The Staff of the U.S. Securities and Exchange Commission (SEC) on March 8, 2017 issued a no-action letter (Staff Letter) in response to a request from Dechert LLP for assurance under Section 12(d)(1) of the Investment Company Act of 1940 (1940 Act).1 The Staff Letter provides no-action assurance to global investment managers and sponsors seeking to offer investment products across non-U.S. jurisdictions using a “master-feeder” arrangement that may conflict with certain “fund of funds” restrictions under the 1940 Act. More specifically, the Staff Letter contemplates non-U.S. feeder funds (Non-U.S. Feeder Funds) investing in a single U.S. open-end investment company registered under the 1940 Act (U.S. Master Fund), in excess of the investment restrictions under Section 12(d)(1) of the 1940 Act. The Non-U.S. Feeder Funds would also be permitted to invest in Foreign Currency Instruments (as defined below) that could, among other things, enable the shareholders of a Non-U.S. Feeder Fund to achieve a return on their investment, as measured in the Designated Currency (as defined below), similar to that of the other shareholders of the U.S. Master Fund, as measured in U.S. Dollars, by reducing the impact of currency fluctuations between the Designated Currency and the U.S. Dollar.
The Staff Letter is significant because it removes obstacles under the 1940 Act to efficiently offering a “master-feeder” investment product across non-U.S. jurisdictions, with off-shore feeder funds and a single U.S. registered master fund. However, a number of other obstacles remain. These include legal restrictions in non-U.S. jurisdictions that may limit certain types of Non-U.S. Feeder Funds with respect to investing in other investment funds (including U.S. Master Funds). An investment in a U.S. Master Fund by a Non-U.S. Feeder Fund may also have adverse tax consequences under the Internal Revenue Code (Code), depending on the structure and investment strategy of the U.S. Master Fund.
Section 12(d)(1) of the 1940 Act is designed to address potential abuses and concerns arising from certain “fund of funds” arrangements.2 Generally, under Section 12(d)(1)(A), the acquisition by a registered or unregistered investment company (acquiring fund) of shares of any registered investment company (underlying fund) is limited, at the time of purchase, to:
3% of the underlying fund’s outstanding voting shares;
5% of the acquiring fund’s total assets in any one underlying fund; or
10% of the acquiring fund’s total assets in all underlying funds.3
Section 12(d)(1)(B) imposes complementary restrictions and limits the ability of registered open-end investment companies knowingly to sell their shares to a registered or unregistered investment company.4
However, Section 12(d)(1)(E) provides a conditional exemption from the three restrictions discussed above and permits master-feeder arrangements, subject to the following conditions:
The principal underwriter for the acquiring fund is a broker or dealer registered under the Securities Exchange Act of 1934 (1934 Act) or a person controlled by such broker or dealer;
The only “investment securities” held by the acquiring fund are those of the acquired fund; and
The purchase or acquisition by the acquiring fund is made pursuant to an arrangement with the acquired fund or its principal underwriter whereby the acquiring fund is obligated: (i) to utilize either “pass-through” or “echo” voting;5 and (ii) in the event that the acquiring fund is not a registered investment company under the 1940 Act, to refrain from substituting the acquired fund’s shares unless the SEC approves of the substitution in the manner provided in Section 26 of the 1940 Act.
The Staff Letter provides no-action assurance under Section 12(d)(1) of the 1940 Act to permit:
A Non-U.S. Feeder Fund to acquire (1) shares of a single U.S. Master Fund in excess of the limits in Section 12(d)(1)(A) and (2) Foreign Currency Instruments; and
The U.S. Master Fund, its principal underwriter and any broker or dealer to sell such shares to the Non-U.S. Feeder Fund in excess of the limits in Section 12(d)(1)(B).
The structure above (Proposed Structure) would be subject to several conditions, a number of which are described below, including modified requirements under Section 12(d)(1)(E). In issuing the Staff Letter, the Staff appeared to support the public policy reasons outlined in the Request Letter, including the potential benefit to the U.S. mutual fund industry.
Non-U.S. Feeder Funds and Affiliations Among the Parties
Under the Staff Letter, a Non-U.S. Feeder Fund must be limited to foreign publicly-offered investment vehicles whose securities are generally redeemable upon demand to the fund or foreign publicly-traded investment vehicles whose securities are listed on one or more foreign securities exchanges. Moreover, a Non-U.S. Feeder Fund must be organized in, and regulated under the laws of, a “Permitted Foreign Jurisdiction,” which is a jurisdiction whose securities regulator has entered into a cooperative arrangement with the SEC to facilitate consultation and cooperation between the SEC and the foreign securities regulator.6
In addition, a Non-U.S. Feeder Fund must:
Limit its distribution activities to non-U.S. jurisdictions;7 and
Be managed by either: (i) the registered investment adviser to a U.S. Master Fund or (ii) an investment adviser not registered with the SEC that controls, is controlled by, or is under common control with, the investment adviser to, and the principal underwriter for, a U.S. Master Fund (Feeder Fund Adviser).8
Permissible Hedging by the Non-U.S. Feeder Funds
Notwithstanding the requirement in Section 12(d)(1)(E) that the shares of the U.S. Master Fund must be the only “investment securities” held by a Non-U.S. Feeder Fund, the Non-U.S. Feeder Fund would be permitted to invest in foreign currency and foreign currency-related instruments (Foreign Currency Instruments9) to mitigate the effects of currency fluctuations between or among the currency of the foreign jurisdiction in which shares of the Non-U.S. Feeder Fund are primarily offered and sold (Designated Currency) and the U.S. Dollar and/or other foreign currencies. However, the scope of a Non-U.S. Feeder Fund’s currency hedging would be limited as follows:
For all Non-U.S. Feeder Funds, a Non-U.S. Feeder Fund could seek to hedge the performance of the applicable U.S. Master Fund, as measured in U.S. Dollars, back to its Designated Currency;10 and
For Non-U.S. Feeder Funds that seek to approximate the returns of an index, a Non-U.S. Feeder Fund could seek to hedge the U.S. Dollar and/or foreign currency exposure associated with the applicable U.S. Master Fund’s portfolio holdings back to its Designated Currency, subject to certain conditions discussed in the Staff and Request Letters (including that: (i) the U.S. Master Fund seeks to approximate the returns of an index; (ii) the U.S. Master Fund’s currency exposure does not materially deviate from the currency exposure of the index; and (iii) the index provider is not a first- or second-tier affiliate of the investment adviser to the U.S. Master Fund).11
A Non-U.S. Feeder Fund may purchase Foreign Currency Instruments for the hedging purposes described above and not for speculative purposes (i.e., for the purpose of generating excess investment returns).
SEC Jurisdiction Over the Proposed Structure
Under Section 12(d)(1)(E)(i), the principal underwriter for the acquiring fund must be a broker-dealer registered under the 1934 Act, or a person controlled by such a broker-dealer. Section 12(d)(1)(E)(i) appears designed to ensure that the SEC has sufficient jurisdiction to monitor and pursue claims against a principal underwriter with respect to its activities in connection with an acquiring fund. The Request Letter noted that the Non-U.S. Feeder Funds might not have a principal underwriter that is, or that is controlled by, a broker-dealer registered under the 1934 Act, or, for that matter, might not have any principal underwriter at all.
However, on the basis of the affiliations among the parties to the Proposed Structure (as described above), the Staff accepted that these jurisdictional concerns would be addressed, provided that the Feeder Fund Adviser:
Designates the investment adviser to the U.S. Master Fund as agent in the United States for service of process in any suit, action or proceeding before the SEC or any appropriate court with respect to the Non-U.S. Feeder Fund, and consents to the jurisdiction of the U.S. courts and the SEC with respect to its activities in connection with the Non-U.S. Feeder Fund;
Upon receipt of an administrative subpoena, demand or request for voluntary cooperation made during a routine or special inspection or otherwise with respect to the activities of the Non-U.S. Feeder Fund, promptly provides to the SEC and its Staff copies of its books and records with respect to the activities of the Non-U.S. Feeder Fund (and, to the extent the Feeder Fund Adviser is prohibited by applicable law from doing so, it will use its best efforts to secure permission to do so);12 and
Files with the SEC a written representation, signed by a duly authorized officer, which agrees to these conditions.13
Non-U.S. Feeder Fund Voting
As described above, under Section 12(d)(1)(E), a Non-U.S. Feeder Fund is required to utilize either “pass-through” or “echo” voting. However, the Request Letter stated that a Non-U.S. Feeder Fund might not be able to comply with either the “pass-through” or “echo” voting requirements because the laws and/or market practices of a non-U.S. jurisdiction in which the Non-U.S. Feeder Fund operates may preclude compliance (or could be interpreted to preclude compliance) with these requirements. Accordingly, depending on the circumstances, a Non-U.S. Feeder Fund may: (i) abstain from voting; (ii) withhold voting; or (iii) refrain from voting. The Staff agreed that these alternative voting methods provide the same safeguards against the potential for undue influence as the “pass-through” or “echo” voting requirements under Section 12(d)(1)(E).
A Non-U.S. Feeder Fund must comply with Section 12(d)(1)(E)(iii)(bb) by refraining from substituting its investment in the U.S. Master Fund (i.e., a complete redemption of the shares of one U.S. Master Fund and subsequent purchase of shares of another U.S. Master Fund), unless the SEC has approved the substitution by order issued to the Non-U.S. Feeder Fund. This condition was not modified by the Staff Letter.
Non-U.S. and Tax Issues
The Staff Letter is significant because it removes obstacles under the 1940 Act to efficiently offering a “master-feeder” investment product across non-U.S. jurisdictions, with off-shore feeder funds and a single U.S. registered master fund. However, a number of other obstacles remain. For example, there may be legal restrictions in some non-U.S. jurisdictions that may limit certain types of Non-U.S. Feeder Funds with respect to investing in other investment funds (including U.S. Master Funds). Importantly, under the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, which generally permits retail pooled investment vehicles to be managed and marketed on a cross-border basis in Europe, UCITS are currently prohibited from investing solely in the shares of a U.S. registered investment company. This limitation effectively prohibits the ability of a UCITS to serve as a Non-U.S. Feeder Fund – an unfortunate outcome given the popularity of UCITS in Europe among retail investors.14 Although certain pooled investment vehicles that operate under the Alternative Investment Fund Managers Directive (AIFMD) may serve as a Non-U.S. Feeder Fund, the AIFMD imposes certain limitations that should be considered before relying on the Staff Letter.
Moreover, income distributed by the U.S. Master Fund to a Non-U.S. Feeder Fund would generally be subject to U.S. withholding tax at a rate of 30%. Depending on the tax structure and investment strategies of the funds, such withholding tax may be reduced to the extent distributions by the U.S. Master Fund are derived from certain qualifying sources (e.g., interest income from U.S. borrowers and capital gains from the sale of securities). Additionally, depending on the circumstances, such withholding tax may be reduced under an applicable income tax treaty and/or be creditable against the non-U.S. tax liability of non-U.S. investors in the jurisdictions in which they are tax resident. As such, U.S. Master Funds that are structured to limit the potential impact of U.S. withholding tax may be the most likely funds to avail themselves of the relief provided in the Staff Letter.
The Staff Letter is a significant next step in the evolution of the global “master-feeder” arrangement, and the Staff Letter may permit this type of an arrangement in certain non-U.S. jurisdictions. Global investment managers and sponsors that seek to rely on the Staff Letter should carefully consider all of the conditions outlined in the Staff and Request Letters and understand the unique fund formation, distribution, tax and other requirements in non-U.S. jurisdictions.