Investment Company Act of 1940 - Section 3(c)(5)(C)
Redwood Trust, Inc.
October 16, 2017
RESPONSE OF THE CHIEF COUNSEL'S OFFICE
DIVISION OF INVESTMENT MANAGEMENT
In your letter, dated September 5, 2017, you request assurance that the staff of the Division of Investment Management (the “Staff”) will not recommend that the U.S. Securities and Exchange Commission (the “Commission” or the “SEC”) take enforcement action under Section 7 of the Investment Company Act of 1940 (the “1940 Act” or “Act”) if certain wholly-owned subsidiaries of Redwood Trust, Inc. (“Redwood”), an internally managed, residential mortgage finance company that has elected treatment as a real estate investment trust (“REIT”) for federal income tax purposes, treat their investments in certain types of instruments by which Fannie Mae and Freddie Mac transfer credit risk to the private sector as “real estate-type interests” for purposes of utilizing the exclusion from the definition of investment company set forth in Section 3(c)(5)(C) of the 1940 Act.
You state the following:
● Redwood, through its wholly-owned subsidiaries (“Redwood Subsidiaries”), acquires mortgages, mortgage-backed securities (“MBS”) and other real-estate related assets. Among the assets Redwood acquires are securities (referred to as “credit risk transfer securities”) that effectively transfer to institutional investors a portion of the credit risk of mortgage pools that are owned by Fannie Mae or Freddie Mac or that back MBS whose timely principal and interest payments are guaranteed by Fannie Mae or Freddie Mac.
● Although credit risk transfer securities may be issued using different structures, such securities have the following commonalities: (1) the payment of the stated principal and interest on such securities is not guaranteed; (2) the performance of the securities is designed to simulate the delinquency and principal payment experience of a designated reference pool of mortgages that are owned by Fannie Mae or Freddie Mac or that back specified Fannie Mae- or Freddie Mac-guaranteed MBS; (3) their payments are not derived directly from mortgage cash flows; (4) the securities are not secured by and do not represent a direct ownership interest in mortgages; and (5) ownership does not empower investors to control the servicing of, or foreclose on, any of the pooled mortgages.
Section 3(c)(5)(C) of the Act, in relevant part, provides an exclusion from the definition of investment company for any person that is "primarily engaged in …[the business of] purchasing or otherwise acquiring mortgages and other liens on and interests in real estate."
We have taken the position that the exclusion in Section 3(c)(5)(C) may be available to an issuer if: at least 55% of its assets consist of "mortgages and other liens on and interests in real estate" (called "qualifying interests") and the remaining 45% of its assets consist primarily of “real estate-type interests;” at least 80% of its total assets consist of qualifying interests and real estate-type interests; and no more than 20% of its total assets consist of assets that have no relationship to real estate (these factors together, the “Asset Composition Test”).
We generally have taken the position that qualifying interests are assets that represent an actual interest in real estate or are loans or liens fully secured by real estate. We generally also have taken the position that an asset is not a qualifying interest for purposes of Section 3(c)(5)(C) if it is an interest in the nature of a security in another issuer engaged in the real estate business. We have, however, indicated that certain mortgage-related instruments that may not be treated as qualifying interests may be treated as real estate-type interests.
You state that the credit risk transfer securities, as described in your letter, should be treated as real estate-type interests for purposes of the Asset Composition Test that certain Redwood Subsidiaries utilize to rely on the exclusion provided in Section 3(c)(5)(C) of the Act. Among other things, you note that credit risk transfer securities share similar characteristics with, and have the same economic substance as, agency partial pool certificates. Accordingly, you state that a Redwood Subsidiary may hold up to 45% of its assets in credit risk transfer securities and be able to rely on Section 3(c)(5)(C), provided that at least 55% of its assets are in qualifying interests and meet the other conditions of the exclusion.
Based on the facts and representations in your letter, we would not recommend enforcement action to the Commission under Section 7 of the 1940 Act if the Redwood Subsidiaries treat their investments in the credit risk transfer securities, as described in your letter, as real estate-type interests for purposes of the Asset Composition Test in utilizing the exclusion from the definition of investment company set forth in Section 3(c)(5)(C) of the 1940 Act.
Associate Director and
 Section 3(a)(1) of the Act, in relevant part, defines an investment company as any 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 (as defined by Section 3(a)(2) of the Act) having a value exceeding 40% of the value of its total assets (exclusive of Government securities and cash items) on an unconsolidated basis. Section 7(a) of the 1940 Act prohibits an investment company organized or otherwise created under the laws of the United States or of a state and having a board of directors from, among other things, offering or selling any security (or engaging in certain other activities) by use of the mails or any means or instrumentality of interstate commerce unless the company is registered under the 1940 Act.
 Persons relying on the Section 3(c)(5)(C) exclusion also may not be in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates.
 See, e.g., Salomon Brothers, Inc., SEC Staff No-Action Letter (June 17, 1985); Citytrust, SEC Staff No-Action Letter (Dec. 19, 1990); Greenwich Capital Acceptance Inc., SEC Staff No-Action Letter (Aug. 8, 1991).
 We have not objected if an issuer treated as qualifying interests, among other assets, mortgage loans fully secured by real estate, fee interests in real estate, second mortgages secured by real property, deeds of trust on real property, installment land contracts and leasehold interests secured solely by real property. See, e.g., United States Property Investment N.V., SEC Staff No-Action Letter (May 1, 1989); Division of Investment Management, SEC, The Treatment of Structured Finance Under the Investment Company Act, Protecting Investors: A Half Century of Investment Company Regulation (1992) Ch. 1 (“Protecting Investors Report”) at n. 345 and accompanying text; United Bankers, SEC Staff No-Action Letter (Mar. 23, 1988); The State Street Mortgage Co., SEC Staff No-Action Letter (July 17, 1986); First National Bank of Fremont, SEC Staff No-Action Letter (Nov. 18, 1985); American Housing Trust I, SEC Staff No-Action Letter (May 21, 1988); Health Facility Credit Corp., SEC Staff No-Action Letter (Feb. 6, 1985).
 See Urban Land Investments Inc., SEC Staff No-Action Letter (Nov. 4, 1971); The Realex Capital, SEC Staff No-Action Letter (Mar. 19, 1984); M.D.C. Holdings, SEC Staff No-Action Letter (May 5, 1987). This position is consistent with the position taken by the Commission in a 1960 release that discussed the applicability of the federal securities laws to the then newly enacted Internal Revenue Code REIT provisions. In that release, the Commission stated that a REIT might not be able to rely on Section 3(c)(5)(C) if it invests “to a substantial extent in other [REITs] . . . or in companies engaged in the real estate business or in other securities.” See Real Estate Investment Trusts, Investment Company Act Release No. 3140 (Nov. 18, 1960).
We have, however, made exceptions to these positions. See, e.g., Capital Trust Inc., SEC Staff No-Action Letter (May 24, 2007) (certain Tier 1 mezzanine loans); Capital Trust Inc., SEC Staff No-Action Letter (Feb. 3, 2009) (“2009 Capital Trust Letter”) (certain “B Notes”); American Home Finance Corp., SEC Staff No-Action Letter (Apr. 9, 1981) (agency whole pool certificates).
 See, e.g., Protecting Investors Report, supra note 4 at n.268-269 and accompanying text (agency partial pool certificates and residual interests in real estate mortgage investment conduits (“REMICs”) are not qualifying interests for purposes of Section 3(c)(5)(C) but may be treated as real estate-type interests for purposes of determining compliance with that section). See infra note 7 (defining agency partial pool certificates).
 Agency partial pool certificates are certificates issued by Fannie Mae or Freddie Mac that represent less than the entire ownership interest in a mortgage pool. See, e.g., Protecting Investors Report, supra note 4 at n.267.
The Incoming Letter is in Acrobat format.