On Oct. 7, 2020, the Securities and Exchange Commission (SEC) voted to adopt a new rule (Rule 12d1-4), and related amendments to existing rules and forms, to enact a comprehensive regulatory framework for “fund of funds” arrangements (whereby funds invest in other funds). The rule adoptions also serve to rescind much of the current regulatory framework and exemptive relief addressing funds of funds. The new framework is intended to create a consistent and efficient rules-based regime for the formation, operation and oversight of funds of funds and provide flexibility to fund managers to allocate and structure investments efficiently, without the delays and costs of seeking individualized exemptive orders.
Existing Regulatory Framework
Section 12(d)(1) of the Investment Company Act of 1940 (the “1940 Act”) prohibits registered funds (and the companies, including funds, such registered funds control) from (a) acquiring more than 3% of another fund's outstanding voting securities, (b) investing more than 5% of its total assets in any one fund, or (c) investing more than 10% of its total assets in funds generally. In connection with this provision, Section 12(d)(1)(B) of the 1940 Act prohibits a registered open-end fund and any principal underwriter thereof or registered broker-dealer from knowingly selling securities to any other investment company if the acquiring fund would: (x) together with the companies it controls, own more than 3% of the acquired fund's outstanding voting securities, or (y) together with other funds (and companies they control), own more than 10% of the acquired fund's outstanding voting securities. The restrictions aim to alleviate 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 the current regime, funds of funds are permitted to operate due to three statutory exemptions that allow for fund of funds arrangements in certain narrowly tailored circumstances, and through exemptive orders issued by the SEC. The exemptive orders are issued to funds of funds that the SEC finds to be consistent with public interest and the protection of investors, and subject these funds of funds to certain conditions designed to prevent abuses. This regime, however, has led to a regulatory environment in which similarly situated funds of funds are subject to different conditions. Continuous creation of novel fund of funds structures also presents difficulty in SEC evaluation of the applicability of exemptive orders.
Changes to the Regulatory Framework
The amendments being adopted by the SEC intend to replace this current framework with a more consistent and efficient system. Under new rule 12d1-4, a registered investment company (RIC) or business development company (BDC) will be permitted to acquire securities of any other RIC or BDC in excess of the limits prescribed by the 1940 Act, so long as the following conditions are satisfied:
- The acquiring fund and each of its “advisory groups” (consisting of the investment adviser or sub-adviser and entities controlling, controlled by or under common control with that adviser or sub-adviser, treated separately) does not control an acquired fund (except in certain limited circumstances).
- The acquiring fund and its advisory group must use mirror voting 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 or 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 factors (including 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) in approving the funds of funds transactions and make certain findings regarding these arrangements (including that 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 material terms that would enable each to make the appropriate findings under this rule — a termination provision and a requirement that the acquired fund provide fee and expense information to the acquiring fund — prior to the acquisition of shares in excess of the 1940 Act limits.
- A general three-tier prohibition, with certain exceptions. 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.
The new rule will also provide an exemption from the prohibition in Section 17(a) of the 1940 Act on certain affiliated transactions. Absent an exemption, Section 17(a) prohibits a fund that holds 5% or more of an acquired fund's securities from making any additional follow-on investments in the acquired fund. (Funds of funds that involve funds within the same group of investment companies or that have a common or affiliated investment adviser are also affected by this prohibition, regardless of the amount of securities held.) The adopted rule and amendments will allow fund of funds arrangements when the acquiring fund is in the same group of investment companies as the acquired fund or the acquiring fund's investment sub-adviser or any person controlling, controlled by, or under common control with such investment sub-adviser acts as the acquired fund's investment adviser. These exceptions to Section 17(a) are limited in scope to those necessary for a fund of funds to operate under the new rule and are consistent with exemptive relief that had been issued by the SEC in other scenarios related to Section 17(a).
The SEC release also contemplates new disclosures that will be required on Forms N-CEN and N-1A under the new rule and amendments. A requirement will be added to Form N-CEN that would require reporting if a management company relied on the new rule or certain statutory exemptions related to funds of funds during the reporting period. In addition, open-end funds that invest 10% or less of their total assets in acquired funds may omit Acquired Fund Fees and Expenses from their bottom line expenses in Form N-1A fee tables, and disclose this amount in a footnote to the table instead. The amendments to Form N-CEN will not require compliance until 425 days after publication of the SEC release in the Federal Register.
Rescission of Existing Rules, Exemptive Orders and Staff Guidance
In connection with the new rule and amendments, the SEC is rescinding current Rule 12d1-2 under the 1940 Act. Rule 12d1-2 had codified three types of relief for funds of funds that had not conformed to Section 12(d)(1) limits, including the ability to (a) acquire the securities of other funds that are not part of the same group of investment companies; (b) invest directly in stocks, bonds and other securities; and (c) acquire the securities of money market funds in reliance on Rule 12d1-1. 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 that fall outside of the scope of this new rule, nor any portions of orders that are outside the scope of the new rule (even if the rest of the exemptive order is rescinded); no relief from Section 17(a) and 17(d) of the 1940 Act, nor from Rule 17d-1 under the 1940 Act, is being rescinded. The SEC staff will also withdraw its 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.
The full text of the SEC release can be found here: https://www.sec.gov/rules/final/2020/33-10871.pdf
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