Foley Governance and Regulatory Alert: SEC Adopts New Rule for Fund of Funds Arrangements

Foley & Lardner LLP

Foley & Lardner LLPOn October 7, 2020, the Securities and Exchange Commission (“SEC” or “Commission”) adopted a new rule, Rule 12d1-4, and related amendments designed to permit a registered investment company or business development company or “BDC” to acquire the securities of any other registered investment company or BDC in excess of the limits in section 12(d)(1) of the Investment Company Act of 1940.  The related amendments are the following:

  • The SEC is rescinding Rule 12d1-2, which permits funds that primarily invest in funds within the same fund group to invest in unaffiliated funds and non-fund assets.  As a result, funds wishing to create certain types of fund of funds arrangements that exceed the statutory limitations will be required to rely on Rule 12d1-4 and comply with its associated conditions.
  • The SEC is amending Form N-CEN to require funds to report whether they relied on Rule 12d1-4 or the statutory exception in section 12(d)(1)(G) of the Investment Company Act during the applicable reporting period.

The new rule will be effective 60 days after publication in the Federal Register, but, 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 rescission of Rule 12d1-2 and the Commission’s exemptive orders will be effective one year from the effective date of the rule.

Foley will provide an analysis of the new rule, and related insights, in a client alert to be published in the near term.  Meanwhile, the summary of the new rule provided by the SEC is found below. Click HERE to see the full SEC release.

Rule 12d1-4

Rule 12d1-4 will permit a registered investment company or business development company or “BDC” (referred to as “acquiring funds”) to acquire the securities of any other registered investment company or BDC (referred to as “acquired funds”) in excess of the limits in section 12(d)(1) of the Investment Company Act of 1940.  The rule will create a consistent framework for fund of funds arrangements to replace the existing approach, which depends on the Commission’s exemptive orders and varies based on an acquiring fund’s type. Open-end funds, unit investment trusts, closed-end funds (including BDCs), exchange-traded funds and exchange-traded managed funds will all be able to rely on Rule 12d1-4 as both acquiring and acquired funds.

While the rule contains elements from the Commission’s current exemptive orders permitting fund of funds arrangements, it is tailored to enhance investor protections while providing funds with flexibility to meet their investment objectives in an efficient manner.  The rule’s conditions include the following:

  • Limits on Control and Voting.  Rule 12d1-4 will prohibit an acquiring fund from controlling an acquired fund and will require an acquiring fund that holds more than a certain percentage of an acquired fund’s outstanding voting securities to vote those securities in a prescribed manner in order to minimize the influence that an acquiring fund may exercise over an acquired fund.  An acquiring fund that is part of the same fund group as the acquired fund and an acquiring fund that has a sub-adviser that acts as adviser to the acquired fund will not be subject to the control and voting conditions.
  • Required Evaluations and Findings.  To address concerns that an acquiring fund could exert undue influence over an acquired fund or charge duplicative fees and expenses, the rule will require certain evaluations and findings be made before the acquiring fund invests in an acquired fund.  These differ depending upon whether a fund is the acquiring or acquired fund and whether it is a management company, unit investment trust, or a separate account funding variable insurance contracts.
  • Required Fund of Funds Investment Agreements.  In addition, the rule will require funds that do not share the same investment adviser to enter into a fund of funds investment agreement memorializing the terms of the arrangement.  This and the evaluation and finding requirements replace a proposed requirement that would have prohibited an acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares from redeeming more than 3% of the acquired fund’s total outstanding shares in any 30-day period.
  • Limits on Complex Structures.  To limit funds’ ability to use fund of funds arrangements to create overly complex structures, Rule 12d1-4 generally will prohibit funds from creating three-tier fund of funds structures, except in certain circumstances, including an exception that will permit an acquired fund to invest up to 10% of its total assets in other funds (including private funds) without restriction (the “10% bucket”).  The 10% bucket will provide flexibility for fund of funds arrangements to evolve, while permitting certain structures that could benefit investors through greater efficiency. 

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