Investment Company Act of 1940 - Section 3(c)(5)(C)

August 15, 2019

RESPONSE OF THE CHIEF COUNSEL'S OFFICE
DIVISION OF INVESTMENT MANAGEMENT

In your letter, dated April 12, 2019, 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 certain assets (discussed below) as “qualifying 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. Redwood, through its wholly-owned subsidiaries (“Redwood Subsidiaries”), acquires and sells mortgages, mortgage-backed securities (“MBS”) and other real estate-related assets (together, “real estate-related assets”).

Section 3(c)(5)(C) of the Act

Section 3(c)(5)(C) of the Act, in relevant part, provides an exclusion from the definition of investment company “for any 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." 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 (“miscellaneous assets”) that have no relationship to real estate (these factors together, the “Asset Composition Test”).[1]

Mortgage Servicing Rights (“MSRs”)

You state that a Redwood Subsidiary will often sell mortgage loans to third parties or to securitization trusts but retain the MSRs associated with such loans (“Created MSRs”). You state that when it retains the Created MSR, the Redwood Subsidiary remains responsible for the servicing of the associated loan and has the right to receive a portion of the interest and fees collected from the borrower for being responsible for performing specified mortgage servicing activities. You argue that Created MSRs should be treated as qualifying interests for purposes of the Asset Composition Test that certain Redwood Subsidiaries utilize to rely on Section 3(c)(5)(C) because such assets are acquired as a direct result of the Redwood Subsidiary’s mortgage banking activities.

The Staff recently acknowledged that an issuer that purchases or otherwise acquires whole mortgage loans may acquire certain other assets as a direct result of being engaged in the business of purchasing or otherwise acquiring whole mortgage loans and that, under certain facts and circumstances, those assets might also be indicative of the issuer being in the business of acquiring whole mortgage loans.[2] The Staff concluded that in these instances, such assets could potentially be treated as qualifying interests for purposes of Section 3(c)(5)(C). Consistent with this view, we would not recommend enforcement action to the Commission under Section 7 of the Act if a Redwood Subsidiary treats Created MSRs as qualifying interests for purposes of the Asset Composition Test in utilizing Section 3(c)(5)(C) because such assets are acquired as a direct result of the issuer being engaged in the business of purchasing or otherwise acquiring whole mortgage loans.[3]

Cash Proceeds

You state that a Redwood Subsidiary may receive cash proceeds from principal amortizations, interest payments and payoffs in connection with its real estate-related assets, as well as from the sale of such assets (including to securitization trusts) (together “cash proceeds”). You state that such cash proceeds typically are later reinvested in additional real estate-related assets. You argue that the status of an issuer relying on Section 3(c)(5)(C) should not be affected by the conversion of real estate-related assets into cash proceeds under these circumstances, particularly if such cash proceeds are shortly thereafter used to acquire additional real estate-related assets. You suggest that for a period of up to 12 months after receipt, these cash proceeds should retain the same characterization, for purposes of the Asset Composition Test, as the assets from which they were derived. For example, you argue that cash proceeds derived from whole mortgage loans generally should be treated as qualifying interests,[4] and cash proceeds derived from certain MBS generally should be treated as real estate-type interests.[5]

We would not recommend enforcement action to the Commission under Section 7 of the Act if a Redwood Subsidiary, for purposes of the Asset Composition Test under Section 3(c)(5)(C), characterizes cash proceeds of real estate-related assets in the same manner as the assets from which the cash proceeds were derived, provided that (i) the proceeds are invested in cash items (as that term has been defined for purposes of Section 3(a)(1)(C) of the Act and Rule 3a-1 under the Act),[6] and (ii) such characterization is maintained only until the proceeds are distributed or reinvested in new assets or 12 months after receipt, whichever comes first.[7]

Conclusion

The statements in this letter represent the views of the Division of Investment Management. This letter is not a rule, regulation or statement of the Commission and the Commission has neither approved nor disapproved its content.

Rochelle Kauffman Plesset

Senior Counsel