On December 19, 2018, the SEC proposed new Rule 12d1-4 under the Investment Company Act of 1940, which, if adopted, would permit a fund to acquire shares of another fund in excess of the limits of Section 12(d)(1) of the 1940 Act without obtaining a separate exemptive order from the SEC and would expand the types of permissible fund-of-funds arrangements. In connection with the new rule, the SEC would rescind current Rule 12d1-2 under the 1940 Act and most existing fund-of-fund exemptive orders granted under Section 12(d)(1) and would make certain amendments to Rule 12d1-1 and Form N-CEN.

Section 12(d)(1) of the 1940 Act generally prohibits any registered fund (the acquiring fund) from (1) acquiring more than 3% of another fund's (the acquired fund's) outstanding voting securities (the 3% Limit); (2) investing more than 5% of its assets in any one fund; and (3) investing more than 10% of its total assets in funds generally. These limits apply to both registered and unregistered funds with respect to their investments in a registered fund, and to a registered fund with respect to its investment in an unregistered fund. At present, many funds have obtained separate exemptive orders under Section 12(d)(1) to enable investments beyond these limitations. Proposed Rule 12d1-4 would implement a consistent regulatory framework for funds-of-funds.

A fund relying on Rule 12d1-4 would be required to comply with certain conditions. These conditions would generally be similar to those under existing fund-of-funds exemptive orders:

  • Control and Voting. An acquiring fund and its advisory group (i.e., the fund's investment adviser or sub-adviser and its controlling persons) would be prohibited from controlling, individually or in the aggregate, an acquired fund. Once invested in an acquired fund above the 3% Limit, an acquiring fund would be required to either (1) seek voting instructions from its shareholders and vote 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). 
  • Redemption Limits. An acquiring fund that invests in an acquired fund’s shares above the 3% Limit would be prohibited from redeeming more than 3% of the acquired fund’s total outstanding shares in any 30-day period. This condition would replace the requirement under existing exemptive orders for fund boards to make certain findings and adopt procedures to prevent overreaching by the acquiring fund and its affiliates. This condition would also eliminate the need for participation agreements between acquiring funds and acquired funds. 
  • Fees. Before investing in an acquired fund and at least annually thereafter, an acquiring fund’s adviser would be required to determine that the investment is in the acquiring fund’s best interest, considering the complexity of and the aggregate fees associated with the resulting fund-of-funds structure. The adviser would be required to report its findings and the basis therefor to the acquiring fund’s board.  
  • Complexity of Arrangement. Fund-of-funds arrangements would be limited to two-tiered structures (other than in limited circumstances). Accordingly, a fund relying on the proposed rule—or one that wants to preserve the flexibility to do so—would be required to disclose in its registration statement that it is (or may be) an acquiring fund for purposes of Rule 12d1-4. 

Current Rule 12d1-2 provides additional flexibility to funds that invest in funds within the same fund group (in reliance on Section 12(d)(1)(G) of the 1940 Act) to invest in unaffiliated funds and other types of securities. In proposing Rule 12d1-4, the SEC proposed rescinding Rule 12d1-2 following a one-year grace period following the adoption of Rule 12d1-4. The SEC also proposed amending Rule 12d1-1 to enable funds relying on Section 12(d)(1)(G) to continue to invest in an unlimited amount of unaffiliated money market funds (e.g., cash sweep arrangements).

The SEC also proposed an amendment to Form N-CEN that would require funds to report that they relied on Rule 12d1-4 or the statutory exemption in Section 12(d)(1)(G) during the applicable reporting period.

Comments on the proposed rule and related amendments are due 90 days after publication of the proposing release in the Federal Register. 

The proposing release is available at: https://www.sec.gov/rules/proposed/2018/33-10590.pdf