On May 24, the Office of the Chief Counsel of the Division of Investment Management of the Securities and Exchange Commission issued a no-action letter on the status of mezzanine loans under the Investment Company Act of 1940. The letter has significant implications for real estate investments trusts engaged in commercial lending.

Section 3(c)(5)(C) of the Investment Company Act contains a provision that excludes from the coverage of the Act certain issuers engaged in real estate activities. That section generally excludes from the definition of an Investment Company an issuer that is “primarily engaged in...purchasing or otherwise acquiring mortgages and other liens on and interests in real estate”. In prior no-action letters the Staff had taken the position that, in order for an issuer to rely on this exemption, at least 55% of its assets must be invested in “mortgages and other liens on and interests in real estate” (qualifying interests), at least 25% of its assets must be invested in real estate type interests (subject to reduction to the extent that more than 55% of its assets are invested in qualifying interests) and up to 20% of its assets may be invested in miscellaneous investments.

Until this recent no-action letter, there was substantial uncertainty as to whether mezzanine loans would be classified as qualifying interests. In issuing the no-action letter, the Staff noted that, in the commercial real estate financing industry, second mortgages, which have always been classified as qualifying interests, have effectively been replaced in part by Tier I mezzanine loans. In the context of the Staff’s letter, a Tier I Mezzanine Loan, is a loan to a special purpose property owning entity that is secured by all of the ownership interests in that entity. Subject to certain additional limitations described in the no-action letter, the Staff concludes that Tier I Mezzanine Loans would be considered qualifying interests for the purpose of complying with the exclusion from the definition of an investment company provided by Section 3(c)(5)(C) of the Investment Company Act. (Capital Trust, Inc., 5/24/07)

http://www.sec.gov/divisions/investment/noaction/2007/capitaltrust052407-3c5c.pdf