Qualified Intermediary or Common Thief?

(Please note: I made a few updates tonight (3/25) after finding out new information)

I read at The Santa Barbara Independent that local investors have lost almost $10 million when the fund of a local company, Qualified Exchange Services (QES), were found missing. This is likely part of a much larger scam involving perhaps $100 million in funds. I did some research and found that his is an unregulated industry that was set up to address the needs of the Internal Revenue Service's 1031 Tax Deferred Exchange. McGhan Medical Coporation (now Inamed) founder Don McGham has been charged with filing false financial statements.

The tax deferred exchange process is a way sellers of an investment property can sell their property and acquire a replacement property without seeing any taxable capital gain. In essence, the "qualified intermediary" (QI) holds the property between the sale and purchase of replacement property.

From what I understand, this business model is not structured to protect the customer. Although most QIs are honest and ethical -- and not all use this business model -- this is what can happen:

1) A QI can keep all or part of the interest on the funds held in between sale and purchase. There is no legal reason for this as the IRS allows customers to keep all of their interest. The IRS is considering changing this and taxing on the interest whether or not the QI is involved. (Update: actually the IRS is considering taxing the interest to the exchanger even if the QI keeps all or part of that interest. This would be a positive step for customers to become well aware of what
interest is earned on their funds).

2) Accounts are not segregated. QIs can mingle funds to maximize interest for themselves.

3) When accounts are not segregated, the risk of theft is greater. McGhan found that he could buy a QI and use the funds for his own purposes. Imagine using these funds to buy more QIs and having access to even more funds. Consider $10 million at 5.25% and you have monthly interest of $42,730.

I'm not an expert at this but it seems each of the sellers in this case have breached a fiduciary responsibility to their customers by giving up control of the funds they held without making sure they were protected. The customers have now lost their money and could not complete their exchange -- a double whammy from which they may not ever recover.