Aug. 15, 2019
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”).
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. 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.
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, and cash proceeds derived from certain MBS generally should be treated as real estate-type interests.
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), 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.
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
 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 issued a number of no-action letters that address the types of assets that may be treated as qualifying interests and real estate-type interests. Information regarding the application of Section 3(c)(5)(C), including a partial list of relevant no-action letters, can be found on the Commission’s website at https://www.sec.gov/divisions/investment/guidance.shtml#mortgages-reit.
 Great Ajax Funding LLC, SEC Staff No-Action Letter (Feb. 12, 2018) (an issuer that acquires whole mortgage loans, which it then transfers into a securitization trust which it sponsors for the purpose of obtaining financing to acquire additional whole mortgage loans, may treat any securities issued by that trust that it retains as qualifying interests because such securities are acquired as a direct result of the issuer being engaged in the business of purchasing or otherwise acquiring whole mortgage loans).
 Our position does not extend to MSRs that are acquired in a different manner (e.g., from an unaffiliated third party). See id.
 See, e.g., United States Property Investment N.V., SEC Staff No-Action Letter (May 1, 1989) (mortgage loan secured exclusively by real estate in which the value of the real estate was equal or greater than the note evidencing the loan); 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 (mortgage loan in which 100% of the principal amount of each loan was fully secured by real estate at the time of origination and 100% of the market value of the loan was fully secured by real estate at the time of acquisition).
 See, e.g., Redwood Trust, SEC Staff No-Action Letter (Oct. 16, 2017); Protecting Investors Report, supra note 4 at nn. 268-269 and accompanying text (agency partial pool certificates and residual interests in real estate mortgage investment conduits 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).
 The Commission has set forth the following as cash items for purposes of Rule 3a-1: cash, coins, paper currency, demand deposits with banks, timely checks of others, cashier checks, certified checks, bank drafts, money orders, travelers’ checks, and letters of credit. See Investment Company Act Release No. 10937, at text accompanying n.11 (Nov. 13, 1979). In addition, the Staff has taken the position that shares of a money market fund generally may be treated as a cash item for purposes of Section 3(a)(1)(C) of the Act and Rule 3a-l. See Willkie Farr & Gallagher, SEC Staff No-Action Letter (Oct. 23, 2000).
 You did not request, and we are not providing assurance that, in the event that cash proceeds come to represent a substantial portion of a Redwood Subsidiary’s assets other than on a temporary basis, that Subsidiary would still be primarily engaged in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate” within the meaning of Section 3(c)(5)(C).