Tag: Section 3(c)(5)

Analysis of a 3(c)5 Fund

Dodd-Frank created a new legal definition for a “private fund” as pooled investment vehicles that are excluded from the definition of “investment company” under the Investment Company Act of 1940 by section 3(c)(1) or 3(c)(7) of that Act.

Under 3(c)(1), the main limitations are that you have one hundred or fewer holders of beneficial interest in the fund and that you do not propose to sell them in a public offering. Under 3(c)(7) you can go beyond the 100 owners, but they need to be “qualified purchasers.” That means they need to have a bigger wallet.

Real estate funds managers have used these standards because they are bright-line tests. It also skirts around the issue of whether the fund is investing in “securities” and “what is a security”. The SEC has taken a broad view on what could considered a security.

Real estate fund managers have also looked at 3(c)5 and wondered if they can rely it as an exclusion under the Investment Company Act:

(5) 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 one or more of the following businesses:
… (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

The SEC issued a new no-action letter to Redwood Trust that takes a deep look at some features of this exclusion. Although the credit risk transfer certificates at issue in the letter are not widely applicable to real estate fund managers, the discussion around the exclusion is useful:

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”).[3]

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 [4]

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.[5]

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.[6]

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California Redefines “Private Fund”

I’ve spent a great deal of brain power on the definition of “private fund” under the Investment Advisers Act. California has added its own twist on the definition. It’s a twist that is very important to real estate fund managers.

Working through the definition of “private fund” requires wading through the Investment Company Act. Congress chose to define it as a “an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3), but for sec­tion 3(c)(1) or 3(c)(7) of that Act”. Then it requires a re-visit to the first week of discussion in a securities law class over what is a security.

Most private funds, including real estate funds, have looked at the exclusions under sec­tion 3(c)(1) or 3(c)(7) as safe harbors from registration under the Investment Company Act. They have very clear requirements fro compliance. With the new definition of “private fund” under the Investment Advisers Act, many real estate fund managers have looked at the exclusion under Section 3(c)(5) and wondered if that will work as an exclusion.

California is the first state to recognize the loophole and proposed changes to its definition of private fund in the proposed changes to Rule 260.204.9:

“Qualifying private fund” means an issuer that qualifies for the exclusion from the definition of an investment company under section 3(c)(1), 3(c)(5), or 3(c)(7) (or any combination thereof) of the Investment Company Act of 1940, as amended….[my emphasis]

Given the twisted definitions under the Investment Advisers Act, fund managers could classify themselves out of the federal level of registration and into the state level. At the state level, a fund manager could find other exemptions and exclusions from registration. Although, the state level definitions are continuing to change and catch up to the changes brought by Dodd-Frank.

I have not worked through the implications of this new definition of “private fund”. I decided I’d rather deal with the Securities and Exchange Commission than a collection of state regulators. For a real estate fund manager with operations in California who didn’t register with the SEC, you may need to re-visit the analysis for your exemption.

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Yes, the SEC Wants Real Estate Fund Managers to Register

After six months baking in the oven, the new Form ADV is ready. (To be more precise, the new Part 1 is ready. Part 2 has been sitting on the table for almost a year.) Form ADV still calls for real estate fund managers to register as investment advisers

Earlier I had pointed out how a real estate fund manager could be considered an investment adviser and have to register with the SEC under the Investment Advisers Act. In the Proposed Changes to Form ADV the SEC included “real estate fund”. They also changed the way you calculate assets under management, taking in the value of the fund assets, not just securities held by the fund.

While waiting for Form ADV to finish baking, I wondered if there might be some clarification or changes to pull real estate funds out of the registration requirement. It didn’t happen.

As you can see from the image above, “real estate fund” is still one of the choices when it comes to designating the type of fund. That gives it equal status with hedge fund, venture capital fund, and private equity fund. The definition of real estate fund is unchanged in the instructions for Part 1A of Form ADV:

“Real estate fund” means any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course, and that invests primarily in real estate and real estate related assets.

Maybe there is room under the definition of “private fund”? In the Glossary it’s defined as “An issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that Act.” That does leave open the position that the fund could be exempt under section 3(c)(5). That’s a murkier exemption than the one provided by 3(c)(1) or 3(c)(7).

The other confusion over how to value the assets under management is gone. The old version of Form ADV had a 50% test for assets under management. If less than 50% of the value was not securities, then you didn’t have a securities portfolio and the value was zero.

The new way of calculating assets under management for a private fund from the Instructions for Part 1A:

For purposes of this definition, treat all of the assets of a private fund as a securities portfolio, regardless of the nature of such assets. For accounts of private funds, moreover, include in the securities portfolio any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.

It still gets back to being a “private fund” and relying on a 3(c)(1) or 3(c)(7), instead of a 3(c)(5) definition. One thing to realize is that the definition of “private fund” actually comes from Section 402 of Dodd-Frank, not from the wishes of the SEC. The intent of the SEC is clear, even if there may be some wiggle room.

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Real Estate Funds and the Investment Company Act

Traditionally, private fund managers have looked at the section 3(c)(1) or section 3(c)(7) exemptions from the definition of “investment company” to avoid the restrictions of being regulated under the Investment Company Act. Dodd-Frank defined a “private fund” as being “issuer that would be an investment company as defined in Section 3 of the Investment Company Act, but for section 3(c)(1) and section 3(c)(7) of that Act.”

If you want to avoid being a “private fund” you need to look at the other exemptions under the Investment Company Act. Section 3(c)(5) is available for real estate funds:

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 one or more of the following businesses: …  (C) purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.

The SEC has issued some guidance on what is meant by that exemption.

In a No Action Letter issued to Realex Capital Corporation in 1984, the Securities and Exchange Commission did not decline to take action. Realex was looking to invest as a limited partner in a limited partnership that would own and operate a building. The SEC took the position that the interests would be “investment contracts” and therefore securities, not real estate for purposes of section 3(c)(5). Realex would be relying on the efforts of the managing partners for the success of the enterprise. In this case, Reaex had only limited major decision rights. For example there was a limitation on sale, but Realex could only object if it did not receive net cash proceeds at least equal to its capital contributions.

In a pre-REMIC No Action Letter, the SEC agreed not to action against Premier Mortgage Corporation for a mortgage pooling fund. Premier would acquire whole mortgage loans secured by first liens on the property.

Getting closer to real estate funds, United States Property Investments NV asked for clarification from the SEC for their fund that would be investing in real estate and real estate interests. In 1989, the SEC said the fund’s investment strategy would allow it qualify for the exemption under 3(c)(5). The fund would invest only in fee interests in real estate, joint ventures formed to acquire real estate, mortgage loan secured by real estate, and interests in joint ventures formed to make mortgage loans secured by real estate. At least 55% of the investments would be exclusively backed by real estate. The remainder would mortgage loans secured primarily, but not exclusively, by real estate.  The fund’s joint venture interests would be exclusively general partnership interests and would be active in the management and operation, including consent for major decisions.

Following that letter, City Trust followed up with a similar investment fund that would established for buying commercial mortgage loans and equipment loans in the form of industrial development bonds. This letter request combined the real estate mortgages in clause (C) of 3(c)(5)  with the purchase money debt for merchandise, insurance, and services in clause (A).

The United States Property Investments NV letter is the most useful to real estate private equity funds looking for 3(c)(5) as an exemption to avoid being defined as a “private fund.” It’s not clear what lesser amounts of real estate would be acceptable. It’s also not clear whether a more complicated structure of ownership would change the analysis. Real estate funds often have lots of intervening entities to satisfy tax, ERISA, financing and management issues.

The other thing to keep in mind is that using the 3(c)(5) exemption may get you out from under the definition of a private fund, but does not necessarily mean that you are not an investment adviser. It just means that the management company is not an adviser to a private fund.

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Image of Royal Exchange London is from the Library of Congress

Are you an Investment Company?

Fund managers are dealing with Dodd-Frank and the requirements under the Investment Advisers Act made by the Securities and Exchange Commission. Of course, a fund manager needs to focus on other areas of financial regulation and enforcement by the Securities and Exchange Commission. Fund managers need to keep focused on how they comply with the Investment Company Act.

Section 3 of the Investment Company Act has this definition:

1. When used in this title, “investment company” means any issuer which–

A. is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;

B. is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or

C. 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 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

This leaves you with the tricky analysis of whether your investments are securities. To avoid that mess, most private funds look to two exemptions from the definition of “investment company”: 3(c)1 and 3(c)7.

Under 3(c)(1), the main limitations are that you have one hundred or fewer holders of beneficial interest in the fund and that you do not propose to sell them in a public offering. Under 3(c)(7) you can go beyond the 100 owners, but they need to be “qualified purchasers.” That means they need to have a big wallet.

One challenge for private funds who do not want to register under the Investment Advisers Act is that private fund is defined as an “issuer that would be an investment company as defined in Section 3 of  the Investment Company Act, but for section 3(c)(1) and section 3(c)(7) of that Act.”

There are other exemption available, but they are harder to fit under. You may have a trail of paper work stating that you fall under the section 3(c)(1) or section 3(c)(7) exemption, even though you could claim to fit under one of the other exemptions.

For example, 3(c)(5) is available for real estate funds:

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 one or more of the following businesses: …  (C) purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.

There are some additional limitations that come with this based on some SEC No Action letters. I’ll put some information together on that later.

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Image is Exchange hall, Copenhagen, Denmark, between ca. 1890 and ca. 1900, published by The Library of Congress