[dnanian]

You're going to want to partition HD3 into two volumes, one for each source volume (HD1/HD2).

And, yes, when you Smart Update, the changes are copied (or deleted files removed), whether or not they're in subfolders, if those folders are supposed to be copied.

We wouldn't 'not copy' Folder-C's file just because they're elsewhere in the drive. They'll be copied if they're updated.