Washington, D.C. – September 1, 2011 – (RealEstateRama) — The Securities and Exchange Commission today voted unanimously to request public comment on the treatment of asset-backed issuers as well as real estate investment trusts (REITs) and other mortgage-related pools under the Investment Company Act.
Through an advance notice of proposed rulemaking, the SEC is seeking public input on possible amendments the agency might consider proposing to Rule 3a-7, which excludes certain issuers of asset-backed securities from having to comply with the requirements of the Investment Company Act. An advance notice of proposed rulemaking provides the public the opportunity to weigh in even before the SEC develops a formal rule proposal.
Through a separate concept release, the SEC is seeking public comment on interpretations of a provision in the Investment Company Act – Section 3(c)(5)(C) – that may be used by some companies engaged in the business of acquiring mortgages and mortgage-related instruments such as some REITs. A concept release is a Commission-approved document that poses an idea or ideas to the public to get their views.
“We are inviting public comment in light of the significant developments in the asset-backed and mortgage markets. We want to assure that our regulatory approach is updated to reflect the current market environment while still meeting our investor protection goals,” said SEC Chairman Mary L. Schapiro.
Public comments should be received within 60 days from the date of publication in the Federal Register.
Asset-Backed Issuers and Mortgage-Related Pools Under the Investment Company Act
Asset-backed securities are created by buying and bundling loans or interests in loans – such as residential mortgage loans, commercial loans, or student loans – and creating securities backed by those assets that are then sold to investors.
Under the Investment Company Act, entities that issue asset-backed securities typically meet the definition of “investment company,” thereby requiring them to comply with the provisions of the Act. In 1992, however, the Commission adopted Rule 3a-7 under the Investment Company Act, which specifically excludes some asset-backed issuers from the definition of “investment company” provided they meet certain specified conditions.
One of the conditions is that the asset-backed securities generally be rated by a nationally recognized statistical ratings organization (NRSRO) – but the condition was not primarily intended as a measure of credit-worthiness of the issuer. Instead, the Commission included the credit rating condition because it believed that as part of the ratings process, the rating agencies assessed the issuer’s investor protection measures.
In the aftermath of the recent financial crisis, the Commission has engaged in various regulatory initiatives to address concerns raised by credit rating procedures and methodologies.
Advance Notice of Proposed Rulemaking
The Advance Notice of Proposed Rulemaking would solicit public comment on possible amendments to Rule 3a-7 including the role, if any, that credit ratings should continue to play in the rule.
The Advance Notice asks about:
- Revising the Conditions in the Rule: To be able to use Rule 3a-7, an issuer must meet the rule’s conditions including the existing rating condition. The Advance Notice seeks public input about possibly removing the rating condition and replacing it with new conditions. Rather than rely on rating agencies to assess the issuer’s structure and operations, such new conditions could address the structure and operations of asset-backed issuers. Possible new conditions also could require the issuer to undergo an independent review to protect investors in the asset-backed securities from self-dealing and overreaching by insiders. Additional possible conditions could help ensure that the issuer preserves and safeguards its assets and cash flow.
- How the Rule is Used: Rule 3a-7 excludes from the definition of “investment company” any asset-backed issuer that holds specified assets and meets the rule’s conditions, so that the issuer does not have to comply with the requirements of the Investment Company Act. The Advance Notice asks whether Rule 3a-7 issuers should still be considered “investment companies” for the limited purpose of determining whether an entity investing in Rule 3a-7 issuers is itself an “investment company” that should comply with the requirements of the Investment Company Act.
- Availability of Section 3(c)(5) to Asset-Backed Issuers: The Investment Company Act contains a provision – Section 3(c)(5) – that may be used instead of Rule 3a-7 by some asset-backed issuers, including certain issuers of mortgage-backed securities. This provision was not specifically intended to be used by asset-backed issuers. The Advance Notice asks whether Section 3(c)(5) should be amended to limit the ability of asset-backed issuers to rely on that section, or whether the Commission should use its rulemaking authority to define the relevant terms in that provision so as to limit its availability to those companies that are intended to be encompassed by that section.
Companies that are engaged in the business of acquiring mortgages and mortgage-related instruments have been relying on a provision, Section 3(c)(5)(C) to be excluded from the definition of “investment company” and consequently from the requirements of the Investment Company Act.
Section 3(c)(5)(C) was enacted to exclude from the definition of “investment company” companies that were engaged in the mortgage banking business and were not considered to be in the investment company business. Since Section 3(c)(5)(C) was enacted in 1940, the mortgage markets have evolved and expanded, and the provision has been used by a wide variety of types of pooled vehicles and other companies unforeseen at the time of enactment. These issuers include certain mortgage-backed securities issuers and certain REITs.
The SEC is concerned that mortgage-related pools potentially are making judgments about their status under the Investment Company Act without sufficient SEC guidance on the interpretive issues that arise under that provision. The SEC also is concerned that certain mortgage-related pools today appear to resemble investment companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded under this section.
The companion Concept Release solicits comment on the interpretive issues relating to some REITs and other mortgage-related pools that rely on the Section 3(c)(5)(C) exclusion.
The Concept Release provides an overview of mortgage-related pools and requests data and comment on their management styles, corporate governance, and similarities to traditional investment companies. It also discusses the legislative, administrative and interpretive background of Section 3(c)(5)(C).
The Concept Release asks, for example, whether a test could be devised to differentiate companies that are primarily engaged in the real estate and mortgage banking business from those companies that look like traditional investment companies, and what factors should the Commission consider in such a test.
Both releases will be published in the Federal Register and commenters will have 60 days from the date of publication to submit their comments.