Release No. 34-11220

January 31, 1975

NOTICE OF ADOPTION OF RULE 3a 12-5 AND AMENDMENTS TO RULE 15c2-5 UNDER THE SECURITIES EXCHANGE ACT OF 1934

The Securities and Exchange Commission announced today the adoption of Rule 3a12-5 under the Securities Exchange Act of 1934 (the "Act") which will exempt certain investment contract securities involving the direct ownership of specified residential real property offered by broker-dealers from Sections 7(c) and 11(d)(1) of the Act, subject to certain conditions. The Commission also announced the adoption of amendments to Rule 15c2-5 under the Act which have the effect of liberalizing certain disclosure and suitability requirements for broker-dealers in connection with the offer or sale of a security involving an extension or arrangement of credit not subject to Regulation T (12 CFR 220). Rule 3a12-5 and the amendments to Rule 15c2-5 are being adopted pursuant to Sections 3(a)(12), 7(c), 11(d)(1), 15(c), and 23(a) of the Act. The effective date for Rule 3a12-5 and the amendments to Rule 15c2-5 is March 3, 1975.

On June 7, 1974, in Securities Exchange Act Release No. 10845, the Commission published its proposal to adopt Rule 3a12-5. It has considered the comments and views of all interested persons concerning this proposal and now adopts Rule 3a12-5, and amends Rule 15c2-5, in the form set forth below.

Background

The rationale behind the adoption of Section 7 of the Act was to limit the amount of credit which might be devoted to speculation in the securities markets, ¹ to maintain the availability of credit for financing local commerce and industry, ² to prevent undue market volatility by exerting a positive, stabilizing effect on the market, ³ and to protect investors from purchasing on too thin a margin. ⁴

Section 11(d)(1) was enacted by Congress to prevent "one of the greatest potential evils attributable to the combination of the broker and dealer functions in the same person"--the extension of credit on new issues by underwriter-brokers. ⁵ This potential conflict of interest so troubled Congress that it was "deemed advisable to include a statutory prohibition" ⁶ even prior to the completion of a Commission study on the advisability and feasibility of segregating the functions of the broker and dealer. ⁷

In response to requests from interested parties, the Commission reviewed the impact of Sections 7(c) and 11(d)(1) on the sale of certain investment contracts involving residential real property, such as investment contracts involving the sale of a condominium ⁸ in light of the statutory purposes of those sections. Upon completion of its review, the Commission published for comment proposed Rule 3a12-5 under the Act. After reviewing the comments received from interested parties, it is the view of the Commission that the unique characteristics of investment contract securities involving the direct ownership of specified residential real property (particularly in light of the traditional modes of financing such real property and the lack of the secondary trading market therefor) make the existence of the concerns addressed by Sections 7(c) and 11(d)(1) of the Act unlikely. The Commission has determined, therefore, to adopt an exemption from the provisions of Sections 7(c) and 11(d)(1) of the Act for the arranging of credit by broker-dealers offering such securities, subject to certain conditions.

Based upon its experience and the letters of comment received in response to Securities Exchange Act Release No. 10845, the Commission has made certain changes in Rule 3a12-5 as adopted. Additionally, amendments to Rule 15c2-5 (which is applicable to brokers and dealers offering, inter alia, investment contract securities on which they, directly or indirectly, arrange for the extension of credit not subject to Regulation T) are being adopted today.

Policy Questions

The Commission specifically requested comment on two policy questions in the context of the offering of residential real property investment contract securities:

(1) Does the lake of a secondary trading market for such investment contracts outweigh the prohibition which Congress established for the extension or arranging of credit by broker-dealers for "purpose loans" against other than "approved collateral"?

(2) Would permitting the extension or arranging of credit by broker-dealers for such investment contracts tend to encourage investment in such securities rather than other types of securities and therefore be less likely to ensure a rational allocation of capital?

After carefully reviewing the comments received with respect to these two questions, the Commission has concluded that the lack of a secondary trading market is a significant factor in support of the proposed exemption and that permitting extensions of credit pursuant to the terms of the exemption is in the public interest and for the protection of investors.

Direct Interest

Some commentators questioned whether the conveyance of less than a fee simple interest in real property to the purchaser constituted a direct interest in real property within the coverage of the rule. Specific reference was made to long term leasehold interests and interests in trusts which are offered to purchasers in lieu of a fee simple interest, whether because of restrictions under foreign or domestic law regarding the conveyance of real property or otherwise.

The Commission has carefully reviewed the question of the application of Rule 3a12-5 to investment contracts involving an interest in the real property which is less than a fee. The ability of an owner to transfer such an interest, the right to receive the proceeds of sale, the incidents of ownership, and, most significantly, the willingness of lenders to extend mortgage or similar financing, all support a conclusion that certain leasehold interests and beneficial interests in a trust should be treated comparably to a fee. Therefore, for purposes of Rule 3a12-5, the term direct interest has been defined in subparagraph (b)(2) to include a fee, leasehold interest, and/or a beneficial interest in a trust which, under applicable local law, is financed by a loan secured by a mortgage, deed of trust, or other similar security interest in real property.

The Commission has also concluded that indirect interests in real property, such as limited partnership interests and interests in real estate investment trusts, should not be included within the coverage of Rule 3a12-5. These securities possess characteristics essentially similar to equity securities and can be marketed in small denominations.

Other Investment Contracts

In Securities Exchange Act Release No. 10845, the Commission also solicited comment on the question of whether the coverage of proposed Rule 3a12-5 should be extended to investment contract securities that include a direct interest in real property other than residential real property.

After reviewing the comments the Commission has concluded that Rule 3a12-5 should be limited to investment contracts consisting of a direct ownership interest in specified residential real property as defined. Adoption of Rule 3a12-5 will permit the continuation of traditional real estate financing practices for purchasers of residential real property. For purposes of the rule, the term "residential real property" is defined in subparagraph (b)(1) as real property containing living accommodations, whether used on a permanent or transient basis. This definition is not intended to impose a requirement upon the purchaser of the investment contract that he occupy the premises.

While the Commission believes that the need for relief from the credit restrictions of Sections 7(c) and 11(d)(1) of the Act has been demonstrated for residential real property investment contracts, no similar need has been presented at this time for extending the coverage of the rule to other types of investment contracts involving interests in non-residential real property and personal property.

Issuers of non-residential real property and personal property investment contracts and broker-dealers offering such contracts for sale to the public are reminded of the adoption by the Board of Governors of the Federal Reserve System of an amendment to Section 220.6(1) of Regulation T which becomes effective on March 3, 1975. This amendment will have the effect of treating the extension of credit on any part of an investment contract security as credit on the entire security and would prohibit broker-dealers from arranging for such credit unless collateralized in compliance with the requirements of Regulation T.

Credit Terms

Subparagraph (a)(3) of proposed Rule 3a12-5 requires that the credit be extended by a lender unaffiliated with the issuer or the broker-dealer offering these securities. The Commission believes that the lack of affiliation of the lender is a necessary requirement to assure that the financing is based upon an independent appraisal of the property and the credit worthiness of the borrower. Therefore, the requirement that the lender not be in a control relationship with the issuer or the selling broker-dealer, or affiliates thereof, has been retained in the final version of the rule. This is not designed to prohibit an ownership interest in a developer/issuer by a lender, or vice versa, so long as such interest does not constitute control. Because the existence of a control relationship can only be made in light of the specific facts of a particular case, such a determination must be made by the issuer, the lender, and their counsel. The Commission also believes that the unaffiliated lender provision makes unnecessary the requirement in subparagraph (a)(2) of the proposed rule that the credit must be reasonably related to the current market value of the real property. Accordingly, that subparagraph has been deleted.

The Commission takes the view that traditional real estate lending practice--in which the lender assesses and relies on the credit worthiness of the purchaser and the security value of the underlying real property--should result in prudent loans. However, in recognition of the business practice of the resort and second-home industry, Rule 3a12-5 will permit the lenders security interest to extend to common areas and recreational facilities incidental to the residential real property investment contract and to uniform furniture packages and fixtures if required by the issuer or subject to his approval. In addition, a lender will not be precluded from protecting his security interest by requiring an assignment of rents contingent on default or requiring a guarantor or co-signer on the debt obligation provided that the issuer, its affiliates, or the broker or dealer offering the securities does not guarantee or co-sign the purchasers debt obligation.

Subparagraph (a)(2) of the rule has been revised to avoid a possible ambiguity resulting from the requirement that the credit be repaid by "regular" payments of principal and interest. It was not intended that each payment consist of equal amounts of principal and interest; this provision has been revised therefore to refer to "periodic" payments of principal and interest pursuant to a schedule of amortization established by the governing instruments. So-called "balloon financing", if extended by an unaffiliated lender and in compliance with the terms and conditions of Rule 3a12-5, will nevertheless be specifically permissible.

Disclosure and Suitability

Subparagraphs (b)(1) and (2) of proposed Rule 3a12-5 would have imposed disclosure and suitability obligations upon the person offering these investment contract securities. The Commission views disclosure and suitability as a necessary and fundamental condition of the exemption for the protection of investors. The disclosure and suitability standards originally contained in subparagraphs (b)(1) and (2) of proposed Rule 3a12-5 have been deleted, however, in reliance on the existing obligations of broker-dealers under Rule 15c2-5 of the Act, specifically subparagraphs (a)(1) and (2) thereunder, to make complete disclosure to, and a determination of suitability for, prospective customers to whom the broker-dealers offer securities on which they, directly or indirectly, arrange for the extension of credit not subject to Regulation T. Subparagraph (a)(1) of Rule 15c2-5 has been amended by the addition of a proviso to permit the delivery of the information required by that subparagraph in another document, e.g., a prospectus, to satisfy the disclosure requirements of that subparagraph. Subparagraph (a)(2) of Rule 15c2-5 has been amended to permit the broker-dealer to retain in his files the written basis for his suitability determination, rather than delivering this statement to a customer. However, subparagraph (a)(2) of Rule 15c2-5 has been amended to make clear that a copy of the written basis for the suitability determination made by the broker-dealer must be made available to the customer on request.

In order to make clear that, for purposes of Rule 15c2-5, credit extended in reliance upon the exemption from Section 7(c) provided by Rule 3a12-5 is not credit "in compliance with the requirements of" Regulation T, the proviso to subparagraph (b) of Rule 15c2-5 has been amended.

The Commission wishes to emphasize that Rule 3a12-5 is in the nature of an experiment and that the activities of persons seeking to avail themselves of the exemption afforded by the rule will be carefully scrutinized to assure that such activities are not inconsistent with the public interest and provide for the protection of investors. In as much as Rule 3a12-5 is premised, in part, upon the lack of a secondary trading market for investment contract securities involving the direct ownership of specified residential real property, the Commission would reconsider the appropriateness of the rule adopted today if secondary trading markets develop for these investment contract securities.

The Commission hereby adopts Rule 3a12-5 and amends Rule 15c2-5 pursuant to Sections 3(a)(12), 7(c), 11(d)(1), 15(c), and 23(a) of the Securities Exchange Act of 1934, as amended. The Commission has determined that because: (1) the proposal to adopt Rule 3a12-5 has been exposed for public comment since June 7, 1974; and (2) the amendments to Rule 15c2-5 relieve a restriction within the meaning of the Administrative Procedure Act, 5 U.S.C. 553(d), additional public comment is not necessary and there is good cause to, and the Commission hereby does, declare Rule 3a12-5 and the amendments to Rule 15c2-5 effective on March 3, 1975. The full text of Rule 3a12-5 and Rule 15c2-5 (amendments underscored; deletions bracketed) is attached hereto:

Rule 3a12-5: Exemption of Certain Investment Contract Securities From Sections 7(c) and 11(d)(1)

(a) An investment contract security involving the direct ownership of specified residential real property shall be exempted from the provisions of Sections 7(c) and 11(d)(1) of the Act with respect to any transaction by a broker or dealer who, directly or indirectly, arranges for the extension or maintenance of credit on the security to or from a customer, if the credit:

(1) is secured by a lien, mortgage, deed of trust, or any other similar security interest related only to real property; Provided, however, That this provision shall not prevent a lender from requiring (i) a security interest in the common areas and recreational facilities or furniture and fixtures incidental to the investment contract if the purchase of such furniture and fixtures is required by, or subject to the approval of, the issuer, as a condition of purchase; or (ii) an assignment of future rentals in the event of default by the purchaser or a co-signer or guarantor on the debt obligation other than the issuer, its affiliates, or any broker or dealer offering such securities;

(2) is to be repaid by periodic payments of principal and interest pursuant to an amortization schedule established by the governing instruments; Provided, however, That this provision shall not prevent the extension of credit on terms which require the payment of interest only, if extended in compliance with the other provisions of this rule; and

(3) is extended by a lender which is not, directly or indirectly controlling, controlled by, or under common control with the broker or dealer or the issuer of the securities or affiliates thereof.

(b) For purposes of this rule:

(1) "residential real property" shall mean real property containing living accommodations, whether used on a permanent or transient basis, and may include furniture or fixtures if required as a condition of purchase of the investment contract or if subject to the approval of the issuer.

(2) "direct ownership" shall mean ownership of a fee or, leasehold estate or a beneficial interest in a trust the purchase of which, under applicable local law, is financed and secured by a security interest therein similar to a mortgage or deed of trust, but it shall not include an interest in a real estate investment trust, an interest in a general or limited partnership, or similar indirect interest in the ownership of real property.

* * * * *

Rule 15c2-5: Disclosure and Other Requirements When Extending or Arranging Credit in Certain Transactions

(a) It shall constitute a "fraudulent, deceptive, or manipulative act or practice" as used in section 15(c)(2) of the Act for any broker or dealer to offer or sell any security to, or to attempt to induce the purchase of any security by, any person, in connection with which such broker or dealer, directly or indirectly offers to extend any credit to or to arrange any loan for such person, or extends to or participates in arranging any loan for such person, unless such broker or dealer, before any purchase, loan or other related element of the transaction is entered into:

(1) Delivers to such person a written statement setting forth the exact nature and extent of (i) such persons obligations under the particular loan arrangement, including, among other things, the specific charges which such person will incur under such loan in each period during which the loan may continue or be extended, (ii) the risks and disadvantages which such person will incur in the entire transaction, including the loan arrangement, (iii) all commissions, discounts, and other remuneration received and to be received, in connection with the entire transaction including the loan arrangement, by the broker or dealer, by any person controlling, controlled by, or under common control with the broker or dealer, and by any other person participating in the transaction; Provided, however, That the broker or dealer shall be deemed to be in compliance with this subparagraph if the customer, before any purchase, loan, or other related element of the transaction is entered into in a manner legally binding upon the customer, receives a statement from the lender, or receives a prospectus or offering circular from the broker or dealer, which statement, prospectus or offering circular contains the information required by this subparagraph; and

(2) Obtains from such person information concerning his financial situation and needs, reasonably determines that the entire transaction, including the loan arrangement, is suitable for such person, and delivers to such person retains in his files a written statement setting forth the basis upon which the broker or dealer made such determination .; Provided, however, That the written statement referred to in this subparagraph must be made available to the customer on request.

(b) This section shall not apply to any credit extended or any loan arranged by any broker or dealer subject to the provisions of Regulation T (issued by the Board of Governors of the Federal Reserve System) if such credit is extended or such loan is arranged, in compliance with the requirements of such regulation, only for the purpose of purchasing or carrying the security offered or sold: Provided, however, That notwithstanding this paragraph, the provisions of paragraph (a) shall apply in full force with respect to any transaction involving the extension of or arrangement for credit by a broker or dealer (i) in a special insurance premium funding account within the meaning of Section 4(k) of Regulation T or (ii) in compliance with the terms of Rule 3a12-5.

By the Commission.

²Id.

³S. Rep. No. 792, 73d Cong., 2d Sess. 8 (1934).

⁴Id. at 3; S. Rep. No. 1455, 73d Cong., 2d Sess. 11 (1934).

⁵H.R. Rep. No. 1383, 73d Cong., 2d Sess. 22 (1934).

⁶S. Rep. No. 792, 73d Cong., 2d Sess. 12 (1934).

⁷Pursuant to Section 11(e) of the Securities Exchange Act, the Commission conducted a study of the abuses connected with, among other things, the combination of underwriter-broker and participating broker-dealer functions but did not recommend the segregation of such functions. Securities and Exchange Commission, Study of the Feasibility and Advisability of the Complete Segregation of the Functions of Dealer and Brokers, 43-45, 109 (1936).

⁸See Securities Act Release No. 5347 (Jan. 4, 1973).