|September 20, 2011|
Previously published on September 9, 2011
The U.S. Securities and Exchange Commission (the "Commission") has issued a concept release (the "Concept Release")1 regarding the status under Section 3(c)(5)(C) of the Investment Company Act of 1940, as amended (the "Investment Company Act"), of companies 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 Commission is reviewing various interpretive issues as to how Section 3(c)(5)(C) is and should be applied and requests input on those issues.
According to the Commission, Section 3(c)(5)(C) was enacted to exclude from regulation under the Investment Company Act companies that were engaged in the mortgage banking business and that did not resemble issuers in the investment company business. However, as the mortgage markets have evolved, many companies have come to rely on Section 3(c)(5)(C) in ways that were unforeseen when this provision was enacted.
The Commission has not provided any official interpretive guidance regarding Section 3(c)(5) since 1960, and interpretive issues regarding Section 3(c)(5)(C) have been addressed primarily through no-action letters from the Commission's staff (the "Staff"). Nevertheless, the Commission now states that those no-action letters may have contained or led to interpretations that are beyond the intended scope of the Section, and that mortgage-related pools may have been making interpretive judgments without sufficient Commission guidance. The Commission 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.
The Commission approved the issuance of the Concept Release at an open meeting held on August 31, 2011. At that meeting, the Commission also approved issuance of a pair of companion releases, including an advance notice of proposed rulemaking regarding the status of asset-backed issuers under the Investment Company Act,2 and a concept release discussing the use of derivatives by investment companies.3
Companies That Rely on Section 3(c)(5)(C)
The Commission cites five concerns that the extensive regulatory scheme imposed by the Investment Company Act was intended to address:
- Companies that were organized, operated or their portfolio securities selected, in the interest of insiders;
- Companies issuing excessive amounts of senior securities (i.e., with excessive leverage);
- Companies employing unsound or misleading methods of computing asset values or not being subjected to independent scrutiny;
- Companies operating without adequate assets; and
- Companies whose assets were not adequately protected from commingling or appropriation by insiders.4
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." According to the Concept Release, this provision "originally was intended to exclude from the definition of investment company, among other things, companies that did not resemble, or were not considered to be, issuers that were in the investment company business."5 Types of companies that rely on Section 3(c)(5)(C) include: companies that originate mortgages and hold those mortgages and participations in those mortgages; companies that acquire mortgages and mortgage-related instruments (such as mortgage participations, mezzanine loans and mortgage-backed securities ("MBS")) from affiliates and third parties; companies that invest in real estate, mortgages and mortgage-related instruments; and companies that invest in agency securities6 and other MBS.
The Commission perceives many similarities between some of today's mortgage-related pools and traditional investment companies, such as 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 Commission expresses concern that some mortgage-related pools may raise the potential for the same types of abuses that the Investment Company Act was designed to address, including deliberate misvaluation of assets, extensive leverage and insider overreaching.7
The Commission says that it is "interested in learning more about mortgage-related pools."8 It goes on to request comment on the types of companies that rely on Section 3(c)(5)(C), the differences between companies that originate and continue to hold their own mortgages and mortgage-related assets and those that only invest in mortgages and mortgage-related assets, other exclusions from the definition of “investment company” that are used by similar companies, and the similarities and differences between mortgage-related pools and traditional investment companies. The Commission asks about "the types of abuses that the Investment Company Act was intended to prevent that might be associated with mortgage-related pools,"9 as well as existing regulatory schemes, industry practices and other safeguards that may address these concerns.10
Interpretation of the Section 3(c)(5)(C) Exclusion
As noted above, the Commission believes that Section 3(c)(5) originally was intended to exclude from the definition of investment company companies that did not resemble, or were not considered to be, issuers that were in the investment company business. The Concept Release states that the legislative history of the last amendment to this provision indicates that it "sought to ensure 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."11
The most recent official Commission guidance on Section 3(c)(5)(C) was contained in a 1960 release that discussed the application of the federal securities laws to REITs (the "1960 Release").12 The 1960 Release contained the unsurprising conclusion that REITs investing exclusively in fee interests in real estate or mortgages or liens secured by real estate could rely on Section 3(c)(5)(C) if they met the other requirements of the exclusion, but that a REIT that was invested to a substantial extent in other types of securities might not qualify.13
Since the date of the 1960 Release, the Staff has provided guidance on Section 3(c)(5)(C) primarily through the issuance of no-action letters, in which the Staff generally has required that at least 55% of the issuer’s assets consists of mortgages and other liens on and interests in real estate ("qualifying interests"), and that at least 25% of the issuer's remaining total assets consist of real estate-type interests, subject to reduction to the extent that qualifying interests exceed 55%. The Commission notes that the Staff has taken no-action positions that a variety of interests may be 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.
According to existing Staff no-action positions, securities issued by REITs, limited partnerships and other entities that invest in real estate, mortgages or mortgage-related instruments, or are in the real estate business, generally are not qualifying interests. Staff no-action positions also indicate that loans where at least 55% of the fair market value of the loan was secured by real estate at the time the issuer acquired the loan, and agency partial pool certificates, are not qualifying interests but may be treated as real estate-type interests.
The Commission notes that mortgage-related pools have determined that other assets, including bridge loans, certain construction and rehabilitation loans, wrap-around mortgage loans, and investments in distressed debt that are fully secured by real estate, constitute qualifying interests. Some mortgage-related pools have determined that a convertible mortgage may be treated as two separate assets — a fully secured mortgage loan (which is a qualifying interest) and an option to purchase real estate (which is a real estate-type interest). The Commission also notes that there appear to be different views within the industry as to the characterization of certain types of investments. For instance, some mortgage-related pools treat commercial mortgage-backed securities ("CMBS") as real estate-type interests, while others treat certain CMBS as qualifying interests.14
The Concept Release states that the Commission is "concerned that mortgage-related pools are making judgments about their status under the Investment Company Act without sufficient guidance," that some "might interpret the statutory exclusion provided by Section 3(c)(5)(C) in a broad manner, while others might interpret the exclusion too narrowly," and that Staff no-action letters "may have contained, or led to, interpretations that are beyond the intended scope of the exclusion and inconsistent with investor protection."15 The Commission "is concerned that certain types of companies today appear to resemble in many respects management investment companies that are registered under the [Investment Company] Act and may not be the kinds of companies that were intended to be excluded from regulation. . .by Section 3(c)(5)(C)."16
The Commission requests 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 Staff 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";17
- 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 to be covered by Section 3(c)(5)(C); and
- Whether the Commission 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 to be covered by Section 3(c)(5)(C).
Possible Commission Action
The Commission asks what steps it could take to provide greater clarity and consistency regarding the status of mortgage-related pools under the Investment Company Act, mentioning as possible courses of action rulemaking (such as a safe harbor or definitional rule), interpretive or exemptive relief, or taking no further action. Notably, the Commission does not mention the possibility of seeking congressional action before changing the Staff's longstanding interpretive positions.
The Commission requests 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 Commission suggests that, if such a test were appropriate, one factor that must be considered when determining whether a company is primarily in the business contemplated by Section 3(c)(5)(C) is the composition of the company's assets. The Commission 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 Commission 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.
1 Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Releated Instruments, SEC Rel. No. IC-29778 (Aug. 31, 2011), available at http://sec.gov/rules/concept/2011/ic-29778.pdf.
2 Treatment of Asset-Backed Issuers under the Investment Company Act, SEC Rel. No. IC-29779 (Aug. 31, 2011), available at http://sec.gov/rules/concept/2011/ic-29779.pdf. Our client alert on this release is available at http://www.bingham.com/Media.aspx?MediaID=12825.
3 Use of Derivatives by Investment Companies under the Investment Company Act of 1940, SEC Rel. No. IC-29776 (Aug. 31, 2010), available at http://sec.gov/rules/concept/2011/ic-29776.pdf. Our client alert on this release is available at http://www.bingham.com/Media.aspx?MediaID=12823.
4 Concept Release, at 12.
5 Id., at 6.
6 I.e., MBS issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac and Ginnie Mae.
7 Id., at 10-13.
8 Id., at 13.
9 Id., at 14.
10 Id., at 13-15.
11 Id., at 15.
12 Real Estate Investment Trusts, SEC Rel. No. IC-3140 (Nov. 18, 1960) (discussing Section 3(c)(6)(C), which has since been re-designated as Section 3(c)(5)(C)).
13 Concept Release, at 15-17.
14 Id., at 17-21.
15 Id., at 21.
17 Id., at 23.