8.24.2009 The SEC issued a no-action letter addressing investments by foreign funds into U.S. mutual funds. The foreign funds obtained no-action relief to invest in the U.S. mutual funds in excess of the limits imposed by §§ 12(d)(1)(A)(ii) and (iii) of the Investment Company Act of 1940 (1940 Act).

Section 12(d)(1)(A) of the 1940 Act, in relevant part, generally prohibits an investment company and companies it controls (including unregistered funds) from:

  1. Acquiring more than 3% of a registered investment company’s outstanding voting securities;
  2. Investing more than 5% of its total assets in any one acquired registered investment company; or
  3. Investing more than 10% of its total assets in all acquired investment companies.

Similarly, § 12(d)(1)(B) of the 1940 Act, in relevant part, generally prohibits a registered open-end investment company, its principal underwriter and any other broker-dealer from selling securities to any investment company or companies it controls (including unregistered funds) if the sale will cause:

  1. The acquiring investment company, together with companies it controls, to own more than 3% of the acquired registered investment company’s outstanding voting securities; or
  2. More than 10% of the acquired registered investment company’s voting securities to be owned by investment companies generally.

The SEC’s 1966 report to Congress, analyzing the public policy implications of fund holding companies (PPI Report), described the SEC’s concerns about the rapid growth and abusive practices of Fund of Funds, Ltd., an unregistered fund operated in Geneva, Switzerland, which was marketed to members of the U.S. military stationed overseas and had controlling interests in U.S. registered funds. The PPI Report described a number of abuses relating to fund holding companies. The abuses included:

  1. The pyramiding of voting control in the hands of persons that owned only a nominal stake in the acquired company;
  2. The ability of the acquiring company to exercise undue influence over the adviser of the acquired company through the threat of large-scale redemptions and the concomitant loss of advisory fees received by that adviser;
  3. The difficulty of investors appraising the true value of their investments due to the complex structures involved; and
  4. The layering of sales charges, advisory fees and administrative costs.

The incoming letter successfully argued that permitting the Foreign Funds to invest in U.S. Funds beyond the restrictions imposed by §§ 12(d)(1)(A)(ii) and (iii) of the 1940 Act does not present the potential for harm that Congress sought to address in its 1970 amendments to § 12(d)(1). It further successfully argued that the first two concerns described above, the improper exercise of voting control and undue influence through the threat of redemptions, involve overreaching of an acquired fund and its shareholders. The SEC agreed that these concerns are addressed adequately with respect to the U.S. Funds and their shareholders.

The incoming letter noted that the other concerns described above, duplicative fees and unnecessary complexity, involve harm to an acquiring fund and its shareholders. The SEC agreed that it has no significant regulatory interest in protecting the acquiring funds and their shareholders from such abuses in this case. In support of this contention, the incoming letter represented that the Foreign Funds will not offer or sell their shares in the United States or to U.S. persons and that the Foreign Funds’ transactions with their shareholders will be consistent with the definition of “offshore transactions” in Regulation S.

The SEC stated in the no-action letter that permitting the Foreign Funds to invest in U.S. Funds beyond the restrictions imposed by §§ 12(d)(1)(A)(ii) and (iii) does not present the potential for harm that Congress sought to address in its 1970 amendments to § 12(d)(1). The no-action letter was conditioned on the following representations:

  • Each Foreign Fund will comply with the restrictions of § 12(d)(1)(A)(i) of the 1940 Act;
  • Each Foreign Fund will not offer or sell securities in the United States or to any U.S. person;
  • Each Foreign Fund’s transactions with its shareholders will be consistent with the definition of “offshore transactions” in Regulation S under the Securities Act of 1933; and
  • Each U.S. Fund will comply with the restrictions of § 12(d)(1)(B) of the 1940 Act.

Click http://www.sec.gov/divisions/investment/noaction/2009/dechert082409.htm to access the no-action letter.