Commingling Funds - is it legal?

Question

At a recent real estate seminar I attended the presenter said that it is illegal to commingle funds from different private lenders to purchase a property. The example he used was borrowing money from 2 relatives (50% each), sticking it into the same bank account, and then using it to pay for a property.

Is this really illegal? If so what are some ways to get around it? Any additional explanation of the laws related to this topic would be much appreciated as I haven't been able to find much Googling.

Mike McDermott · Answer

POOL FUNDS ALL DAY LONG (but do it right.)

@Kenny Wolfenberger originally asked a question about POOLING, with some underlying confusion about what is a SECURITY.  Let's take a look at both questions.

A promissory note is a security.  Pure and simple.  If we're in a bar, and I borrow $10 from you and I scrawl on a napkin that I'll pay you back $15 by Tuesday, you and I have developed an unlicensed, unregistered security.  It's that simple.

Think about it.  You could turn around and sell that napkin to the NEXT GUY for $12 that very same night.  Holder of the note gets the payment.  Does NEXT GUY have any interest in me?  Nope.  Does he profit from the efforts of a third party?  Yep.  Is NEXT GUY involved in actively managing me?  NO!  Even if it's an IOU scrawled on a napkin, it's a security.

In the original example where the funds of two people are combined then invested, it's not whether they make a security or not, it's whether they're pooled!

Scenario One:  Person A lends money on a house.  He gets a first mortgage.  Person B lends money on the same house and she gets a second mortgage. NOT POOLED!  Two separate notes, two separate unlicensed, unregistered securities.  Can person A sell his note to someone else?  Unless there is a clause saying the contract is not assignable, then yes he can.  Same for person B.  There are two separate securities that are legal because of the exemption allowing these types of transactions.

Scenario Two:  Person A and Person B each give the investor $50,000, the investor uses that $100,000 to buy a house.  He gives Person A a first and person B a second.  POOLED!  Those funds were combined before the transaction.  Even if the net result is the same, POOLING took place at the point the funds were accepted before the mortgages were issued.

There are exemptions that allow for Scenario One.  If you're borrowing from people you know and have an existing relationship with, if you're doing a one-one transaction, if you didn't advertise, etc., then Scenario One is perfectly legal.

Those exemptions do not exist for Scenario Two.  Pooling is restricted (not illegal), but if done incorrectly, you would be in violation of Regulation D of the SEC code.  The code provides for extremely stiff penalties, so DON'T DO IT!

Now, if you want to POOL, there are ways to do it correctly.  File a SCOR form with your state's department that oversees financial transactions.  Depending on the state you're in, not only will you be able to POOL, you'll be able to advertise to strangers, and you'll be able to solicit for funds in some of the neighboring states.

The Small Corporate Offering Registration (SCOR) form is also known as a U-7.  It is long and annoying and asks redundant questions, but it is worth it to a small investor who wants to:

1. Advertise for funds.

2. Solicit Strangers

3. Raise funds out of state.

Google SCOR Form or U-7.  There is a ton of information out there.  You can also download the forms at http://www.nasaa.org/industry-resources/corporation-finance/scor-overview/scor-forms/

So, in short:

A.  All notes are securities.

B. Most one-to-one notes have an exemption that allow you to generate unlicensed/unregistered securities.

C. Pooling is restricted and can be sanctioned if done incorrectly.

D. Filing a SCOR (U-7) with your state allows you to advertise, pool, solicit strangers and solicit in some other states (Check your own state regs.  They vary.)

So, good luck with all of this.  Let's keep our money local.  Don't occupy Wall Street:  ESCAPE WALL STREET!  Keep up the great work!

Jeff Greenberg · Answer

Existing relationship or not does not change whether or not it is a security.  The sponsor of a private placement, which is a security, must have a pre existing relationship with the investor prior to presenting a deal.  Enter the JOBS act and 506c rule which changed some of that.  There are many threads on that discussion.

Dion DePaoli · Answer

All Notes are Securities:

SEC. 2. (a) DEFINITIONS.—When used in this title, unless the

context otherwise requires—

(1)The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement,..............
	
	Yes, all notes are securities.  
	
	Certain types of notes and certain issuers and certain purchasers are exempt.  The exemptions run both at federal and state levels.  
	
	In the case of the family investment example:
	
	1.  The deal is a security by definition.  (see Howey Test)
	2.  The issuer has exemption based on the issuer and potential investor
	
	Originating the loan itself and selling of the investment (Note) can be viewed as two different ideas and sets of public protections.  In order to hold yourself out to the public to make (originate) residential real estate loans a license and registration is required.  This idea protects the public when obtaining a mortgage against their property for terms, disclosures and other risks.  So rules like SAFE Act help govern this body of ideas, protect the public in regards to the types of mortgages and terms of the same that are offered.  In regards to Seller financed deals, I believe we have many threads here on BP.
	
	Solicitation of the 'investment' side of the loan can be viewed as a separate idea.  Investments in debt and equity when solicited the public are governed by securities laws.  Within the Securities Act is a provision to allow institutions under license and oversight by other agencies to engage public and private investment offerings.  So institutions like banks and the GSE's and other similar type institution fall into this idea.  
	
	Solicitations which are not presented to the public or which are private solicitations of investment have some exemptions exclusive to their own 'class' of investment.  (Private offerings are not Public offerings)  Such exemptions as an example like under Regulation D.  In our family example, when we approach our relatives, this type of exemption kicks in.  
	
	I think what ends up being the mind bending exerciser is the approach to understand the rules by folks.  In that regard, the rules don't work in a straight forward manner like many want or perhaps think.  The idea flows more like, all investments are securities.  Sometimes the issuer creates the allowance of the exemption and sometimes the audience allows for the exemption.  
	
	I think many times the mental approach is around the asset itself.  For instance, is a mortgage a security?  The answer to that question is yes and sometimes registration is required and sometimes it is exempt from registration requirements.  So the asset itself is both and which side of the fence it falls onto depends on other details outside of simply 'what is the asset'.  The parties involved influence the exemptions.

Bill Gulley · Answer

Good stuff Dion.

Think of comingling funds as a cook making stew. As long as that cook prepared all the ingredients in the stew, that cook made it, if it's good or bad he gets the credit. He's also entitled to any profits if he sells it and the liability if it makes anyone sick. But if you have another cook fix the beef, celery and carrots, neither one can claim the stew as theirs alone.

If you open a checking account in your name and your wife deposits her pay check to that account, you can't claim that all the money is yours just as one cook can't make the claim as the stew being his. So, there are laws that effect comingling monies, your wife has an interest in that account even though she may not be able to draft checks on the account. She has a marital interest as well and in community property states, she may have a marital interest in the money even if she didn't make a deposit.

The idea behind comingling funds is to who may have an interest in the funds. In notes, there are exemptions for notes that don't use comingled funds and when other requirements are met, like registration of a fund, or holding a license as a bank or brokerage or insurance company there are additional exemptions. That leaves unregistered funds or entities not licensed and individuals out in the cold, without exemptions.

As Dion mentioned, the title company deposits all the money into one account. But they do not deposit other's monies in their company operations account. While the money is deposited into one account, an escrow account, these are not comingled funds as state laws provide for the holding of money in an escrow account with specific accounting requirements. Here, the cook who fixed the carrots is credited separately from the cook who prepared the beef. And the stew is never prepared, just as the total amounts in an escrow account may not be used for the same goal or transaction mixing the money with other depositors. Funds are held in trust. Escrow accounts can get very messy as to accounting for funds held in trust, the entire account balance must be balanced to each of the accounts held, if a deposit is made from an operations fund or funds not held in trust, then the entire escrow account becomes tainted, the accounts won't balance and that can be a violation of law. So, comingling funds can be illegal as the trustee may not have any interest in or create any liability against the rights of those credited with that stew.

There are other trust accounts as well, securities brokers, mortgage brokers, banks, institutional lenders, attorneys, insurance companies, even pawn brokers have requirements to holding funds or accounts in trust for others and mixing the ingredients can violate laws.

This same concept is used to keep the funds of partners separate in a business entity, owner's capital accounts. Funds may be on deposit in one account, but that balance must reflect the capital accounts of the partners. When accounts don't balance you could have a violation of law with respect to theft or embezzlement if funds are not properly accounted for. Someone may be taking more credit than deserved for that stew and that can be a violation of law.

Last point, I promise, your LLC is a separate entity, just as you are a separate person. Comingling your personal money in your LLC can pierce the corporate vial as you and the LLC become one cook sharing in the stew, and the stew may not be divided any longer, it can be mostly all from either entity regardless of the contributions added. The stew is no longer seen as separate ingredients but rather as a pot of stew being its own form or substance collectively. So, comingling assets or money can have legal consequences.

State and federal laws address comingling funds, as Dion mentioned in different ways and exceptions apply to pooling funds, how funds are used, accounted for, applied and credited are governed by laws in certain types of business transactions. Bon Appetit  :)

Dion DePaoli · Answer

In regards to the speaker.  Frankly, I have discounted what he has said to zero.  Not impressed and clearly he doesn't know what he is talking about.
	
	Pooled investment funds commingle money and assets to make investments ALL THE TIME.  So, if he was right, which is not, Pension Funds and Mutual Funds are illegal I guess.  (Yea...they are not illegal.)
	
	Commingling becomes an issue when specific investment criteria calls for funds to not be commingled.  That said, there is no innate rule that says that funds can not be commingled.  In most cases, even that is hard to come by since funds can be commingled and seperate accounting for the funds can still occur.  A simple RE example of this is a Title Company Escrow account.  The title company has one bank account, all funds go in to one account but are accounted for seperately.

Phil C. · Answer

In RE Salespersons Class, Commingling is defined as mixing money or properties of others with personal or business funds.  But the example used was if a client put down a 50k deposit on a house and you put that in your own personal bank account.   The law is designed to keep accurate records of funds so there's no issue later.  I believe you can technically put different funds in the same account, but you better keep accurate records and the $'s better add up. It is advised to put separate funds in separate escrow accounts to keep the funds separate.

But I think in the context of your speaker, I dont think it's commingling, you are just raising funds to buy an investment property jointly.

I'm relatively new to the game, so please correct me if I am wrong in any of this!

Thanks

Phli

Joel Owens · Answer

Is It not a security if you have an existing relationship with parties that want to invest with you??

Say you have known other investors for years and are friends you already have that connection. Didn't the soliciting laws just change recently?

I thought having an existing relationship and soliciting unknown parties were two very different things and not treated the same.

Ned Carey · Answer

Don,

That has always been my belief by reading the law. Wouldn't that make every mortgage a security as it includes a note? Are most if not all private mortgages breaking the law?

Obviously licensed lending institutions would be exempt but how about private lenders and even hard money lenders? I doubt most small hard money lenders have gone through any process to be a regulated financial institution.

Can you be more specific about exemptions for mortgages?

Thank you,

Ned

Bill Gulley · Answer

But the example given by your seminar speaker isn't illegal because immediate family members sharing in any asset are exempt fro security laws, it's just "a family affair, it's a family affair" wish I could sing it for you, LOL.

If your guy was wrong about that, what else is he wrong about ?

Therefore, not all securities are regulated securities.

See an attorney for what might be illegal in your state. :)

Dion DePaoli · Answer

Not to steal Ned's thunder but ALL NOTES ARE SECURITIES.
	
	Notes secured by real property have some exemptions provided in the law.  
	
	Raising money from ANY investor active or passive is a SECURITY.  Since you are either selling them equity in your company or giving a note as debt.  All securities require registration or be exempt from registration.  
	
	Passive investors or the idea of a passive investor always makes a security since it will ALWAYS fail the Howey Test.  
	
	Howey Test:

• An investment of money has been made,
• In a common enterprise and
• The investor has the expectation of profits, which profits are expected to arise solely, or substantially, from the efforts of the promoter or third party

If those answers are "True" you have a security.  In addition, the risk capital test is conducted in some states and asks whether the money being invested in a venture will be used to develop or acquire the business or enterprise in which the interest is offered. If "True" you have a security.

Commingling Funds - is it legal?

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