilty of providing false information in statements to others.

Kern falsely assured Berkman’s bankruptcy attorney that none of the funds used to settle Berkman’s bankruptcy obligations were derived from Ventures II. Kern also issued a false memorandum to investors in Ventures II to the effect that their funds were secure and were not part of a Ponzi scheme orchestrated by Berkman.

Kern’s primary defense in his South Carolina disciplinary proceedings was that he was totally unaware of Berkman’s malfeasance, and that as soon as he became aware, he resigned as general counsel for the LLCs and encouraged a principal in the companies to act as a whistleblower to the SEC. Kern argued that he had no dishonest or selfish motive, did not profit from his misconduct and showed remorse for the harm caused to investors. The Court said that it took these mitigating factors into consideration in imposing sanctions.

Professor John Freeman, who taught ethics to many of us, was qualified as an expert in the case and testified that when a lawyer acts as general counsel for a private securities company, he or she must exercise due diligence to ensure money is invested for the represented purposes.

Despite the fact that the SEC is not considered by the South Carolina Supreme Court to be a jurisdiction for the purposes of reciprocal jurisdiction against attorneys, this attorney was suspended for eighteen months because of his conduct that led to charges before the SEC.

The lesson to us is clear. Be careful in forming and representing LLCs and use proper due diligence in statements made to the investors in those entities. Lacking a dishonest motive is not enough to protect lawyers from discipline.

*In the Matter of Kern, South Carolina Supreme Court Opinion 27820 (June 27, 2018)

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Statute of Elizabeth case provides important reminders

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Conveyance to an LLC is set aside

A recent South Carolina Court of Appeals case* affirmed a Circuit Court order that set aside a conveyance under the Statute of Elizabeth. This is yet another tale of woe from the economic downturn.

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Kenneth Clifton was a successful real estate developer who commonly purchased investment property in his own name. When he developed property, he transferred his interest to a limited liability company (LLC). He organized more than forty LLCs during his career.

In 1993, Clifton and Linda Whiteman purchased approximately 370 acres in Laurens County in their individual names as tenants in common.

Clifton routinely borrowed money from lenders to finance his developments. At issue in this case were three loans from First Citizens Bank totaling around $4 million. These loans were renewed over the years as Clifton made progress payments.

When the real estate market slowed in 2008, Clifton sought additional extensions for two of the loans. First Citizens asked for a personal financial statement. Clifton’s financial statement claimed a net worth of $50 million with real estate comprising over $48 million. The subject 370 acres in Laurens was included. The statement stated Clifton owned a 50% unencumbered interest valued at approximately $1.5 million. Relying on this financial statement, First Citizens renewed the loans to mature in 2009.

Later in 2008, Clifton requested an extension on the third loan. Just prior to receiving the extension, Clifton and Whiteman transferred their interests in the property to Park at Durbin Creek, LLC (PDC). Clifton testified that he and Whiteman chose to transfer this property to PDC over Whiteman’s concern about personal liability because the property was being leased to third parties for recreational hunting purposes. All three loans were extended to mature in 2009.

Clifton failed to make payments, to provide a business plan or to secure additional collateral. First Citizens initiated foreclosure proceedings in February of 2009 and eventually secured a deficiency judgment of $745,000 against him.

During the foreclosure proceedings, Clifton and his daughters entered into an assignment agreement resulting in a transfer by Clifton in PDC to Streamline, an LLC that was nonexistent on the date of the transfer but whose members, upon creation, were Clifton’s daughters and ex-wife.

In 2010, First Citizens initiated supplemental proceedings, but by this time, Clifton had no remaining assets. First Citizens began this case under the Statute of Elizabeth (S.C. Code §27-23-10), alleging causes of action for fraudulent conveyance, civil conspiracy and partition.

court money 2The Circuit Court found sufficient “badges of fraud” to infer Clifton possessed fraudulent intent when he transferred his 50% interest in the property to PDC.

This is the first valuable reminder from this case:  The conveyance to Streamline was held void ab initio because Streamline did not exist at the time of the conveyance. (Dirt lawyers, make sure your entities are properly created before you assist your clients in making conveyances to them!)

A second valuable reminder involves requirements concerning transfers of interests in member-managed LLCs like PDC. When Clifton attempted to transfer his interest in PDC to a separate LLC, he failed to obtain Whiteman’s consent. Section 33-44-404 (c)(7) of the South Carolina code states that, in a member-managed LLC, the admission of a new member requires the consent of all members. The lack of consent in this case would have invalided the transfer to streamline even if the transfer to PDC had been held valid. (Dirt lawyers, make sure you follow statutory procedures when dealing with transfers of interests in entities.)

The case then sets out a simple South Carolina primer on the Statute of Elizabeth. The statute provides:

Every gift, grant, alienation, bargain, transfer and conveyance of lands…for any intent or purpose to delay, hinder, or defraud creditors and others of their just and lawful actions, suits, debts, accounts, damages, penalties, and forfeitures must be deemed and taken…to be clearly and utterly void.

Citing earlier cases, the Court of Appeals stated that this statute can be used to set aside conveyances whether or not consideration is paid.

Where there is valuable consideration, the following element must be established:

  1. The transfer was made with the actual intent to defraud creditors;
  2. The grantor was indebted at the time of the transfer;
  3. The grantor’s intent is imputable to the grantee.

Where there is no valuable consideration, no actual intent to hinder or delay creditors is required. Instead, the transfer will be set aside if:

  1. The grantor was indebted to the plaintiff at the time of the transfer;
  2. The conveyance was voluntary; and
  3. The grantor failed to retain sufficient property to pay the indebtedness to the plaintiff at the time when the plaintiff seeks to collect the debt.

In this case, the Circuit Court found and both parties agreed that valuable consideration was paid. For that reason, First Citizens was required to prove that Clifton transferred the property with the intent to delay, hinder or defraud First Citizens.

Citing earlier cases again, the Court of Appeals stated that when a party denies fraudulent intent, as Clifton did, the creditor must prove “badges of fraud”. One badge of fraud may not create a presumption of fraud, but several badges of fraud does create the presumption.

Nine badges of fraud have been identified by our courts:

  1. The insolvency or indebtedness of the transferor;
  2. Lack of consideration for the conveyance;
  3. Relationship between the transferor and the transferee;
  4. The pendency or threat of litigation;
  5. Secrecy or concealment;
  6. Departure from the usual method of business;
  7. The transfer of the debtor’s entire estate;
  8. The reservation of benefit to the transferor; and
  9. The retention by the debtor of possession of the property.

The Court held that six of the nine badges of fraud were present in this case, resulting in a presumption of fraud. The Court next considered whether Clifton successfully rebutted the presumption. The Court concluded that Clifton wanted to protect the property from creditors, despite offering the legitimate reason for the transfer, that Whiteman was concerned about personal liability on hunting property.

Finally, the Court held that the invalidity of the conveyance of Clifton’s undivided 50% interest in the property does not invalidate Whiteman’s conveyance despite the fact that only one deed was used.

* First Citizens Bank and Trust Company, Inc. v. Park at Durbin Creek, LLC, South Carolina Court of Appeals Case 5469 (February 15, 2017)

Hot off the presses UPL case!

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(But it only affects real estate peripherally)

The South Carolina Supreme Court handed down a UPL decision in a declaratory judgment action in its original jurisdiction on February 22.*

The Court accepted the action to determine whether Community Management Group, LLC and its employees engaged in the unauthorized practice of law while managing homeowners’ associations. The Court found that the respondents did, in fact, engage in UPL. At the outset of the case, the Court had issued a temporary injunction halting the offending activities.

Community Management Group, without the involvement of an attorney, prepared and recorded notices of liens and related documents; brought actions in magistrates’ courts to collect debts; and filed the resulting judgments in circuit courts. The entity also advertised that it would perform these services “in house”.

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In a 1992 administrative order entitled In re Unauthorized Practice of Law Rules Proposed by South Carolina Bar**,  the Court had modified prior case law to allow a business to be represented by a non-lawyer officer, agent or employee. The Court had also promulgated South Carolina Magistrate Court Rule 21, which provides, “A business…may be represented in a civil magistrates’ court by a non-lawyer officer, agent or employee…”

The central question in the action at hand was whether the word “agent” in these authorities includes third party entities and individuals like Community Management Group and its employees. The Court held it does not and was never intended to.

The Court had earlier held that filing claims in probate courts does not amount to UPL, but stated in the present case that it is the character of the services rendered that determines whether the services constitute the practice of law. Filing claims in Probate Court, according to the Court, does not require the professional judgment, specialized knowledge or ability of an attorney. The Court found that the services required to represent a business in magistrates’ courts are not comparable to filing claims in probate courts.

Community Management Group conceded that it prepared a lien document for the purpose of putting a cloud on title so property could not be sold unless the homeowner paid overdue assessments. This stated purpose demonstrated to the Court that the lien documents were “instruments”, that is, written legal documents that define rights, duties, entitlements or liabilities.

Citing a 1987 case near and dear to the hearts of all South Carolina dirt lawyers, State v. Buyers Service***, the Court reminded us that preparing and recording legal documents is the practice of law.

This current case is a Per Curiam decision, but acting Justice Pleicones did not participate. We are holding our collective breath to learn the results of a Quicken Loan case pending in the original jurisdiction of the Court, and the present case may give us at least a small hint.

stay tunedWe have already received an underwriting question about this case in our office. We were asked whether our attorney agents can ignore the liens filed in contravention of this case. The answer is that we can discuss the specifics on a case-by-case basis, but it appears that although the liens may be invalidated by a court, dirt lawyers and title companies should not generally take this risk without the involvement of a court. If you run into this issue in connection with your closings, call your title insurance underwriter to discuss your options!

*Rogers Townsend & Thomas, PC v. Peck, South Carolina Supreme Court Opinion 27707 (February 22, 2017)

**309 S.C. 304, 422 S.E.2d 123 (1992)

***292 S.C. 286, 468 S.E.2d 290 (1987)

County May Owe Duty to Lot Owners in Failed Subdivision

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Infrastructure regulations were not followed

scales - blue backgroundOn January 6, the S.C. Court of Appeals reversed the Georgetown County Circuit Court’s directed verdict and remanded a case involving failed West Stewart Subdivision.* The developer, Harmony Holdings, LLC, went belly up in 2007, leaving the lot owners without roads and utilities after the County failed to follow its own regulations that provided a safety net for such catastrophes.

The plaintiff owned two lots in the subdivision, and filed a negligence action, arguing that Georgetown County had a “tort-like” duty to lot owners under the plain language of its development regulations. The County denied that it owed a duty to lot owners.

The County attorney explained the administrative issues at trial. He testified that in South Carolina, a developer is generally not allowed to sell lots that do not have infrastructure (roads, water and sewer). County regulations, however, allow the County to accept cash, bonds, financial guarantees or letters of credit to ensure money is available to complete infrastructure in case a developer fails.

Under the regulations in question, the County had discretion to accept a letter of credit equal to 125% of the cost estimate to complete the infrastructure. In this case, the developer posted a letter of credit on May 23, 2006 in the amount of $1,301,705 based on a cost estimate of $1,040,000.

Also under the regulations, the County had the power to approve reductions in the letter of credit upon receipt of an engineer’s certification that a certain amount of the work had been completed and sufficient funds were available for the remaining work. Other technical procedures were also required. The County allowed for a reduction in the letter of credit on July 20, 2006, October 9, 2006 and November 8, 2006, reducing the letter of credit to $553,370. In December of 2006, the County was advised that the estimated cost to complete the infrastructure was $1,153,205, which was higher than the original estimate. Despite this information, the letter of credit was reduced again on March 9, 2007 to $156,704.

The letter of credit expired in May of 2007, and the developer gave the county a check for $140,000. In August of 2007, the developer informed the County that it no longer had the financial means to complete the construction. Then the developer declared bankruptcy.

Repko described his lot as “woods” accessible by a path but inaccessible by a road. He testified that he believes his property is valued at “zero”. He said he pays property taxes on his lot, but the County will not allow him to build because of the absence of basic utilities.

The trial court directed a verdict in favor of the County on the grounds that the regulations do not create a private duty to lot owners. (Other issues were argued that will not be discussed here.) The Court of Appeals agreed with the lot owner that the County owed a special duty to him with respect to the County’s management of the financial guaranty that allowed the developer to sell lots.

inigo montoya memeThe County had relied on a 1993 Hilton Head case.** In that case, the preamble to the development ordinances stated, “The town council finds that the health, safety and welfare of the public is in actual danger….if development is allowed to continue without limitation.” When the development failed, a lot owner sued the Town, claiming it had negligently administered its ordinances. The Supreme Court held that the ordinances did not create a special duty to lot owners because their essential purpose, according to the preamble, was to protect the public from overdevelopment.

The Court of Appeals in the current case held that, unlike the Hilton Head ordinances, the Georgetown County regulations contained no express language declaring their purpose, but reviewing them as a whole, the purpose is to protect lot owners in the event the developer does not complete infrastructure.

I expect we have not seen the end of this case!

* Repko v. County of Georgetown, Opinion 5374, January 6, 2016.

** Brady Development Co. v. Town of Hilton Head Island, 312 S.C. 73, 439 S.E.2d 266 (1993).

Another TRID Lender Announcement

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This one has an interesting twist.

US-Bank-Home-MortgageU.S. Bank Home Mortgage (USBHM) recently announced that it, like other large lenders, will prepare and deliver the Closing Disclosure and any necessary revisions to the consumer once the TRID rules become effective on October 3. Settlement agents (closing attorneys in South Carolina) will be responsible for the seller’s Closing Disclosure.

Here’s the twist: USBHM stated that it will only require TRID documents for loans subject to TRID, which would include most closed-end consumer credit transactions secured by real estate, for applications taken on or after October 3. Then it stated, “One exception to this is that USBHM will require TRID disclosures for properties that are title vested in an LLC.”

On its face, this statement would mean that commercial loans involving properties vested in LLCs would be subject to the new Loan Estimate and Closing Disclosure forms. Since the name of this lender is U.S. Bank Home Mortgage, we can only assume this announcement means USBHM will consider any loan secured by residential property vested in a limited liability company to be a consumer loan. As an example, loan on a rental house (an investment property) titled in an LLC, would be subject to TRID rules, according to this lender. The announcement did not make a distinction between single- and multi-member LLCs.

The announcement indicated that USBHM will use various methods of delivery for the Loan Estimate and Closing Disclosure, including regular mail, electronic delivery and tracking through eLynx. (A quick look at eLynx’ website indicates this company provides a network for paperless document collaboration and distribution throughout the financial industry.)

USBHM indicated it will work with settlement agents to prepare the Closing Disclosure for delivery to the consumer, and that collaboration on the numbers will begin seven to ten days before the scheduled consummation date. The bank will continue to place the burden on settlement agents for the accuracy of the closing figures: “The settlement agent will continue to be responsible for ensuring that the Closing Disclosure provided at consummation is accurate to the terms agreed upon with USBHM.”

After the settlement agent and USBHM have agreed on the closing figures, USBHM will deliver the closing disclosure to the consumer and the settlement agent simultaneously through eLynx. The plan is to deliver the closing documents, including the final Closing Disclosure, to the settlement agent one day prior to closing.

surprised woman with bookLocally, we have been speculating that loan documents for various lenders will arrive ten minutes prior to closing despite the three-day rule for the Closing Disclosure. This announcement gives that speculation some credence. There is no requirement of early delivery of the closing documents to the closing attorney.

Locally, we have also been speculating that making changes to the closing figures will be difficult, particularly if the closing takes place outside of normal banking hours. This announcement provides some help by indicating that USBHM will have staff available for after-hours closings provided it has notice that a borrower will be signing outside normal business hours.

To read the entire announcement, follow this link.