Tracing Commingled Funds in Mergers and Acquisitions
Due diligence is a critical component in the M&A process that requires a commitment of time, resources and patience to identify red flags and mitigate a long list of potential financial, operational and regulatory risks before a deal closes. Often, forensic accountants are retained specifically to untangle complex ownership structures and help uncover legal action or instances of fraud that could impact post-deal operations.
Tracing is a forensic accounting technique that can be used to determine: 1) the identity of the owner(s) of funds held in a specific financial account at a specific point in time; and 2) the disposition of specific funds deposited into a financial account (i.e., were the monies spent and, if so, on what? was it converted into another asset? was it transferred to another account? etc.). It presumes funds in a bank account have been commingled, which is simply the mixing together of funds from different sources or parties. This is a common occurrence for most businesses, financial institutions and attorneys overseeing clients’ trust accounts. By default, it is neither nefarious nor illegal.
Because money is fungible, it is not distinguishable from similar or identical assets deposited in a bank account. Therefore, it is not possible to trace exactly which dollar(s) came from which party. All dollars look the same, absent the recording of serial numbers of each deposited bill, which further assumes deposits were made with actual cash versus electronic funds transfers. For comparison, consider that a blue jellybean you drop into a jar of all orange jellybeans will always retain its unique identity. However, the same is not true if that jellybean is orange. While you can remove a single orange jellybean from the jar, it is most likely not the one you originally dropped into the jar.
The only way to unwind commingled funds and quantify amounts owned by or associated with a party or activity (legal or illegal) is to apply one of the following accepted tracing methodologies.
LIFO (Last-In, First-Out)
Similar to its application in the accounting for inventory, LIFO assumes that the last funds deposited into an account are the first to be withdrawn. i.e., If Peter deposits $100 on Monday, Lisa deposits $100 on Tuesday, and the accountholder spends $100 on Wednesday, Peter will claim Lisa’s money was spent, and the remaining $100 is his.
FIFO (First-In, First-Out)
Also similar to its application in accounting for inventory, FIFO assumes that the first funds deposited into an account are the first to be withdrawn. i.e., If Peter deposits $100 on Monday, Lisa deposits $100 on Tuesday, and the accountholder spends $100 on Wednesday, Lisa will claim Peter’s money was spent, and the remaining $100 is hers.
Pro Rata Rule
Commingled funds are treated as being owned by each party in proportion to each depositor’s dollars as a percentage of the total dollars deposited. While this approach may arguably be more equitable, it can be flawed. i.e., If Peter deposits $100 on Monday, Lisa deposits $100 on Tuesday, and the accountholder spends $100 on Wednesday, this rule will dictate that Lisa and Peter each have a claim to $50.
LIBR (Lowest Intermediate Balance Method)
LIBR stems from trust law but can be applied more broadly. It assumes the accountholder spends their money before spending the other commingled funds. Alternatively, once an account balance equals $0 or is overdrawn, it is assumed that all prior depositors’ funds have been spent, and those depositors would have no claims to future funds.
Each of these tracing methods applied to the same set of facts will result in different outcomes. The decision of which method should be used can depend on legal advice, existing case law and the economic realities. It is important to work with forensic accountants experienced in these matters.