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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
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
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
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
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.
additional commentary on developments in compliance and ethics, visit Compliance Building,
a blog hosted by Doug Cornelius.
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