On June 20, 2006, the SEC adopted several new exemptive rules under Sections 12 and 17 of the 1940 Act. See Investment Company Release No. 27399. While these new rules are principally aimed at “fund of funds,” in the release, the SEC also amended the investment company registration statement forms to mandate new disclosure regarding the fees and expenses of underlying investment companies and private funds in which a registrant invests. While the new disclosure was designed to provide shareholders with transparency into fund of fund expenses, the disclosure requirement is broad enough to apply to nonfund of funds that utilize other investment companies and private funds as cash sweep vehicles, investment vehicles for securities lending collateral, or otherwise. All new registration statements and post-effective amendments filed on or after January 2, 2007 are subject to the new disclosure requirements.
Pursuant to the new disclosure requirements, registered investment companies must disclose in their prospectus fee tables the aggregate direct and indirect fees and expenses of any “Acquired Funds” in which they invest, computed pursuant to a formula set forth in the appropriate registration statement form. An “Acquired Fund” is defined as any company in which the registrant invests, or intends to invest, that: (a) is an investment company; or (b) would be an investment company but for sections 3(c)(1) or 3(c)(7) of the 1940 Act.
The aggregate fees and expenses, expressed as a percentage of net assets, generally must be shown as a separate line item. However, the instructions provide that if the aggregate fees and expenses attributable to Acquired Funds do not exceed one basis point of the average net assets of the registrant, Acquired Fund fees and expenses may be included in “other expenses” in the fee table rather than shown as a separate item. Nevertheless, because the Acquired Fund fees and expenses still need to be calculated in accordance with the instructions and included in the fund’s expenses, a fund’s total operating expenses could be affected by the inclusion of Acquired Fund fees and expenses, even if such fees and expenses fall below the one basis point de minimis threshold.
The instructions require that a registrant aggregate the annual operating expenses and transaction fees of Acquired Funds that it directly or indirectly paid. In order to calculate the operating expenses, a fund is required to use the net expense ratio of an Acquired Fund as published in its most recent shareholder report. If an Acquired Fund is a newly formed fund or it did not publish an expense ratio in the most recent shareholder report, then a registrant should use information disclosed in the most recent communication (e.g., prospectus, semi-annual report or similar document) from the Acquired Fund to the registrant. If the Acquired Fund has no operating history, then any fees payable to the Acquired Fund’s investment adviser or affiliates as stated in the Acquired Fund’s prospectus, offering memorandum or similar document should be used.
The SEC acknowledged in the release that this amendment to the expense table could cause a discrepancy between the total operating expenses of a fund shown in the fee table and the expense ratio disclosed in the fund’s financial highlights. In order to address the possible shareholder confusion that could occur as a result of this discrepancy, the SEC will permit a clarifying footnote to the fee table explaining any difference.
This new disclosure obligation has raised numerous questions for the industry. In response to some of the uncertainty, the staff of the SEC has recently confirmed that the definition of an Acquired Fund is not intended to include structured finance products, collateralized debt obligations and other securities not typically thought of as pooled investment vehicles. Additionally, the SEC staff has invited industry suggestions on how to distinguish between pooled products and other types of securities that could unintentionally fall within the definition of an Acquired Fund. However, because the compliance date for the new disclosure requirement has now passed, it is important that funds that invest in any underlying pooled products, regardless of amount, work with their fund accountants, administrators and legal counsel in order to ensure proper and accurate disclosure in all new fund filings and annual updates to registration statements.