U.S. Securities and Exchange Commission (SEC) staff issued a no-action letter that permits an exchange-traded fund (ETF) to exceed the limits imposed by sections 12(d)(2) and 12(d)(3) of the Investment Company Act of 1940 (1940 Act) and Rule 12d3-1 thereunder to invest in securities issued by insurance companies or securities of issuers engaged in securities-related activities so that the investment adviser of the ETF (Adviser) can better replicate the index that the ETF seeks to track.

Background

The ETF that obtained the no-action relief seeks to approximate the investment performance of the S&P High Yield Dividend Aristocrats Index (Index) by investing in a portfolio of stocks with generally the same risk and return characteristics of the Index. Some of the issuers represented in the Index are either insurance companies or companies that derive a substantial portion of their revenues from securities-related activities.

Section 12(d)(2) of the 1940 Act generally prohibits a registered investment company from purchasing or otherwise acquiring any security issued by any insurance company if, as a result of the purchase or acquisition, the registered investment company (and any company or companies controlled by it) would own in the aggregate, or as a result of such purchase or acquisition will own, more than 10 percent of the total outstanding voting stock of the insurance company.

Section 12(d)(3) of the 1940 Act generally prohibits a registered investment company from purchasing or otherwise acquiring any security issued by a broker, dealer, an underwriter, an investment adviser to an investment company or an investment adviser registered under the Investment Advisers Act of 1940.

As the ETF grew in size, it encountered the regulatory restrictions of sections 12(d)(2) and 12(d)(3) of the 1940 Act and Rule 12d3-1 thereunder limiting the percentage amount an investment company may own of the outstanding voting stock of insurance companies or securities of issuers engaged in securities-related activities. The Adviser began to employ a sampling strategy for the ETF, whereby the Adviser uses quantitative analysis to select securities included in the Index, securities that are not included in the Index, and derivatives that have a similar investment profile (in terms of key risk factors, performance attributes and other economic characteristics) as the Index or components of the Index (e.g., market capitalization, industry weightings, etc.).

Notwithstanding the Adviser’s use of the sampling strategy, the Adviser stated that the most efficient and accurate way to manage the ETF consistent with its investment objective would be to acquire the outstanding voting stock of insurance companies and the securities issued by other equity issuers in the same approximate proportion as these issuers represent in the Index.

No-Action Relief

Section 12(d)(2)

The legislative history relating to section 12(d)(2) provides that “investment companies acquiring controlling blocks of stock of insurance companies” was a “relationship [that] may have very undesirable features.” Moreover, Congress deemed section 12(d)(2) a “salutary provision, because of the possible effect upon the insurance companies through the ownership by investment companies whose business it is to trade in securities.”

The Adviser successfully argued that the SEC historically has interpreted section 12(d)(2) as “prohibiting control of an insurance company by an investment company but permitted acquisition of stock of an insurance company upon assurance that there would be no such control.” It further stated that the ETF will not own the securities of an insurance company in an amount exceeding the approximate proportion that the insurance company’s stock represents in the Index. It added that the ETF has a non-fundamental investment restriction that prevents it from investing in the securities of a company for the purpose of exercising management or control. As a condition of the no-action relief, the Adviser stated that the ETF:

  • will not exercise a controlling influence over the management or policies of the insurance company; and
  • will either: (a) vote its shares in the insurance company as directed by an independent third party, or (b) vote its shares in the insurance company in the same proportion as the vote of all other holders of the insurance company’s shares.

Based upon these conditions, the SEC staff agreed it would not recommend enforcement action under section 12(d)(2) of the 1940 Act against the ETF if the ETF owns more than 10 percent of the total outstanding voting stock of an insurance company.

Section 12(d)(3)

The ETF also sought and obtained no-action relief from section 12(d)(3) of the 1940 Act. Rule 12d3-1 under the 1940 Act exempts from the prohibitions of section 12(d)(3) certain acquisitions of securities issued by persons engaged in securities-related activities. Rule 12d3-1(b)(1) permits a registered investment company, immediately after its acquisition of an equity security, to own no more than 5 percent of the outstanding securities of that class of an issuer that, in its most recent fiscal year, derived more than 15 percent of its gross revenues from securities-related activities.

In the release proposing amendments to Rule 12d3-1, the SEC identified two apparent Congressional purposes for prohibiting investment company investments in securities issued by persons engaged in securities-related activities:

  • “to limit, at least to some extent, the exposure of registered investment companies to entrepreneurial risks peculiar to securities-related businesses,” and
  • “to prevent potential conflicts of interest and reciprocal practices,” such as directed brokerage.

The Adviser in the incoming letter successfully argued that the ETF’s proposed investment activities do not raise the concerns that underlie section 12(d)(3) of the 1940 Act if the ETF exceeds the limitations set forth in Rule 12d3-1 under the 1940 Act. The Adviser’s reasons were the same reasons cited above for the ETF’s ability to exceed the limits of section 12(d)(2). The Adviser noted again that the ETF would acquire equity securities in the same approximate proportion as these issuers represent in the Index. The SEC staff therefore agreed that it would not recommend enforcement action under section 12(d)(3) of the 1940 Act against the ETF if the ETF owns securities issued by an equity issuer above the section 12(d)(3) and Rule 12d3-1 thresholds.