As part of this seven-part series, we’ve been going through different hot topics that regulators such as the SEC or state regulators are focused on, and they are going to be, in my prediction, increasingly vigilant to protect the investing public. This next topic is definitely not allowed and is a very hot topic. If you are doing it, then you need to stop it immediately. If you’re not doing it, you definitely don’t want to get trapped into doing it or thinking that it’s okay.
So what is this hot topic that state and federal regulators are going to be definitely looking for? I think there will be greater scrutiny in the future and certainly a desire to go after people who are doing this more and more. The idea is something kind of simple, and probably on its face, you’re thinking, “Oh yeah, of course you can’t do that.” That idea is commingling. Commingling is not allowed. Commingling is not part of any of the funds.
Let’s talk about exactly what commingling is in this context, where I see it happen kind of under the radar, that causes a problem. Let’s put up a whiteboard. Let’s talk about the problem that is obviously wrong. The one that’s obviously wrong is you’ve got a fund here with money invested in it. This is your fund LLC. The wrong approach is when money comes out just for a short time because you want to put together another pool, you want to put together something new, but you need to pay, say, your attorney. You need to pay legal fees. So you want to pay your syndication attorney in order to pay him legal fees and draft documents for you. This is obviously not allowed. You are not allowed to commingle your joint bank and your bank accounts this way. The same problem occurs if you need a place to just temporarily park some money – you can’t just put it into the fund LLC. It’s not allowed.
So that’s the obvious case of commingling. What I see happening a lot of times, and certainly I have had clients ask about whether or not this is allowed (and the answer is no, it’s not), looks something like this: You’ve got your fund LLC here, and you’ve got your management company here. I’m drawing them as buckets because really, a fund is just a bucket of assets. So let’s call this Fund One LLC, Fund Two LLC, and Fund Three LLC.
So you’re here, you’ve got these three funds that are going and they’re working wonderfully. You’ve identified a potential opportunity that you would like to create over here, and this is, say, Fund Four. Let’s put it into context – let’s say these are real estate deals, as that happens a lot. So you’ve identified Fund Four, and you don’t know how to get it started. You’ve found this great asset that you want to buy, but you don’t have the cash to do it.
What some people think they can do, and you can’t, is this: The thought comes up of how can I just borrow money here? Can I borrow money from Fund Three to put the down payment on or put the deposit down on this property? So that when it gets locked up in escrow, and as soon as this fund has enough money, we’ll repay that money back plus interest? And the answer is probably not.
Now, it’s possible that your fund allows for loans to be made to other projects, which is okay. But at the end of the day, the analysis goes something like this: Do the investors in Fund Three have a problem with this going on? Is there any way that they’re going to have a problem? Or were they told specifically, “We may make loans to our other investment companies in order to repay them back, including investment companies that are managed by the same manager”? If the answer is no, which most of the time it will be, then you can’t do it.
So that’s the commingling problem that happens, and it’s the commingling problem that actually is very prevalent because managers don’t see what they’re doing as buckets. They see them as really a list of assets and sets of investors and things like that. But the truth is that they’re buckets, and they’re totally self-contained. If they’re going to do something outside of Fund One or Fund Two or Fund Three, if those things are going to be doing something outside of what those specific vehicles are, your investors are being wronged. Money is being taken from them, maybe it’s just an opportunity cost for an opportunity that’s not even there, but it’s affecting them. It’s their money, and they have the right to have what they expect happen with their money.
So that’s the problem that I see happening with commingling. Now regulators know this happens, they see it happen. And if they know this is going to happen and see this is going to happen in one of your funds, you can bet they’re going to be calling, and there’s going to be some major enforcement action to bring something down. If an investor got wind of this happening and they were to let the SEC or a state regulator know, I would bet 100 donuts that they would be investigating it as quickly as possible and stopping that kind of action with whatever enforcement actions they have, because it’s just plain illegal to be using funds that way.
My name is Tilden Moschetti. I am a syndication attorney with the Moschetti Syndication Law Group. The whole point of these videos here is to help you understand what compliance is and help you be in compliance with the SEC and state regulators. I’m a huge fan of Regulation D and all the rules that are related to it because it makes raising money very knowledgeable, very formulaic, very doable for people. It keeps the cost for you as a regulator down and lets you do what you want to do in order to raise funds and protects the investor public as well. So if I can help you stay in compliance with the SEC and the state regulators, that’s what I enjoy doing. And I enjoy working on projects and with good clients. So feel free to give us a call if you think you might be one of these.