The US Securities and Exchange Commission staff has confirmed that a depositor of mortgage securitization trusts may rely on the exclusion from registration provided by Section 3(c)(5)(C) of the Investment Company Act of 1940, a signal that the staff recognizes that a company engaged in the real estate finance business might, as a result of its operations, hold assets other than those specified in Section 3(c)(5)(C).

In a recent no-action letter issued to Great Ajax Funding, LLC,^[1] the staff of the US Securities and Exchange Commission (SEC) agreed that a depositor into multiple mortgage securitization trusts was engaged primarily in the real estate finance business for purposes of Section 3(c)(5)(C) under the Investment Company Act of 1940. The depositor’s securitization trusts were formed to finance mortgages and real estate interests, and the depositor’s assets consisted of subordinated securities and residual interests issued by the securitization trusts, in addition to mortgages and interests in real estate.

The Section 3(c)(5)(C) Exclusion

The definition of “investment company” under Section 3(a)(1) of the Investment Company Act includes an issuer that is, or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities; or is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis. The definition of “investment securities” is quite broad and can include mortgage loans and other real estate–related investments.

Traditionally, real estate investment trusts (REITs) and many other real estate investment and finance companies have relied on an exclusion from the definition of “investment company” under Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C), in relevant part, applies to issuers that are primarily engaged in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”

Historically, the SEC staff has long taken the position that the “primarily engaged” requirement of Section 3(c)(5)(C) will be satisfied if at least 55% of an entity’s total assets consist of “mortgages and other liens on and interests in real estate” (so-called “qualifying interests”) and at least 25% of its assets consist of other real estate–related assets. The 25% requirement for real estate–related assets is reduced to the extent that qualifying interests exceed 55%.

Direct ownership interests in real estate and loans that are fully secured by real estate have been considered to be qualifying interests. The SEC staff has looked at various other types of assets through the lens of whether they are the functional equivalent of the types of real estate interests more commonly accepted as qualifying interests. These include so-called “whole pool certificates,”^[2] which represent the entire beneficial interest in a pool of mortgage assets. In contrast, the staff has taken the position that “partial pool certificates,” which represent less than the entire beneficial ownership interest in a mortgage pool (and which constitute the majority of mortgage-backed securities issued), and residual interests in mortgage-backed securities transactions are not the functional equivalent of real estate interests and thus are not qualifying interests.

Great Ajax Funding No-Action Letter

In the Great Ajax Funding no-action letter, the staff gave no-action advice in respect of a subsidiary of the operating partnership of a mortgage REIT. That entity serves as the depositor of multiple securitization trusts, which are used as vehicles to securitize pools of whole mortgage loans from the portfolio of the operating partnership. Each securitization trust issues senior notes to investors, which are secured by the mortgage loans in the transferred pool and are paid out of the cash flows from those mortgages. In exchange for the pool assets contributed to a securitization trust, the depositor receives subordinated securities issued by the trust and the residual interest in the trust.

As noted above, partial pool certificates and residual interests generally have not been considered to be qualifying interests by the SEC staff. In the Great Ajax Funding no-action letter, however, the SEC staff acknowledged that the real estate finance business has evolved substantially since the enactment of the Investment Company Act, with the creation and use of new debt financing techniques and mortgage-related products. The staff recognized that a company engaged in the real estate finance business might, as a result of its operations, hold assets other than those specified in Section 3(c)(5)(C).

Rather than focusing solely on the assets held by the depositor in question, the staff used what appears to be a more principles-based approach. The staff expressed the view that factors such as a company’s assets, sources of income, historical development, and public representations of its policy, and the activities of its officers, directors, and employees, as well as other relevant factors, may indicate that the company is primarily engaged in the real estate finance business, even if it does not necessarily satisfy the 55%/25% asset test. The staff concludes that the depositor could treat as qualifying interests any securities issued by a securitization trust that are acquired as a direct result of being engaged in the business of purchasing or otherwise acquiring whole mortgage loans.

Other Implications

The Great Ajax Funding no-action letter may be helpful for many depositors of mortgage-backed securitization trusts, as it points to a potentially useful exclusion from categorization as an investment company that may not have been previously considered. In addition, the rationale of the letter may be equally applicable to depositors of securitization trusts that issue securities backed by receivables that relate to the purchase or sale of specific merchandise, insurance, or services under Section 3(c)(5)(A) or (B).

In 2011, the SEC issued a concept release regarding Section 3(c)(5)(C), which cast some doubt on the future of the 55%/25% asset test.^[3] According to the concept release, the SEC was concerned that existing staff guidance was not sufficient, and that while some may have been interpret the scope of Section 3(c)(5)(C) too broadly, others may have been interpreting it too narrowly. The Great Ajax Funding letter demonstrates that the staff remains open to looking at Section 3(c)(5)(C) in new ways if the facts other than an entity’s asset composition demonstrate that it is primarily engaged in the real estate finance business.

Despite the SEC staff’s historical position that partial pool certificates and residual interests are not qualifying assets, some mortgage REITs and others have taken the view that consecutive subordinate classes of mortgage-backed securities transactions may be treated as qualifying assets if they include, among other things, special servicing rights (i.e., the right to deal with the pool loans if the deal fails to perform as expected, including foreclosures and loan modifications). This position is based, in part, on prior SEC staff guidance that joint ventures or partnerships and loan participations may be qualifying assets if they are the functional equivalent of owning the underlying real estate loans, and if they carry with them the right to foreclose. The Great Ajax Funding letter does not specifically address this position, but the staff notes that its position does not encompass asset-backed securities “that are acquired in a different manner (e.g., from an unaffiliated third party) because acquiring such assets in this manner could be more consistent with the issuer being engaged in an investment activity rather than a financing activity." 

[1] Great Ajax Funding LLC, SEC No-Action Letter (Feb. 12, 2018).

[2] The staff’s express view has been limited to whole pool certificates issued or guaranteed by government-sponsored enterprises such as Ginnie Mae, Fannie Mae, and Freddie Mac, though in the view of some there is no principled reason to distinguish other types of whole pool certificates.

[3] Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments, SEC Rel. No. IC-29778 (Aug. 31, 2011); see also Morgan Lewis LawFlash, SEC Issues Concept Release Regarding Mortgage REITs and Section 3(c)(5)(C) of the Investment Company Act (Sept. 9, 2011).