Alert September 13, 2011

SEC Seeks Public Comment on the Status of Mortgage-Related Pools under Investment Company Act

The SEC issued a concept release (the “Release”) requesting public comment to assist it in reviewing interpretive issues under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”) regarding the status under the Act of companies that are engaged in the business of acquiring mortgages and mortgage-related instruments, and rely on the exclusion from the definition of “investment company” in Section 3(c)(5)(C) of the Act (collectively, “Mortgage-Related Pools”).  The Release describes this review as being motivated by, among other things, (a) the development of new and complex mortgage‑related instruments, (b) concerns about the scope and application of SEC staff guidance, (c) the resemblance of certain Mortgage-Related Pools to investment companies such as closed-end funds that were not intended to be excluded from regulation under the Investment Company Act and (d) concern over whether a company whose primary business consists of investing in agency whole pool certificates or other mortgage-backed securities is the type of entity that Congress intended to be encompassed by the exclusion provided by Section 3(c)(5)(C).  This article provides highlights of the various requests for comment in the Release.

Past and Possible Future Guidance.  The Release observes that Section 3(c)(5)(C) does not have an extensive legislative history, has not been comprehensively addressed by the SEC and generally has been addressed in SEC staff no‑action letters only on a case-by-case basis, leading to the concern that Mortgage‑Related Pools are making judgments about their status under the Investment Company Act without sufficient guidance.  The Release requests comment on the guidance provided by SEC staff no-action letters and more generally, how difficult or easy it has been to determine the status of Mortgage-Related Pools under the Investment Company Act.  The Release highlights the following issues, among others:

  • Is it appropriate to determine whether an issuer is “primarily engaged” in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate, based on whether at least 55% of the company’s assets consists of “qualifying interests” and the remaining 45% of the company’s assets consists primarily of “real estate‑type interests”?

  • Should the SEC define “other liens on and interests in real estate” for purposes of Section 3(c)(5)(C)?  Should such a definition include only those assets that are directly related to real estate, rather than including, for example, interests in a mortgage or in a pool or other entity that holds real estate? 

  • Should the SEC provide guidance on the treatment of specific types of mortgage‑related instruments for purposes of Section 3(c)(5)(C), noting in particular differing approaches taken by Mortgage-Related Pools with respect to certain types of CMBS.

Other Possible Considerations.  The Release observes that other factors may help differentiate companies that are primarily engaged in the real estate and mortgage banking business from companies that resemble traditional investment companies, and asks for comment on appropriate factors to consider in making those distinctions.  In so doing, the Release asks whether factors such as a company’s sources of income, its historical development, the activities of its officers, directors and employees and how the company has publicly characterized itself should be considered in determining a company’s primary business. (These factors are criteria that have been used the SEC for investment company status determinations under other provisions of the Act.)

Advance Notice of Proposed Rulemaking on Rule 3a-7.  The SEC has also issued an advance notice of proposed rulemaking (the “ANPR”) with respect to Rule 3a‑7 under the Investment Company Act, which provides a conditional exclusion for issuers of asset‑backed securities (“ABS”) from the definition of “investment company” under the Act.  Among other things, the ANPR notes the difference in the regulatory treatment of issuers of mortgage‑backed securities who rely on Rule 3a-7 and are subject to its conditions as compared to those who rely on Section 3(c)(5) and are not.  The ANPR requests comment on whether the SEC should seek statutory amendments to Section 3(c)(5) that would preclude ABS issuers from continuing to rely on that exclusion, or alternatively whether the SEC should engage in any rulemaking, consistent with Section 3(c)(5), that would define terms used in Section 3(c)(5) so as to limit its availability. 

Public Comment.  Comments on the Release and the ANPR must be submitted by November 7, 2011.