On December 7, 2012, the Division of Swap Dealer and Intermediary Oversight (the "Division") of the Commodity Futures Trading Commission ("CFTC") issued CFTC Letter No. 12-44 (the "Letter"). The Letter grants no-action relief with respect to operators of certain pooled investment vehicles organized as mortgage real estate investment trusts ("mREITS") that fail to register as commodity pool operators ("CPOs"). The issue addressed in the Letter arises from the revised definition of "commodity pool operator" brought about by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which expanded the definition of "commodity interests" to include "swaps" and therefore conferred commodity pool status on any fund or similar enterprise that entered into any swap. As a result, operators of such funds or other similar enterprises would either have to register, or claim an exemption from registering, as CPOs, in either case by December 31, 2012.

The Letter opens with a description of mREITS, their activities, and their tax status. In particular, the Division notes that in order for an entity to be classified as an mREIT, it needs both to elect to be taxed as a real estate investment trust under the Internal Revenue Code of 1986 (the "Code") and to satisfy two income tests on an annual basis. The first test provides that at least 75 percent of the mREIT's annual gross income must be derived from certain qualifying real estate-related sources. The second test cites the Code's requirement that at least 95 percent of an mREIT's annual gross income must consist of items that in combination would satisfy the 75 percent test plus other passive income, such as interest and dividends. Under both of these tests, income from a "qualified REIT hedging transaction," as defined in the Code, is excluded from the calculations. In general terms, the Code limits "qualified REIT hedging transactions" to transactions entered into (i) in the ordinary course of an mREIT's business to manage interest rate, price or currency fluctuations, and credit risk related to the carrying of qualifying real estate assets or (ii) primarily to manage the risk of currency fluctuations with respect to any qualifying income under the two income tests. The Division also states that all qualifying REIT transactions must be identified on the day that they are executed, noting that income derived from a transaction that is not a "qualified REIT hedging transaction" will, if such income exceeds a certain percentage threshold, cause an entity to be ineligible for REIT status.

The Letter continues by noting that most SEC-registered mREITS are not "investment companies" under the Investment Company Act of 1940 (the "Act"), because they meet the exclusion test set forth in Section 3(c)(5)(C) of the Act. That exclusion, as interpreted through SEC pronouncements, applies if at least 55 percent of an entity's assets consists of mortgages or other liens on or interests in real estate (the functional equivalent of an interest in real estate or a loan or lien fully secured by real estate, as per the SEC), with the remainder invested primarily in real estate-type interests. The Letter further provides that the predecessor to the Division had previously issued three no-action letters to the directors of mREITs that utilized futures and options to mitigate interest rate risk on the basis of representations made by the mREITs that (i) the income derived from its futures positions would be less than 5 percent of their respective taxable income and (ii) the mREITs would limit their respective initial margin and option premiums to no more than one percent of the fair market value of each mREIT's total assets.

However, applying an expansive interpretation of the "operated for the purpose of trading" text contained in the definition of "commodity pool," the Division nonetheless concluded that mREITs that utilized swaps were properly considered commodity pools; absent relief from the Division, their operators would be required to register as CPOs. Notwithstanding that conclusion, the Division decided, for the reasons set forth in the preceding paragraphs and to strike a balance between the CFTC's regulatory objectives and the operational circumstances facing certain specialized funds, not to recommend that the CFTC take enforcement action against the operator of an mREIT that failed to register as a CPO, provided that:

  1. The mREIT limits the initial margin and premiums required to establish its commodity interest positions to no more than 5 percent of the fair market value of the mREIT's total assets;
  2. The mREIT limits the net income derived annually from its commodity interest positions that are not qualifying hedging transactions to less than 5 percent of the mREIT's gross income;
  3. Interests in the mREIT are not marketed to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options, or swaps markets; and
  4. Either (i) the company has identified itself as a "mortgage REIT" in Item G of its last U.S. income tax return on Form 1120-REIT; or (ii) the company has not yet filed its first U.S. income tax return on Form 1120-REIT but has disclosed to its shareholders that it intends to identify itself as a "mortgage REIT" in its first U.S. income tax return on Form 1120-REIT.

The Letter expressly states that an mREIT that seeks to avail itself of the no-action relief must file a claim to use the relief; it is not self-executing. Such claim must: (i) state the name, main business address, and main business telephone number of the mREITs for which the relief is being claimed; (ii) be signed by a person authorized to bind the mREIT; and (iii) be filed with the Division using the email address "dsionoaction@cftc.gov" with "mREIT" in the subject line, prior to December 31, 2012 (for an mREIT in operation as of December 1, 2012) or otherwise within 30 days after an mREIT begins to operate as such.

The Letter may be accessed here.