On August 31, 2011, the SEC issued a Concept Release announcing that the Commission and its staff are reviewing interpretive issues and seeking public comment on interpretations related to Section 3(c)(5)(C) of the Investment Company Act of 1940 (the “Act”) and its use by REITs in acquiring mortgages and mortgage-related instruments. A copy of the Concept Release can be found here and comments may be submitted here within 60 days from the date of publication of the Concept Release in the Federal Register.
In the Concept Release, the SEC expresses concern that some entities that rely on the Section 3(c)(5)(C) exclusion resemble investment companies that are required to register under the Act, are not the kinds of companies that were intended to be excluded from regulation by Section 3(c)(5)(C) of the Act, and may raise the potential for the types of abuses, such as deliberate misvaluation of the company’s holdings, extensive leveraging, and overreaching by insiders, that the Act was intended to address.
Section 3(c)(5)(C) of the Investment Company Act of 1940
REITs generally meet the definition of investment company under Section 3(a)(1)(A)1 and/ or 3(a)(1)(C)2 of the Act. However, many REITs rely on Section 3(c)(5)(C) of the Act which excludes from the definition of investment company any person who is primarily engaged in, among other things, “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate”.
SEC No-Action Letters and Their Interpretations
Section 3(c)(5)(C) of the Act does not have a comprehensive legislative history and issuers base much of their analysis as to its applicability on interpretations of numerous SEC no-action letters.
In the Concept Release, the SEC summarizes the conclusions of some of the no-action letters and the interpretations that issuers have made of these conclusions.
55% Qualifying Interests
Among other requirements, when determining whether the Section 3(c)(5)(C) exclusion applies to an issuer, the SEC has focused on whether at least 55% of the issuer’s assets consist of mortgages and other liens on and interests in real estate (called “qualifying interests”).
The SEC has generally viewed the following asset types as qualifying interests:
- Assets that represent an actual interest in real estate;
- Loans or liens that are fully secured by real estate3;
- Assets that can be viewed as the functional equivalent of, and provide the same economic experience as, an actual interest in real estate or a loan or lien fully secured by real estate. Examples of these assets include whole-pool agency RMBS4; and
- Certain commercial real estate B-Notes.
The SEC also notes (without expressing a view)5 that some issuers have taken the position that the following assets are qualifying interests as long as such assets are fully secured by real estate:
- Bridge loans;
- Certain construction and rehabilitation loans;
- Wrap-around mortgage loans; and
- Investments in distressed debt.
45% Real-Estate Type Interests and Miscellaneous Investments
In addition to the “qualifying interests” requirement, the SEC has looked at, among other things, whether the remaining 45% of the issuer’s assets consist “primarily” of “real estate-type interests”. That is, whether at least 25% of the issuer’s assets are invested in real-estate type interests (subject to reduction to the extent that the issuer invested more than 55% of its assets in qualifying interests) and no more than 20% of its assets are invested in miscellaneous investments.
The SEC has generally viewed the following asset types as real estate-type interests:
- Loans where 55% of the fair market value of the loan is secured by real property at the time the issuer acquired the loan; and
- Agency partial-pool certificates6.
The SEC notes that some issuers treat convertible mortgages (mortgages with an option to purchase the underlying real estate) as two assets:
- A mortgage loan that is a qualifying interest (so long as it is fully secured); and
- An option to purchase real estate that is assigned an independent value and is treated as a real estate-type interest.
The SEC further notes that some issuers treat CMBS as qualifying interests while others treat CMBS as real estate-type interests.
SEC Concerns and Questions
In the Concept Release, the SEC expresses concern that some issuers might interpret the exclusion under Section 3(c)(5)(C) of the Act too broadly or too narrowly, and that interpretations of the no-action letters may have been made which are beyond the intended scope of the exclusion and which are inconsistent with investor protection.7
In order to address these concerns, the SEC has asked a number of questions in the Concept Release, some of which are summarized below:
Uncertainty and Applicability
- Is there uncertainty or differing views as to the availability of the Section 3(c)(5)(C) exclusion?
- Is the Section 3(c)(5)(C) exclusion being used consistent with the purposes and policies underlying that provision and investor protection?
- Are some REITs giving too broad or too narrow an interpretation to the Section 3(c)(5)(C) exclusion?
“Qualifying interests” / “real estate-type interests”
- Is the “qualifying interests” / “real estate-type interests” requirement appropriate?
- Does this approach cause companies to invest in a different manner than they otherwise would in order to be able to rely on the Section 3(c)(5)(C) exclusion?
SEC No-Action Letters on “Liens on or Interests in Real Estate”
- Should the analyses in SEC no-action letters regarding whether an asset is a “lien on or interest in real estate” for purposes of Section 3(c)(5)(C) be relevant in formulating SEC guidance for REITs? For example, should mortgage participations be treated as interests in real estate and, if so, what types of participations and why?
- Should a company whose primary business activity consists of holding mortgage participations be the type of company that is excluded from the definition of investment company?
Agency Whole-Pool RMBS
- Should agency whole-pool certificates be treated as interests in real estate?
- Should a company whose primary business is investing in agency whole-pool certificates, or other mortgage-backed securities, be viewed as the type of entity that Congress intended to be encompassed by the Section 3(c)(5)(C) exclusion?
- What would be the economic impact if the SEC does not treat agency whole-pool certificates as interests in real estate?
Other Mortgage-Related Instruments
- Is guidance needed for other instruments and what should that guidance provide? The SEC notes in particular that differing views have been taken by issuers with respect to CMBS.
- What should such guidance with respect to other mortgage-related instruments address? What would be the economic impact of such guidance?
- Is a company whose primary business is investing in CMBS, or other mortgage-backed securities, the type of entity that Congress intended to be encompassed by the Section 3(c)(5)(C) exclusion?
Possible SEC Actions
- Should the SEC engage in a rulemaking such as a safe harbor or definitional rule?
- Should the SEC issue an interpretive release?
- Should the SEC provide exemptive relief?
- Should the SEC take no further action at this time?
- Can a test be devised that would differentiate companies that are primarily engaged in the real estate and mortgage banking business from traditional investment companies?
- Should the SEC define “liens on and other interests in real estate” for purposes of Section 3(c)(5)(C)?
- What other factors may help to differentiate companies that are primarily engaged in the real estate and mortgage banking business from traditional investment companies?