Key Notes:

  • Proposed Rule 12d1-4 streamlines rules for registered fund of funds arrangements by allowing a registered investment company to acquire other registered investment companies and business development companies without the limitations of Rules 12d1-1, 12d1-2 and 12d1-3, but imposes additional conditions on fund of funds arrangements.
  • In light of the Proposed Rule and its conditions, the SEC proposes rescinding Rule 12d1-2 and exemptive orders permitting fund of funds arrangements and amending Rule 12d1-1.
  • The SEC also proposes amending Form N-CEN’s reporting requirements to include disclosure of whether a fund of funds relied on the Proposed Rule during the reporting period.

On December 19, 2018, the Securities and Exchange Commission (SEC) proposed Rule 12d1-4 (Proposed Rule) under the Investment Company Act of 1940, as amended, (1940 Act) to streamline rules for registered fund of funds arrangements. The Proposed Rule would allow registered investment companies to acquire other registered investment companies and business development companies without the limitations of Rules 12d1-1, 12d1-2 and 12d1-3 (FoF Rules), but would impose additional conditions on fund of funds arrangements.

FoF Rules

Funds invest in other funds to meet asset allocation, diversification or other investment objectives. The SEC adopted the FoF Rules to address fund of funds arrangements and prevent investors of an acquiring fund from controlling the assets of the acquired fund, and to shield against excessive fees. Over time, Congress created statutory exceptions to, and the SEC issued exemptive orders from, the FoF Rules. This combination of statutory exceptions and exemptive orders created a regulatory regime where substantially similar fund of funds arrangements are subject to different conditions.

Proposed Rule

The Proposed Rule and related amendments create a consistent, rules-based framework for fund of funds arrangements to follow that is designed to provide additional protections for investors. The Proposed Rule permits a registered investment company to acquire other registered investment companies and business development companies without regard to the FoF Rules’ limitations. It also allows open-end funds, unit investment trusts (UITs), exchange-traded funds and exchange-traded mutual funds to be acquiring or acquired funds, and it provides exemptive relief from Section 17(a) of the 1940 Act, which prohibits an affiliated person of a fund from selling or purchasing any security or property of the fund. The Proposed Rule excludes private funds and unregistered investment companies.

Under the Proposed Rule, fund of funds arrangements must meet the following conditions:

  • Control. An acquiring fund may not exercise control over the acquired fund. The SEC will presume control when the acquiring fund’s beneficial ownership of the acquired fund’s voting securities is 25% or more. An acquiring fund that owns more than 3% of the acquired fund’s voting securities must vote those securities in accordance with instructions from the security holders or in the same proportion as the other security holders vote.
  • Redemptions. An acquiring fund owning more than 3% of an acquired fund’s shares may not redeem more than 3% of the acquired fund’s shares over a 30-day period. The Proposed Rule does not require the acquired fund to track whether a redemption order was submitted in violation of this condition.
  • Excessive fees. An acquiring fund’s adviser must determine that it is in the fund’s best interest to invest in an acquired fund. Likewise, when the acquiring fund is a UIT, the UIT’s principal underwriter must evaluate the complexity of the structure and the aggregate fees associated with the acquired fund and find that the UIT’s fees do not duplicate the acquired fund’s fees. Separate accounts funding variable insurance contracts that invest in an acquiring fund are required to obtain an insurance company’s certification that the fees borne by the separate account, acquiring fund and acquired fund are not excessive. The Proposed Rule imposes recordkeeping requirements for these determinations.
  • Complex structures. An acquiring fund cannot also be an acquired fund unless another fund invests all of its assets in the acquiring fund, or another fund acquires less than 3% of the acquiring fund. Likewise, an acquired fund cannot also be an acquiring fund except in certain enumerated circumstances.

Proposed Rescission of Rule 12d1-2 and Amendments to Rule 12d1-1

Rule 12d1-2 allows a fund relying on Section 12(d)(1)(G) of the 1940 Act to acquire securities of funds within the same fund group to also acquire securities of unaffiliated funds. The SEC proposes rescinding Rule 12d1-2 and exemptive orders permitting fund of funds arrangements in favor of requiring such fund of funds arrangements to rely instead on the Proposed Rule and comply with its conditions. The SEC also proposes amending Rule 12d1-1 to permit a fund of funds that invests in underlying funds within the same fund group to continue to invest in an unlimited amount of unaffiliated money market funds.

Proposed Amendment to Form N-CEN

In addition, the SEC proposes requiring a fund of funds to report on Form N-CEN whether it relied on the Proposed Rule or Section 12(d)(1)(G) of the 1940 Act during each reporting period.

While the SEC has provided a 90-day comment period, it voted unanimously to propose the Proposed Rule and the related amendments. The Proposed Rule may create cost efficiencies and reduce delays by eliminating the need for certain acquiring funds to obtain individual SEC exemptive relief, while providing some flexibility for funds of funds. Although the SEC’s recent proposal is aimed at streamlining the multitude of exemptive orders and, as a result, the often inconsistent rules, some conditions and the rescission of exemptive relief orders may create additional problems for fund of funds arrangements that rely on those exemptive orders.