The Securities and Exchange Commission (SEC) recently overhauled the rules applicable to “fund of funds” arrangements (where funds invest in other funds), rescinding many of the existing rules and exemptions and replacing them with what is intended to be a more consistent, rules-based regime and a streamlined framework. The new rules provide flexibility to fund managers to allocate and structure investments efficiently, without the delays and costs of seeking individualized exemptive orders.
As a general rule, Section 12(d)(1) of the Investment Company Act of 1940 (the 1940 Act) prohibits a registered fund (and the companies or funds they control) from acquiring more than 3% of another fund's outstanding voting securities, investing more than 5% of its total assets in any one fund, or investing more than 10% of its total assets in funds generally.
The reason for these restrictions is rooted in congressional concerns over the potential for an acquiring fund to exercise effective control over the acquired funds, and of duplicative or excessive fees or overly complex fund structures that could result from such arrangements.
Under new Rule 12d1-4, a registered investment company (RIC) or business development company (BDC) may acquire securities of any other RIC or BDC in excess of the limits prescribed by the 1940 Act, provided the following conditions are met:
- The acquiring fund and each of its advisory groups1 do not control the acquired fund, except in certain limited circumstances.
- The acquiring fund and its advisory group must use mirror voting2 if it holds more than 25% of an acquired open-end fund or unit investment trust due to a decrease in outstanding securities of the acquired fund. It must also use mirror voting if it holds more than 10% of a closed-end fund (although if the acquiring fund is the sole shareholder, pass-through voting is permitted).
- Investment advisers to acquiring and acquired funds must consider specific factors3 when approving the fund of funds transactions and make certain findings regarding these arrangements. The investment advisers must find the aggregate fees and expenses of the structure are not duplicative and in the case of the acquired fund's adviser, that the investment would not lead to undue influence.
- If the acquiring and acquired fund do not have the same primary investment adviser, they must enter into an investment agreement that includes terms that would enable each to make the appropriate findings under this rule. The agreement must include a termination provision and a requirement that the acquired fund provide fee and expense information to the acquiring fund.
- The funds avoid a three-tier structure, although there are certain exceptions to this prohibition. In addition to the exceptions, an acquired fund may invest up to 10% of its total assets in other funds without regard to the purpose of the investment or types of underlying funds.
In connection with the new rule and amendments, the SEC is rescinding current Rule 12d1-2 under the 1940 Act. The SEC is also rescinding current exemptive orders that provide relief to fund of funds arrangements that fall within the scope of the new rule. However, the SEC is not rescinding any exemptive orders or portions of exemptive orders that fall outside the scope of this new rule (even if portions of the order within the scope of the rule are rescinded). The SEC staff will also withdraw no-action letters stating that enforcement action will not be taken with respect to noncompliance with Section 12(d)(1). The rescission of Rule 12d1-2, the exemptive orders and the no-action letters will become effective one year from the effective date of the final rule.
Other than as described above, the new rule and amendments will become effective 60 days after publication in the Federal Register. These amendments greatly simplify the rules for fund of funds arrangements and should help make compliance faster and less expensive for funds in those arrangements.
1 The term “advisory group” is defined in the new rules as the investment adviser or sub-adviser and entities controlling, controlled by or under common control with that adviser or sub-adviser, treated separately.
2 Pass-through voting occurs where a financial intermediary that holds, in its own name as registered owner, securities of an issuer that is holding a meeting or vote, seeks instructions from its customers who beneficially own the securities, and votes only those shares for which it has received instructions in accordance with those instructions. Mirror voting is the practice of voting shares for which the intermediary has not received instructions proportionate to the instructions received from other beneficial owners.
3 These factors include scale of the contemplated investments by the acquiring fund, anticipated timing of redemption requests, whether and when the acquiring fund will provide advance notification of investment and redemptions, and the circumstances in which acquired funds may elect to satisfy redemptions in kind.
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