The SEC has issued a concept release (the "Concept Release")1 in which it announced its intention to review the exemption from investment company registration under Section 3(c)(5)(C) of the Investment Company Act and its applicability to companies that are engaged in the business of acquiring mortgages and related instruments ("mortgage-related pools"), particularly real estate investment trusts ("REITs"). The Concept Release does not propose any specific rules. Rather, it states that the SEC is reviewing various interpretive issues as to how Section 3(c)(5)(C) is and should be applied and requests input on those issues.
The SEC has not provided any official interpretive guidance regarding Section 3(c)(5) for over 50 years.2 The SEC has addressed Interpretive issues regarding Section 3(c)(5)(C) primarily through no-action letters from the SEC staff (the "Staff") and registration statement comment letters (most of which the Staff has addressed to publicly traded REITs). Nevertheless, the SEC now advises that its prior guidance may have contained or led to interpretations that are beyond the intended scope of the exemption, and that mortgage-related pools may have been making interpretive judgments without sufficient SEC guidance. The SEC believes that some mortgage-related pools today resemble closed-end funds and may not be the types of companies that Congress intended to exclude from regulation under the Investment Company Act, in particular under Section 3(c)(5)(C).
The 3(c)(5)(C) Exemption
Section 3(c)(5)(C) excludes from the definition of "investment company" "[a]ny person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged . . . [in the business of] purchasing or otherwise acquiring mortgages and other liens on and interests in real estate." The Staff generally has required that, in order to rely on Section 3(c)(5)(C), at least 55% of an entity's total assets consist of mortgages and other liens on and interests in real estate ("Qualifying Interests"), and that at least 25% of the issuer's total assets consist of real estate-related interests, subject to reduction to the extent that the entity's investments in Qualifying Interests exceed 55%. Thus, which assets constitute "Qualifying Interests" is of great importance.
Since 1960, the Staff has taken no-action positions in which it has indicated that a variety of interests may be treated as Qualifying Interests, including:
- assets that represent an actual interest in real estate or are loans or liens fully secured by real estate (such as fully secured mortgage loans, fee interests in real estate, second mortgages secured by real property, deed of trust on real property, installment land contracts and leasehold interests secured solely by real property);
- assets that are the functional equivalent of, and provide the same economic experience as, an interest in real estate or a loan or lien fully secured by real estate (such as Tier I real estate mezzanine loans and "agency whole pool certificates" issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae);
- "B-Notes" in commercial real estate first mortgage loans; and
- participation interests in a mortgage loan fully secured by real estate, if the holder has the right to foreclose on the underlying mortgage in the event of default.
Similarly, the Staff has indicated that certain interests should not be treated as Qualifying Interests but, rather, could be treated as real estate-related interests, including:
- interests in partnerships that invest in real estate;
- agency "partial pool" certificates; and
- loans backed by real estate if at least 55% of the fair market value of the loan is secured by real estate at the time the loan is acquired.
Distinction Between Mortgage Banking and Mortgage-Related Investment Activities
According to the Concept Release, Section 3(c)(5)(C) was originally intended to exclude from the definition of investment company "companies that were engaged in the mortgage banking business and that did not resemble, or were not considered to be, issuers that were in the investment company business." The SEC is concerned that its prior interpretations of 3(c)(5)(C) have led to confusion in the marketplace and to potentially inappropriate use of the 3(c)(5)(C) exemption by entities whose existence was "unforseen"3 at the time the Investment Company Act was enacted in 1940 and which subsequently have come to resemble traditional investment companies. The Concept Release advises that the legislative history of 3(c)(5)(C) indicates that "companies that structured themselves like mutual funds would be subject to regulation under the Investment Company Act, regardless of the types of securities that they held [emphasis added]."4
Similarity of Certain Mortgage-Related Pools to Closed-End Funds
The SEC perceives numerous similarities between some of today's mortgage-related pools and traditional investment companies, which are regulated under the Investment Company Act. These similarities include the pooling of investor funds to purchase securities and provide professional asset management, external management by an investment advisor compensated with an asset-based fee, investment in the same types of assets as some registered and private investment companies, and investor perception that the company is an investment vehicle rather than a company engaged in the mortgage banking business. The SEC expressed concern in the Concept Release that some mortgage-related pools may raise the potential for the same types of abuses that the Investment Company Act was designed to address, particularly extensive leverage, deliberate misvaluation of assets and insider conflicts of interest.
Solicitation of Comments
The SEC has requested comment on the current state of guidance and interpretation concerning Section 3(c)(5)(C), including:
- whether there is uncertainty or differing views as to the interpretation of Section 3(c)(5)(C);
- whether current interpretations are consistent with the purposes of Section 3(c)(5)(C) and investor protection;
- whether some mortgage-related pools resemble traditional investment companies and whether that is consistent with the purposes of Section 3(c)(5)(C) and investor protection;
- whether companies are interpreting Section 3(c)(5)(C) too narrowly or too broadly;
- whether the 55% in qualifying interests, 25% in real estate-type interests test set forth in no-action letters is appropriate and consistent with legislative intent;
- whether current Staff guidance on the classification of particular assets is "relevant in formulating Commission guidance for today's mortgage-related pools";
- how mortgage participations should be treated under Section 3(c)(5)(C), including whether foreclosure rights should be considered "an important attribute," even though the right only exists if the underlying mortgage defaults;
- whether agency whole pool certificates should continue to be treated as Qualifying Interests, and whether a company whose primary business consists of investing in agency whole pool certificates or other MBS is the type of entity that Congress intended Section 3(c)(5)(C) to cover; and
- whether the SEC should provide guidance on other mortgage-related instruments such as CMBS, and whether a company whose primary business consists of investing in CMBS or other MBS is the type of entity that Congress intended Section 3(c)(5)(C) to cover.
The SEC has suggested a number of potential outcomes for the 3(c)(5)(C) exemption, including clarificational rulemaking (such as a safe harbor or definitional rule), interpretive or exemptive relief for certain entities or no further action at all. The SEC has requested comment on whether a test could be devised to differentiate companies that are primarily engaged in the real estate and mortgage banking business from those that resemble traditional investment companies. The SEC suggests that, if such a test were appropriate, one factor that must be considered when determining whether a company is primarily in a business which Section 3(c)(5)(C) contemplates is the composition of the company's assets. The SEC asks if it should define the term "liens on and other interests in real estate," including whether the term should be defined to exclude interests in a mortgage (e.g., participation interests) or interests in a pool or other entity that holds real estate (e.g., whole pool certificates and other RMBS, and CMBS).
Finally the SEC asks whether other factors may help to differentiate companies that are primarily engaged in the real estate and mortgage banking business from those that resemble traditional investment companies, such as their sources of income, their historical development, the activities of their officers and directors, their public representations, and their types of business activities and business expenses.
It is entirely possible that the Concept Release and ensuing comment process could result in substantial changes to the current interpretations of Section 3(c)(5)(C). The SEC takes comments submitted seriously, and we encourage interested parties to comment. Comments may be submitted by going to: http://www.sec.gov/rules/concept.shtml and by clicking on "Submit comments on S7-34-11."