SEC Proposes Rule Changes for Fund of Funds Arrangements
January 7, 2019
On December 19, 2018, the Securities and Exchange Commission (SEC) voted to propose a new rule and related amendments under the Investment Company Act of 1940 (1940 Act) designed to allow a fund to acquire the shares of another fund in excess of the limits of Section 12(d)(1)(A) and (B) of the 1940 Act without obtaining an individual exemptive order from the SEC, subject to certain conditions.
Proposed Rule 12d1-4
Proposed Rule 12d1-4 would permit a registered investment company or business development company (acquiring funds) to acquire the securities of any other registered investment company or business development company (acquired funds) in excess of the limits in Section 12(d)(1)(A) and (B) of the 1940 Act,1 provided that the acquiring fund complies with certain conditions. The proposed rule’s conditions include the following:
- Control and Voting.2 The proposed rule would prohibit an acquiring fund from controlling3 an acquired fund and would require an acquiring fund that holds more than 3% of an acquired fund’s outstanding voting securities to vote those securities in a prescribed manner4 in order to minimize the influence that an acquiring fund may exercise over an acquired fund.
- Redemption Limits. The proposed rule would prohibit an acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares from redeeming more than 3% of the acquired fund’s total outstanding shares in any 30-day period.5
- Duplicative or Excessive Fees. Under the proposed rule, if the acquiring fund is a management company, the acquiring fund’s investment adviser would be required to evaluate the complexity of the structure and aggregate fees associated with the acquiring fund’s investment in the acquired fund and find that it is in the best interest of the acquiring fund to invest in the acquired fund. The acquiring fund’s investment adviser would be required to report its finding and the basis for the finding to the acquiring fund’s board of directors before investing and at least annually.6
- Complex Structures. The proposed rule would prohibit funds from creating three-tier fund of funds structures, except in certain limited circumstances.
Proposed Rescission of Rule 12d1-2 and Certain Exemptive Relief
The SEC is proposing to rescind Rule 12d1-2, which permits funds that primarily invest in funds within the same fund group in reliance on Section 12(d)(1)(G) of the 1940 Act7 to invest in (i) unaffiliated funds (up to certain limits prescribed in Section 12(d)(1)(A) or (F)) and (ii) non-fund assets (e.g., corporate stocks and bonds). The SEC also is proposing to rescind exemptive orders permitting fund of funds arrangements, with limited exceptions. Funds wishing to create certain types of fund of funds arrangements that exceed the statutory limitations would be required to rely on proposed Rule 12d1-4 and comply with its associated conditions.
Proposed Amendments to Rule 12d1-1
In addition, the SEC is proposing to amend Rule 12d1-1 to allow funds that rely on Section 12(d)(1)(G) to continue to invest in unaffiliated money market funds.
Proposed Amendments to Form N-CEN
The proposal also includes amendments to Form N-CEN, which would require funds to report whether they relied on Rule 12d1-4 or the statutory exception in Section 12(d)(1)(G) during the applicable reporting period.
1 Section 12(d)(1) of the 1940 Act limits the ability of a fund to invest substantially in shares of another fund. Section 12(d)(1)(A) prohibits a registered fund (and companies, including funds, it controls) from: (1) acquiring more than 3% of another fund’s outstanding voting securities; (2) investing more than 5% of its total assets in any one fund; or (3) investing more than 10% of its total assets in funds generally. Section 12(d)(1)(B) addresses the other side of the transaction by prohibiting a registered open-end fund (and any principal underwriter thereof or broker-dealer registered under the Securities Exchange Act of 1934) from knowingly selling securities to any other investment company if, after the sale, the acquiring fund would: (1) together with companies it controls, own more than 3% of the acquired fund’s outstanding voting securities or (2) together with other funds (and companies they control), own more than 10% of the acquired fund’s outstanding voting securities.
2 An acquiring fund that is part of the same fund group as the acquired fund and an acquiring fund that has a sub-adviser that acts as adviser to the acquired fund would not be subject to the control and voting conditions.
3 The 1940 Act defines control to mean the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company. The 1940 Act also creates a rebuttable presumption that any person who directly or indirectly beneficially owns more than 25% of the voting securities of a company controls the company and that one who does not own that amount does not control it. A determination of control depends on the facts and circumstances of the particular situation.
4 The acquiring fund would be required to either: (1) seek voting instructions from its security holders and vote such proxies in accordance with their instructions (pass-through voting) or (2) vote the shares held by it in the same proportion as the vote of all other holders of the acquired fund (mirror voting).
5 This prohibition addresses concerns that an acquiring fund could threaten large-scale redemptions to exert undue influence over an acquired fund.
6 The proposed fee conditions, which are designed to prevent duplicative or excessive fees in fund of funds arrangements, vary based on the structure of the acquiring fund; there are specific conditions for management companies, unit investment trusts and separate accounts funding variable insurance contracts.
7 Section 12(d)(1)(G) allows a registered open-end fund or unit investment trust (UIT) to invest in other open-end funds and UITs that are in the same group of investment companies.