The Investment Company Act of 1940 runs the federal framework against an entity that runs as an investment company under §3(a)(1). The Investment Company Act runs the registration framework against the investment company and runs the operational and reporting framework against the registrant. A mortgage fund that runs the §3(a)(1) definition runs into the registration framework against the SEC unless the fund runs against an exemption. Section 3(c)(5)(C) — the “real estate exception” — runs the exemption framework against the mortgage fund that primarily engages in purchasing and holding mortgage interests and real-estate-related interests. This guide walks the §3(c)(5)(C) framework from the qualifying-interest test through the SEC no-action framework, the annual testing discipline, and the common compliance framework against a private mortgage fund.

What §3(c)(5)(C) runs

Section 3(c)(5)(C) of the Investment Company Act runs the exemption framework against an entity that is primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The exemption runs the registration framework off the mortgage fund and runs the fund’s operational and reporting framework against the fund’s own offering framework — Reg D Rule 506(b) or Rule 506(c) under Securities Act §4(a)(2) — rather than the Investment Company Act framework. The exemption runs against an unlimited beneficial-owner base, runs no cap on the fund size, and runs no SEC registration against the fund as an investment company.

The two-tier asset framework

The SEC runs the §3(c)(5)(C) exemption against a two-tier asset framework. The first tier runs at least fifty-five percent of the fund’s assets against qualifying interests in real estate — whole mortgage loans, fee interests in real estate, and other interests the SEC has classified as qualifying. The second tier runs at least eighty percent of the fund’s assets against real-estate-related interests — the qualifying interests from the first tier plus a broader category of real-estate-related instruments. The remaining twenty percent runs against miscellaneous investments outside the real-estate framework. The two tiers run on an asset-by-asset framework against the fund’s balance sheet on each measurement date.

Qualifying interests in real estate

The qualifying-interest framework runs against three asset categories. The first category runs whole mortgage loans — first-position notes secured by real estate, on a senior secured framework against the underlying collateral. The second category runs fee interests in real estate — direct ownership of real-property assets under the fund’s title framework. The third category runs other interests the SEC has classified as qualifying — fully-secured installment land contracts, certain pre-1995 B-pieces under specific SEC no-action positions, and similar instruments that run as the economic equivalent of a whole mortgage loan against the underlying real-estate collateral. The fund runs the qualifying-interest framework against the fifty-five-percent floor on each measurement date.

Real-estate-related interests

The real-estate-related framework runs a broader category against the eighty-percent floor. The category runs against the qualifying interests from the first tier plus four additional categories. The first additional category runs mezzanine loans and B-notes — subordinate-position interests in real-estate-secured lending. The second runs equity interests in real-estate-operating companies — REITs and similar real-estate-focused entities. The third runs agency-issued mortgage-backed securities — Fannie Mae, Freddie Mac, and Ginnie Mae pass-through securities. The fourth runs other real-estate-related interests the SEC has classified through the no-action framework. The fund runs the real-estate-related framework against the eighty-percent floor on each measurement date.

SEC no-action framework

The SEC runs the §3(c)(5)(C) framework through the no-action letter process. The Division of Investment Management runs the staff position framework on the qualifying-interest classification, the real-estate-related classification, and the operational framework against a mortgage fund. The 1996 American Home Finance no-action position runs the seminal framework on the whole-mortgage-loan classification and the fifty-five-percent qualifying-interest floor. Subsequent no-action positions run the framework against the mezzanine-loan classification, the B-note classification, and the agency-mortgage-backed-security classification. The fund runs the asset classification against the no-action position framework rather than against an internal classification framework.

Annual testing framework

The fund runs the §3(c)(5)(C) testing framework on a recurring measurement framework. The standard runs the qualifying-interest and real-estate-related tests on the quarterly cycle against the fund’s balance sheet. The fund runs the asset-classification framework against the fund’s loan-by-loan inventory and the investment-by-investment inventory. The fund runs the documentation framework against the test result on each measurement date and runs the test framework against the fund’s auditor and the fund’s SEC counsel. The fund that runs below the fifty-five-percent qualifying-interest floor or the eighty-percent real-estate-related floor on a measurement date runs into a §3(c)(5)(C) exemption framework violation.

§3(c)(5)(C) compared to §3(c)(1) and §3(c)(7)

The Investment Company Act runs three primary exemptions against a private mortgage fund. Section 3(c)(1) runs the exemption against a private fund with one hundred or fewer beneficial owners, runs against an accredited and non-accredited investor base, and runs no asset-class framework against the fund. Section 3(c)(7) runs the exemption against a private fund with an unlimited investor base, runs against a qualified-purchaser-only investor framework, and runs no asset-class framework against the fund. Section 3(c)(5)(C) runs the exemption against an unlimited investor base (subject to the Securities Act offering framework), runs against an accredited-investor framework under Reg D 506(b) or 506(c), and runs the qualifying-interest and real-estate-related asset-class framework against the fund. The three exemptions run different operational frameworks against the fund and against the lender-investor base.

State-level overlays

The §3(c)(5)(C) exemption runs the Investment Company Act framework off the fund. The state-level framework runs separately against the fund’s offering and against the fund’s operations. The NSMIA framework preempts state registration on Reg D Rule 506 offerings, and the fund runs the Form D filing framework with the SEC within fifteen days of the first sale under Rule 503. The state notice-filing framework runs against the fund in each state where the fund runs an offer. The California Department of Financial Protection and Innovation runs the CFL and CRMLA licensing framework against the fund’s lending operations in California. The California Department of Real Estate runs the §10238 multi-lender framework against the fund where the fund runs a California-broker-arranged multi-lender note in the portfolio.

Common §3(c)(5)(C) compliance pitfalls

Five compliance pitfalls run on a recurring framework against a §3(c)(5)(C) mortgage fund. The first runs the B-note and mezzanine framework — the fund classifies a B-note or mezzanine loan as a qualifying interest where the SEC no-action framework runs it as real-estate-related rather than qualifying. The second runs the agency-mortgage-backed-security framework — the fund classifies an agency MBS as a qualifying interest where the SEC framework runs it as real-estate-related. The third runs the cash-and-Treasuries framework — the fund runs an excess cash or Treasury position outside the eighty-percent real-estate-related framework and runs below the floor on the measurement date. The fourth runs the documentation framework — the fund runs the test result against the auditor without a documented loan-by-loan classification framework. The fifth runs the cure-period framework — the fund runs a test failure without a defined corrective-action framework against the asset-rebalancing cycle.

Frequently Asked Questions

What does §3(c)(5)(C) exempt the fund from?

Section 3(c)(5)(C) runs the Investment Company Act registration framework off the fund. The fund runs no SEC registration as an investment company, runs no Form N-1A or N-2 reporting framework, and runs no 1940 Act operational framework. The fund runs the offering framework against Reg D Rule 506 under the Securities Act and runs the operational framework against the fund’s offering documents, operating agreement, and Subservicing Agreement.

What is the two-tier asset test?

The fund runs at least fifty-five percent of its assets in qualifying interests in real estate — whole mortgage loans, fee interests in real estate, and other interests classified as qualifying under the SEC no-action framework. The fund runs at least eighty percent of its assets in real-estate-related interests — the qualifying interests plus mezzanine loans, B-notes, agency mortgage-backed securities, and other real-estate-related interests under the no-action framework. The remaining twenty percent runs against miscellaneous investments. The fund runs the test on a recurring measurement framework — the quarterly cycle on the standard.

Are mezzanine loans qualifying interests?

The SEC no-action framework runs mezzanine loans and B-notes as real-estate-related interests rather than qualifying interests on the standard classification. The mezzanine and B-note framework runs into the eighty-percent real-estate-related floor but does not run into the fifty-five-percent qualifying-interest floor. A fund that runs a heavy mezzanine and B-note framework runs the qualifying-interest floor against the whole-mortgage-loan and fee-interest framework rather than against the mezzanine framework.

How often does the fund run the test?

The standard runs the §3(c)(5)(C) test on the quarterly cycle against the fund’s balance sheet. The fund runs the asset-classification framework against the loan-by-loan and investment-by-investment inventory, and the fund runs the documentation framework against the test result on each measurement date. The fund runs the test result against the fund’s auditor and the fund’s SEC counsel on the annual cycle.

What happens if the fund fails the test?

A fund that runs below the fifty-five-percent qualifying-interest floor or the eighty-percent real-estate-related floor on a measurement date runs into a §3(c)(5)(C) exemption framework violation. The fund runs the corrective-action framework against the asset-rebalancing cycle — additional whole-mortgage-loan acquisition, divestiture of non-qualifying assets, or reclassification under the no-action framework. The fund runs the corrective framework on a defined cure-period framework — the standard runs a thirty- to sixty-day cure period on the fund’s SEC counsel discipline.

How does §3(c)(5)(C) differ from §3(c)(1)?

Section 3(c)(1) runs the exemption against a private fund with one hundred or fewer beneficial owners and runs no asset-class framework against the fund. Section 3(c)(5)(C) runs the exemption against an unlimited investor base subject to the Securities Act offering framework and runs the qualifying-interest and real-estate-related asset-class framework against the fund. A small mortgage fund runs against §3(c)(1) on the beneficial-owner framework and against §3(c)(5)(C) on the asset-class framework — and runs the choice against the fund’s growth framework against the one-hundred-investor cap.

Does §3(c)(5)(C) preempt state securities registration?

Section 3(c)(5)(C) runs the Investment Company Act framework off the fund and runs no state-level preemption on the fund’s offering framework. The fund runs the Securities Act offering framework under Reg D Rule 506 and runs the NSMIA preemption framework on the Rule 506 offering against state registration. The fund runs the Form D filing framework with the SEC and runs the state notice-filing framework against each state where the fund runs an offer.

Want to set up your mortgage fund the right way?

Mortgage fund subservicing runs against the §3(c)(5)(C) framework, the Reg D Rule 506 offering framework, the Subservicing Agreement framework under 12 CFR §1024.31, and the trust-account framework against the fiduciary discipline. Note Servicing Center runs the fund subservicing framework against the master-subservicer split, the audit-rights framework, the SOC report framework, and the investor-reporting framework.

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This article is educational and does not constitute legal advice. The §3(c)(5)(C) exemption framework runs under the Investment Company Act of 1940 against an entity primarily engaged in the business of purchasing or acquiring mortgages and other liens on and interests in real estate. The qualifying-interest classification framework runs against the SEC no-action position framework. Consult qualified SEC counsel on the specific asset-classification and operational framework against any private mortgage fund.

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