A step forward: SEC streamlines fund of funds arrangements for BDCs and closed-end funds

Eversheds Sutherland (US) LLP

On October 7, 2020, the US Securities and Exchange Commission (the SEC) announced that it voted to adopt new rule 12d1-4 (Rule 12d1-4) under the 1940 Act1 and related amendments (the Final Rule) to streamline and enhance the regulatory framework that applies to funds that invest in other funds (i.e., fund of funds structures).2 Rule 12d1-4 and related amendments were initially proposed in December 2018 (the Proposed Rule) and the SEC adopted the Final Rule with certain modifications to the Proposed Rule.3

Rule 12d1-4 allows a regulated fund, including both closed-end funds registered under the 1940 Act (CEFs) and business development companies (BDCs), to acquire shares of another regulated fund in excess of the limits currently imposed by Section 12(d)(1)(A). Importantly, Rule 12d1-4 permits such fund of funds arrangements without obtaining an individual exemptive order from the SEC, provided certain conditions are met. The Final Rule will go into effect 60 days after publication in the Federal Register, which has not been published as of the date hereof.

Notably, the Proposed Rule had sought comments on existing Acquired Fund Fees and Expenses (AFFE) disclosure requirements (the AFFE Rule), including whether to exempt BDCs from the AFFE Rule or modify the application of the AFFE Rule to BDCs. However, the Final Rule ultimately did not address AFFE disclosure requirements, as discussed further below.

This Legal Alert focuses on those aspects of the Final Rule that are likely to be important to BDCs and CEFs. Most funds of funds that exist today involve a structure where the acquiring or “top tier” fund is an open-end fund. These funds of funds operate pursuant to various exemptive rules and individual fund of funds exemptive orders (referred to as Existing Relief). Note that this Legal Alert does not discuss every way the Final Rule, related amendments, and, most notably, the rescission of rule 12d1-2 and the Existing Relief, alter the way that current funds of funds operate in some significant ways that are not discussed in this Legal Alert.

Scope of the Final Rule

The Final Rule permits registered investment companies (including mutual funds, unit investment trusts (UITs), CEFs (listed and unlisted), exchange-traded funds and exchange-traded mutual funds) and BDCs to acquire the securities of any other registered investment company or BDC in excess of the limits in Section 12(d)(1)(A).

Currently, these limits prohibit a registered fund from:

  • acquiring more than 3% of another fund’s outstanding voting securities;
  • investing more than 5% of its total assets in any one fund; or
  • investing more than 10% of its total assets in funds generally.

Additional highlights of the Final Rule include:This regulatory regime, coupled with Existing Relief and certain statutory exemptions, has resulted in the existence of substantially similar funds of funds arrangements that are subject to different conditions. The Final Rule creates a more efficient and consistent regulatory framework by allowing CEFs and BDCs to acquire the securities of other regulated funds in excess of such limits if the conditions described below are met.

  • BDCs and CEFs Can Serve as “Top-Tier Funds”: Significantly, in an expansion of what is permitted under Existing Relief, the Final Rule allows both CEFs and BDCs to serve as acquiring or “top-tier” funds. However, despite receiving numerous comments on the topic, the Final Rule does not allow private funds to act as acquiring funds. As a result, a private fund may not acquire more than 3% of a regulated fund under the Final Rule. The Final Rule explains the SEC’s view that private funds are not appropriate beneficiaries of the Final Rule because they are not registered with the SEC and would not be subject to SEC periodic reporting requirements. The Final Rule also notes that requiring private funds to pursue the exemptive application process to obtain relief from the general prohibitions in Section 12(d)(1)(A) allows the SEC to design protective conditions that address the unique concerns posed by private funds. For similar reasons, the Final Rule does not include foreign funds.
  • Non-Listed BDCs and CEFs Can Serve as “Underlying Funds”: Additionally, in another expansion of Existing Relief, the Final Rule permits the acquisition of both listed BDCs and CEFs (currently permitted under some Existing Relief) and non-listed BDCs and CEFs (not generally permitted under Existing Relief) beyond the current limits in Section 12(d)(1)(A).


BDCs and CEFs intending to rely on the Final Rule will be required to comply with a number of conditions designed to protect investors from the potential abuses that led to the enactment of Section 12(d)(1), such as concerns related to undue influence and excessive fees. While these conditions are similar to the conditions currently contained in Existing Relief, they are not identical.

The conditions of the Final Rule include:


To address the concern that a fund could exert undue influence over another fund, the Final Rule prohibits an acquiring fund and its “advisory group” from controlling—individually or in the aggregate—an acquired fund, except in certain limited circumstances. The Final Rule defines “advisory group” to mean an acquiring fund’s investment adviser or investment sub-adviser, and any person controlling, controlled by, or under common control with such investment adviser or investment sub-adviser.

Defining “Control”: The 1940 Act defines control as the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with the company.4 The 1940 Act also establishes a rebuttable presumption of control with respect to any person or group that directly or indirectly beneficially owns more than 25% of the voting securities of a company that controls the company.5

Note that the SEC may make a determination that a “controlling influence” exists even if the acquiring fund and its advisory group owns less than 25% of the acquired fund’s voting securities. The SEC’s determination of control depends on the facts and circumstances of each situation. For instance, the SEC has previously held that a controlling influence may exist if the following factors are present:

  • a dominating persuasiveness of one or more persons;
  • the act or process that is effective in checking or directing action or exercising restraint or preventing free action; and
  • the latent existence of power to exert a controlling influence.

Voting Requirements: To further limit the ability of an acquiring fund to exert influence over an acquired fund, the Final Rule requires an acquiring fund and its advisory group to vote their shares of an acquired fund using mirror voting if the acquiring fund and its advisory group (in the aggregate) hold more than (i) 10% of the outstanding voting securities in an acquired CEF or BDC, and (ii) more than 25% of the outstanding voting securities of an acquired open-end fund or UIT due to a decrease in the outstanding securities of the acquired fund. “Mirror voting” means that an acquiring fund would vote the shares it holds of an acquired fund in the same proportion as the vote of all other holders of the shares of such acquired fund. In situations where Rule 12d1-4 or Section 12(d)(1) would require all of the security holders of an acquired fund to engage in mirror voting (e.g., if an acquired fund is offered solely to acquiring funds), pass-through voting will be required instead. “Pass-through voting” means that an acquiring fund would seek instructions from its own underlying security holders with regard to the voting of all proxies with respect to the shares it holds of an acquired fund, and would vote such proxies only in accordance with such instructions.

These voting restrictions under the Final Rule are intended to prevent activist investors from seeking to use one fund to gain control of another unaffiliated fund through voting power.

Required findings

After considering the comments received on the Proposed Rule, the SEC chose not to adopt the redemption limitation in the Proposed Rule that would have prohibited an acquiring fund that holds more than 3% of an acquired fund’s total outstanding shares from redeeming or tendering for repurchase more than 3% of the acquired fund’s total outstanding shares in any 30-day period.

In lieu of such redemption limitation condition, the Final Rule instead requires an investment agreement (discussed below) and the following two findings to be made:

  • an acquired management company’s investment adviser to make certain findings focused on addressing undue influence concerns, including through redemptions, by considering specific enumerated factors, including:
    • the scale of contemplated investments by the acquiring fund and any maximum investment limits;
    • the anticipated timing of redemption requests by the acquiring fund;
    • whether, and under what circumstances, the acquiring fund will provide advance notification of investment and redemptions; and
    • the circumstances under which the acquired fund may elect to satisfy redemption requests in kind rather than in cash and the terms of any redemptions in kind; and
  • an acquiring fund’s investment adviser to make a finding that the aggregate fees and expenses payable pursuant to the fund of funds structure are not duplicative, as described further below.

Duplicative fees and other considerations

To address the concern that a fund of funds structure would result in duplicative or excessive fees, the Final Rule requires the investment adviser to an acquiring fund that is a BDC or CEF to evaluate the complexity of the arrangement and associated fees and expenses, and specifically find that the acquiring fund’s fees and expenses do not duplicate the fees and expenses of the acquired fund (as opposed to the general best interest determination that would have been required by the Proposed Rule). The investment adviser’s findings and the basis thereof would need to be reported to the acquiring fund’s board of directors at the next regularly scheduled board meeting following the investment. Note that the Final Rule includes more board reporting flexibility as compared to the Proposed Rule, which would have required that the acquiring fund’s investment adviser report its findings to the acquiring fund’s board of directors prior to making the initial investment.

Note that imposing responsibility for these determinations on the investment adviser, and not the board, is in keeping with the SEC’s recent efforts to refocus regulatory requirements imposed on fund boards to an oversight function, rather than day-to-day management responsibilities.

The SEC believes that such required findings will protect investors and address concerns over the exercise of undue influence, including the threat of large-scale redemptions as a means of exerting control over the acquired fund.

Fund of Funds investment agreements

In addition, the Final Rule requires an acquiring fund and an acquired fund that do not share the same investment adviser to enter into a fund of funds investment agreement memorializing the terms of the arrangement, including the terms that serve as the basis for the required findings condition. This condition replaces, in part, the redemption limitation condition that had been included in the Proposed Rule and is similar to the type of agreement required by most Existing Relief.

Complex structures

To limit the ability of funds to use fund of funds arrangements to create overly complex structures, the Final Rule includes, as proposed, a condition designed to limit fund of funds arrangements where the acquired fund is itself already an acquiring fund, subject to certain enumerated exceptions, including securities of an investment company that is:

  • acquired in reliance on Section 12(d)(1)(E) (i.e., master-feeder arrangements);
  • acquired pursuant to rule 12d1-1;
  • a subsidiary wholly owned and controlled by the acquired fund;
  • received as a dividend or as a result of a plan of reorganization of a company; or
  • acquired pursuant to exemptive relief from the SEC to engage in interfund borrowing and lending transactions.

However, in order to allow the acquired fund additional flexibility, the Final Rule contains an exception that permits an acquired fund to invest up to 10% of its total assets in other funds without restriction on the purpose of the investment, the type of fund, or the percentage of any underlying fund’s assets held by the acquiring fund (i.e., the 10% Bucket).

Purpose of the conditions

In sum, while an initial reading of this Final Rule may raise concerns that a hostile takeover of a regulated fund such as a BDC or CEF could become more likely or easier to accomplish, the foregoing conditions may prevent such a scenario from arising. For instance, it is unlikely that the Final Rule will meaningfully change the activism landscape given the unlikelihood that an activist shareholder and a regulated fund would agree upon the terms of the required investment agreement described above, and that activist funds could have already obtained the Existing Relief for this purpose. Therefore, while the Final Rule does provide more flexibility for BDCs and CEFs to use fund of funds arrangements, these conditions serve to address concerns such as undue influence and excessive fees and also may help prevent certain hostile intentions from becoming credible threats.

AFFE Rule not addressed

Of particular interest to BDCs, while the Proposed Rule requested comments regarding the AFFE Rule, the Final Rule did not rescind or otherwise modify the AFFE Rule. The AFFE Rule currently requires registered funds that invest in other funds (including BDCs) to include a separate AFFE line item in the “Fees and Expenses” table contained in their SEC disclosure documents. This separate AFFE line item must include the registered fund’s pro rata share of the “acquired fund’s” expenses (including interest expense), which is then added to the registered fund’s overall expense ratio. In approving the AFFE Rule in 2006, the SEC noted its belief that the AFFE Rule would not have “an adverse impact on capital formation.” However, in 2014, Standard and Poor’s and Russell Investment Group removed BDCs from prominent indices, due in part to concerns cited by their registered fund clients regarding the impact of the AFFE Rule on their overall expense ratios as a result of the inclusion of BDCs therein.

In the Final Rule, the SEC indicated that it would not be addressing AFFE disclosure requirements as part of this rulemaking. However, the SEC is still considering modifications to AFFE disclosure as part of its “Investor Experience Proposal,” a separate proposed rule relating to how open-end funds disclose fees in their prospectuses.6 The Investor Experience Proposal includes a provision to permit open-end funds that invest 10% or less of their total assets in acquired funds to omit AFFE from the fund’s bottom-line expenses in the fee table and instead disclose the amount of the fund’s AFFE in a footnote to the Fees and Expenses table. The SEC also requested comment on whether to apply this new provision only to open-end funds or to other types of investment companies, such as BDCs and CEFs.

Additionally, legislation is pending in Congress that, if passed, would exempt BDCs from the AFFE Rule.7 The Access to Small Business Investor Capital Act would require the SEC to adopt rules relating to investment company registration statements to specify that, when calculating the fees and expenses of an acquired fund, the term “acquired fund” does not include a BDC.

As a result of the Investor Experience Proposal and Access to Small Business Investor Capital Act, the momentum to make changes to minimize the impact of the AFFE Rule on BDCs seems to remain.

Compliance dates

As noted above, the Final Rule will be effective 60 days after publication in the Federal Register (the Final Rule has not yet been published in the Federal Register as of the date hereof).

The Final Rule also amends Form N-CEN to require CEFs to report whether they relied on new Rule 12d1-4 during the applicable reporting period. In order to facilitate a transition period, the compliance date for the amendments to Form N-CEN will be 425 days after publication in the Federal Register.


The Final Rule provides flexibility for BDCs and CEFs to utilize fund of funds arrangements without the need to seek individualized exemptive relief, so long as the arrangements satisfy the conditions of the Final Rule. The Final Rule serves to open more investment channels for BDCs and CEFs, as well as make it easier for funds to incrementally invest in such regulated funds. While the amount of interest in taking advantage of the Final Rule remains unclear, especially given the condition requiring the negotiation of a fund of funds investment agreement, the Final Rule certainly provides a step towards greater investment flexibility for BDCs and CEFs.


1 The term “1940 Act” refers to the Investment Company Act of 1940, as amended. Any section or rule references within this alert refer to the 1940 Act and the rules promulgated thereunder unless otherwise stated.
2 Final Rule on Fund of Fund Arrangements, Rel. No. 33-10871 (Oct. 7, 2020).
3 For more information on the Proposed Rule, please see the prior Eversheds Sutherland legal alert, available here.
4 See 15 U.S.C. 80a-2(a)(9).
5 Id.
6 See Tailored Shareholder Reports, Treatment of Annual Prospectus Updates for Existing Investors, and Improved Fee and Risk Disclosure for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, Investment Company Act Release No. 33963 (Aug. 5, 2020) (the Investor Experience Proposal). Comments to the Investor Experience Proposal are due 60 days after publication in the Federal Register. The full text of the Investor Experience Proposal is available here. For more information on the Investor Experience Proposal, please see the prior Eversheds Sutherland legal alert, available here.
7 See Access to Small Business Investor Capital Act, H.R. 7375, 116th Cong. (2020). The full text of the pending legislation is available here.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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