Investment Company Act of 1940

SEC Adopts Rule on Fair Valuation Practices Under Investment Company Act

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On December 3, the SEC adopted Rule 2a-5 establishing an updated regulatory framework for fund valuation practices. The rule requires fund boards of directors (or their designee) to perform certain functions in order to determine in good faith the fair value of a fund’s investments, as required under the Investment Company Act of 1940, including periodically assessing and managing material risks associated with fair value determinations, selecting, applying and testing fair value methodologies, and overseeing and evaluating any pricing services used. Release. Final Rule.

SEC Adopted a New Rule Allowing Registered Funds to Enter Into Derivative Transactions

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On October 28, the Securities and Exchange Commission (SEC) adopted a new rule 18f-4 under the Investment Company Act of 1940 allowing registered funds to enter into derivative transactions, provided they comply with certain conditions intended to protect investors. The rule will become effective 60 days after publication with an 18-month transition period for compliance with the provisions and related reporting requirements. Release.

’40 Act Leeway for Mortgage REITS and Others

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The SEC Investment Management Division published a no-action letter on August 15 addressed to Redwood Trust that provides a certain degree of Section 3(c)(5)(C) compliance leeway for mortgage REITs and mortgage bankers. The Redwood letter is a recognition by the staff that the ebb and flow of mortgage loans into and out of a mortgage banking business, and the retention of cash proceeds from time to time, is an integral part of the business, as is the retention of the right to service loans to facilitate both loan sales and securitizations.

Specifically, the staff concluded that there would be no objection to Redwood treating certain MSRs and cash proceeds in the manner described below for purposes of the Section 3(c)(5)(C) exclusion from the registration requirements of the Investment Company Act of 1940. Redwood Trust No-Action Letter – 2019

  • MSRs created when mortgage loans are sold or securitized can be treated as “qualifying interests” under Section 3(c)(5)(C), and
  • Cash proceeds from mortgage principal amortizations, interest payments and payoffs in connection with real estate-related assets, as well as from the sale of such assets, including to securitization trusts, can retain the characterization of the assets from which the cash proceeds were derived for purposes of Section 3(c)(5)(C), subject to the time limitations indicated in the letter; e.g. sell whole loans and treat the cash proceeds of the sale as “qualifying interests” (subject to such time limitations).

As we stated in our April 12, 2019, letter to the SEC staff on behalf of Redwood, these cash proceeds are “integral parts of and directly related to and arising from Redwood’s mortgage banking activities” and, likewise, created MSRs “are acquired as a direct result of Redwood’s mortgage banking activities”. Our letter references the staff’s Great Ajax no-action letter of February 12, 2018, in which the staff said that it “would be willing to entertain other no-action requests to treat as qualifying interests certain other mortgage-related assets if they are acquired by an issuer as a direct result of the issuer being engaged in the business of purchasing or otherwise acquiring whole mortgage loans (e.g., certain “A-Notes” and servicing rights)”. Orrick Letter to SEC, April 12, 2019

(Redwood also obtained a no-action letter in 2017 relating to the treatment of credit risk transfer securities as “real estate-type interests” under Section 3(c)(5)(C). In the Orrick letter to the staff, we noted, among other things, that credit risk transfer securities share similar characteristics with, and have the same economic substance as, agency partial pool certificates, which are treated as “real estate-type interests” under Section 3(c)(5)(C). In its letter, the staff recognized the similarities between credit risk transfer securities and agency partial pool certificates and concluded that the credit risk transfer securities described could be treated as “real estate-type interests”.  Redwood Trust No-Action Letter – 2017 ; Orrick Letter to SEC, September 5, 2017)

SEC Division of Investment Management Issues Guidance on Holding Companies and the Transient Investment Company Rule Under the Investment Company Act

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Earlier this month, the SEC Division of Investment Management issued guidance with respect to situations in which an operating company may find that, upon the occurrence of an extraordinary event, it meets the definition of an “investment company” under the Investment Company Act of 1940 (“Company Act“), even though it intends to remain in such status only temporarily. Absent an exclusion or exemption from this definition, the operating company may be required to register under the Company Act. Rule 3a-2 under the Company Act, however, provides a one-year safe harbor for such transient investment companies if certain conditions are satisfied.

The Staff of the Division of Investment Management has received inquiries regarding the commencement of the one-year safe harbor as it applies to holding companies that are engaged in various businesses operating through wholly owned and majority-owned subsidiaries where neither the holding companies nor their subsidiaries are regulated as investment companies (“Holding Companies“).

In response, the Staff has clarified that the one-year safe harbor period does not begin until the occurrence of an extraordinary event causes a Holding Company to have certain characteristics of an investment company. It is the staff’s view that when adopting Rule 3a-2, the Commission did not intend to limit the circumstances under which an issuer could rely on the rule in such a way that Holding Companies are treated differently than other issuers because of the Holding Companies’ organizational structures.

Credit Risk Transfer: Making a Successful Program Even Better

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On February 10, Howard Altarescu participated in the Urban Institute / CoreLogic Sunset Seminar, “Credit Risk Transfer: Making a Successful Program Even Better.” The presentation outlined the importance of credit risk transfers (CRT), especially as risk transfers on newly acquired single-family mortgages continues to expand, and also featured speakers from Andrew Davidson & Co., Two Harbors Investment Corp., Genworth U.S. Mortgage Insurance, Urban Institute and CoreLogic.

Howard focused on the legal considerations surrounding the Investment Company Act of 1940 and relevant Real Estate Investment Trust (REIT) tax legislation, contending that while these rules limit Mortgage REIT (mREIT) investment in CRT securities, existing bipartisan support for mREIT participation could result in propitious legislative amendments.

To view the presentation slides in full, please click here.

SEC Rule on ’40 Act Exemption for Business and Industrial Development Companies

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On November 19, the SEC adopted rule 6a-5 under the Investment Company Act of 1940 to establish a standard of credit-worthiness in place of a reference to credit ratings in section 6(a)(5) of the ’40 Act for debt securities purchased by entities relying on an exemption for business and industrial development companies.  The rule implements section 939(c) of the Dodd-Frank Act.  The rule will be effective 30 days after publication in the Federal Register.  SEC Rule.

’40 Act Threshold Adjustment for Qualified Clients

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On February 15, the SEC adopted amendments to the rule under the Investment Company Act of 1940 that permits investment advisers to charge performance based compensation to “qualified clients”. The amendments (i) revise for inflation the dollar amount thresholds that are used to determine whether an individual or company is a qualified client and (ii) exclude the value of a person’s primary residence and certain associated debt from the net worth calculation. The amendments will be effective 90 days after publication in the Federal Register. Final Rule.

CFTC Proposed Amendments to Investment Company Reporting Requirements

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On February 9, the CFTC proposed to amend reporting requirements for investment companies registered under the Investment Company Act of 1940, the advisers of which would be required to register with the CFTC as commodity pool operators pursuant to amendments adopted by the CFTC to Section 4.5. Comments must be submitted within 60 days after publication in the Federal Register. CFTC Release. CFTC Proposed Rules.

SEC Proposed Amendments to Remove Credit Ratings in 1940 Act Rules and Forms

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On March 3, the SEC proposed rule amendments to remove references to credit ratings in certain rules and forms under the Investment Company Act of 1940, in accordance with the Dodd-Frank Act. The proposed amendments would revise the permissible investment standards for money market funds. A security would no longer need to receive a certain credit rating, but would qualify for investment if the fund’s board or its delegate determines that the security presents minimal credit risks. The SEC’s proposed rule amendments also would remove credit ratings in three other areas: repurchase agreements, certain business and industrial development company (BIDCO) investments, and shareholder reports. Comments on the proposed rule amendments must be submitted by April 25. SEC Release. SEC Proposed Rules.