On July 2, 2020, the Securities and Exchange Commission (SEC) entered into a settlement order with a registered adviser and its foreign affiliate (Order) relating to violations of the fund-of-funds ownership restrictions in Section 12(d)(1)(A) of the Investment Company Act of 1940 (1940 Act) and the compliance rules contained in Rule 38a-1 under the 1940 Act and Rule 206(4)-7 of the Investment Advisers Act of 1940 (Advisers Act).1 Registered investment companies (funds) managed by the adviser and non-U.S. investment companies (foreign funds) managed by the adviser’s foreign affiliate violated certain of the Section 12(d)(1)(A) fund-of-funds ownership limitations contained in the 1940 Act through their investments in shares of ETFs. Once these violations by the funds were discovered by the adviser, the Order held that the adviser failed to comply with its trade error policy by not reimbursing client losses arising from the violations and violated the Advisers Act by making misleading disclosures to the funds’ board.
Section 12(d)(1)(A) of the 1940 Act limits a fund’s investment in an underlying fund to 3% of the underlying fund’s outstanding shares and 5% of the fund’s total assets, and places an overall limit of 10% on a fund’s investment in all underlying funds.2 An exemption is available for a fund’s investments in underlying funds so long as the aggregate amount of underlying fund shares held by the fund and all other funds managed by the fund’s adviser is limited to 3% of the underlying fund’s outstanding shares.3 These limitations are measured at the time of purchase.
During the relevant time period, each fund’s aggregate investment in other investment companies exceeded 10% of the fund’s assets, and the funds’ aggregate investment in three ETFs exceeded the 3% aggregate ownership limit contained in the exemption noted above with respect to each ETF during the relevant time period. The Order states that these limitations were breached due to a failure to implement pre-trade screening procedures that were included in the funds’ compliance policies and procedures. Upon discovering the violations, the adviser to the funds directed the sale of the ETF shares to comply with the exemption discussed above, which resulted in losses for the funds with respect to their positions in one ETF.4
The adviser initially determined that it would not reimburse the funds for the losses, although this was inconsistent with its trade error policy. This determination also created a conflict of interest for the adviser, and although the adviser informed the funds’ board regarding the Section 12(d)(1)(A) compliance violations, it failed to inform the funds’ board of the losses incurred in connection with the errors and the resulting conflict. After the SEC commenced an investigation, the adviser informed the board of the losses and reimbursed each fund for the amount of its loss, including interest, in December 2018.
During a separate time period, the foreign funds managed by the adviser’s affiliate purchased shares of two other ETFs in excess of 3% of each ETF’s outstanding shares. Certain foreign funds purchased shares of an ETF in amounts exceeding 20% of the ETF’s outstanding shares and, as a result of the foreign funds’ collective ownership in one of the ETFs, were able to obtain a 15 basis point management fee reduction for all shareholders. Because the 1940 Act’s fund-of-funds limitations apply to unregistered funds that satisfy the definition of “investment company” in the 1940 Act, these investments were in violation of the Section 12(d)(1)(A) fund-of-funds limitations.5
The Order acknowledged the adviser’s “remedial acts promptly undertaken” and fined the adviser and its affiliate collectively $325,000 as a result of the above conduct.
S&K Observations and Insights
The Order highlights the importance of adopting and implementing compliance procedures to ensure a fund’s underlying fund investments align with the technical and complex Section 12(d)(1)(A) fund-of-funds investment limitations and related exemptions. It also highlights the SEC’s continued scrutiny of disclosures to fund boards by fund advisers, particularly with respect to those involving conflicts of interest. The Order suggests that any determination by an adviser to deviate from its stated policies, particularly when such determination involves a conflict of interest for the adviser, will be closely reviewed by the SEC and its staff.
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If you have any questions regarding the items covered in this Seward & Kissel memorandum, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel’s Registered Funds Group.