On October 7, 2020, the US Securities and Exchange Commission (SEC) adopted Rule 12d1-4 (Rule) under the Investment Company Act of 1940 (Act) and related amendments (Amendments) that are collectively designed to provide a more consistent and efficient regulatory framework for funds that invest in other funds (“fund of funds” arrangements). The SEC is also rescinding Rule 12d1-2 under the Act, rescinding most exemptive orders granting relief from Sections 12(d)(1)(A), (B), (C), and (G) of the Act, and withdrawing its no-action letters related to Section 12(d)(1) that fall within the scope of the Rule. In addition, the SEC adopted related amendments to Rule 12d1-1 and Form N-CEN.
The changes were first proposed in December 2018 (Proposal), and the Rule, as adopted, includes several modifications to the Proposal that the SEC made in response to the more than 100 comment letters that it received on the Proposal.
EFFECTIVE AND COMPLIANCE DATES
The Rule and the Amendments will be effective 60 days after publication in the Federal Register, and 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 applicable existing exemptive orders, and the withdrawal of the applicable no-action letters, will be effective one year after the effective date of the Rule and the Amendments. Funds of funds that are currently relying on affected exemptive orders or Rule 12d1-2 will have that one year to amend their compliance programs and transition to the Rule.
APPLICABILITY OF THE RULE
The Rule is available to registered funds and business development companies (BDCs) seeking to invest in other registered funds and BDCs beyond the limits currently imposed by Section 12(d)(1) of the Act. Unregistered funds, such as private funds and foreign investment companies, are not permitted to rely on the Rule.
FUND OF FUNDS ARRANGEMENTS
Section 12(d)(1) of the Act places limits on the investments that funds may make in other funds. Specifically, Section 12(d)(1)(A) prohibits a registered fund from: (i) acquiring more than 3% of another fund’s outstanding voting securities; (ii) investing more than 5% of its total assets in any single fund; or (iii) investing more than 10% of its total assets in funds generally. The SEC has, however, adopted rules and issued various exemptive orders permitting fund of funds arrangements in excess of these limits. As a result, the SEC believes that the current mix of exemptive rules and exemptive relief, as well as two statutory exceptions to the Section 12(d)(1)(A) limits, has led to a regulatory regime with a variety of different fund of funds arrangements that are subject to a wide variety of conditions.
In adopting the Rule and related Amendments, the SEC sought to “eliminate the existing overlapping and potentially inconsistent conditions for funds of funds and to harmonize conditions across different fund arrangements.” To this end, the Rule has the effect of limiting fund of funds arrangements to three types:
- Funds that rely on the Rule;
- Funds that rely on, and comply with the restrictions of Section 12(d)(1)(G) of the Act and, if necessary, Rule 12d1-1 thereunder, as amended; and
- Funds that rely on, and comply with the restrictions of, Section 12(d)(1)(F) of the Act and, if necessary, Rule 12d1-3 thereunder.
CONDITIONS OF THE RULE
The Rule will permit a fund (acquiring fund) to acquire the shares of another fund (acquired fund) in excess of the Section 12(d)(1)(A) limits described above. To rely on the Rule, a fund will have to satisfy, among others, the following conditions:
Control and Voting
- Similar to existing exemptive relief, the Rule prohibits an acquiring fund and its advisory group from controlling an acquired fund. Accordingly, an acquiring fund and its advisory group could own up to 25% of the outstanding shares of an acquired fund. If, due to redemptions, the acquiring fund and its advisory group’s position in an acquired fund becomes more than 25% of the outstanding shares, the acquiring fund would be prohibited from making additional purchases of the acquired fund.
- An acquiring fund and its advisory group are required 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) 25% of the outstanding voting securities of an acquired open-end fund or unit investment trust due to a decrease in the outstanding securities of the acquired fund; and (ii) 10% of the outstanding voting securities of an acquired closed-end fund or BDC.
- Similar to Section 12(d)(1)(G), the mirror voting requirement would not apply if the acquiring fund is in the same group of investment companies as the acquired fund. It also would not apply if the sub-adviser of the acquiring fund, or any person controlling, controlled by, or under common control with the sub-adviser is the acquired fund’s investment adviser or depositor.
- Pass-through voting can be used only if mirror voting is not possible, such as when an acquired fund is only offered to acquiring funds relying on the Rule.
Evaluations and Fund Findings
Before an acquiring fund initially acquires more than 3% of an acquired fund’s voting shares, the investment advisers of both the acquiring fund and the acquired fund must evaluate and make certain findings, subject to each adviser’s fiduciary duty to act in the best interest of each fund it advises, regarding the fund of funds arrangement. This condition, coupled with the “investment agreement” discussed below, replaces the proposed limitation on redemptions by an acquiring fund, which was perhaps the most widely opposed part of the Proposal.
- Acquiring Fund. An acquiring fund adviser must conduct an evaluation of the complexity of the fund of funds structure and its aggregate fees and expenses, and make a finding that the fees and expenses are not duplicative.
- In evaluating the complexity of a fund of funds structure, an acquiring fund adviser should consider (1) the complexity of the acquiring fund’s investment in an acquired fund versus direct investment in assets similar to the acquired fund’s holdings; (2) whether the resulting structure would make it difficult for shareholders to appreciate the fund’s exposures and risks or circumvent the acquiring fund’s investment restrictions and limitations; and (3) whether an acquired fund invests in other funds, which may create additional complexity.
- In evaluating the fees associated with the fund’s investment in acquired funds, an adviser should consider the fees of both the acquiring and acquired funds within the fund of funds arrangement with an eye towards duplication, including whether the acquired fund’s advisory fees are for services that are in addition to, rather than duplicative of, the adviser’s own services to the acquiring fund. The adviser also should consider the other fees and expenses, such as sales charges, recordkeeping fees, sub-transfer agency services, and fees for other administrative services.
- Acquired Fund. An acquired fund adviser must find that any concerns of undue influence associated with the acquiring fund’s investment are reasonably addressed after considering certain specified factors.
- These factors include (1) the scale of contemplated investments by the acquiring fund and any maximum investment limits; (2) the anticipated timing of redemption requests by the acquiring fund; (3) whether, and under what circumstances, the acquiring fund will provide advance notification of investments and redemptions; and (4) 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. These are not the only factors that an acquired fund adviser can consider and the Rule does not dictate how the adviser must evaluate or weigh these factors, but they are designed to focus the analysis on potential ways to reduce the threat of undue influence, including through redemptions, when an acquiring fund invests in the acquired fund beyond the Section 12(d)(1) limits under the Rule.
- In addition to the factors described above, an acquired fund’s adviser must also consider any other relevant regulatory requirements when evaluating a fund of funds arrangement, such as how the adviser will manage the fund’s liquidity risk management program required by Rule 22e-4 under the Act.
- Board Reporting. Each adviser must report its evaluation, findings, and the basis for its evaluation or findings to the fund’s board of directors no later than the next regularly scheduled board meeting.
Fund of Funds Investment Agreements
- The acquiring fund and the acquired fund must enter into a fund of funds investment agreement prior to the acquiring fund acquiring securities of the acquired fund in excess of the limits of Section 12(d)(1) in reliance on the Rule. If both funds have the same investment adviser, an investment agreement is not required but the funds must still memorialize the arrangements that led the adviser to make the required findings for each fund under the Rule.
- A fund of funds investment agreement must include: (1) any material terms necessary for the advisers to make the findings discussed above; (2) a termination provision whereby either party can terminate the agreement with advance written notice within a period no longer than 60 days; and (3) a provision requiring an acquired fund to provide the acquiring fund with fee and expense information to the extent reasonably requested.
Complex Fund Structures
- The Rule restricts the ability to establish three-tier fund of fund structures by limiting (1) the ability of other funds to acquire shares of an acquiring fund that relies on the Rule, and (2) the ability of an acquired fund to invest in other funds. The Rule, however, does include certain enumerated exceptions that allow an acquired fund to invest in other funds, including: (1) securities acquired in reliance on Section 12(d)(1)(E) of the Act (i.e., master-feeder arrangements); (2) investments in money market funds in reliance on Rule 12d1-1 (as further discussed below); (3) acquiring securities of a fund that is wholly owned and controlled by the acquired fund (e.g., a wholly-owned subsidiary that is organized under the laws of a non-US jurisdiction in order to invest in commodity-related instruments); (4) securities received as a dividend or as a result of a plan of reorganization of a fund; or (5) securities acquired pursuant to certain interfund borrowing and lending transactions.
- In addition to the exceptions listed above, the Rule provides additional flexibility by permitting an acquired fund that invests up to 10% of its total assets in other funds, including private funds, regardless of the size of the investment in any one fund.
RESCISSION OF EXISTING EXEMPTIVE ORDERS AND WITHDRAWAL OF NO-ACTION LETTERS
In connection with the adoption of the Rule and Amendments, the SEC is rescinding the exemptive relief previously granted to permit fund of funds arrangements that fall within the scope of the Rule. The exemptive orders covered by the rescission include all orders granting relief from Sections 12(d)(1)(A), (B), (C), and (G) of the Act with one exception – the exemptive orders permitting certain interfund lending arrangements are not being rescinded. In addition, the SEC is withdrawing its no-action letters related to Section 12(d)(1) that fall within the scope of the Rule.
RESCISSION OF RULE 12d1-2
The SEC is also rescinding Rule 12d1-2, which permits a fund of funds relying on Section 12(d)(1)(G) of the Act to (i) invest in securities of funds that are not part of the same group of funds; (ii) invest directly in stocks, bonds, and other securities, and (iii) acquire shares of money market funds in reliance on 12d1-1. By rescinding Rule 12d1-2 and the existing 12(d)(1) exemptive orders, all fund of funds arrangements that currently rely on Section 12(d)(1)(G) and Rule 12d1-2 and/or exemptive relief, will now have to comply with the Rule or discontinue certain investments.
AMENDMENT TO RULE 12d1-1
Because of the rescission of Rule 12d1-2, the SEC is amending Rule 12d1-1 to specifically permit fund of funds arrangements that rely on Section 12(d)(1)(G) to invest in shares of money market funds that are not part of the same group of investment companies as the acquiring fund.
AFFILIATED TRANSACTIONS RELIEF
The Rule provides relief from Section 17(a) of the Act necessary to effectuate a fund of funds arrangement. Absent an exemption, Section 17(a) would prohibit a fund that holds 5% or more of the acquired fund’s securities from making any additional investments in the acquired fund, limiting the efficacy of Rule 12d1-4. In addition, the Rule provides relief from Section 17(a) for exchange-traded funds (ETFs) with regard to the deposit and receipt of baskets by an acquiring fund that is an affiliated person of an ETF (or who is an affiliated person of such a person) solely by reason of holding with the power to vote 5% or more of the ETF’s shares or holding with the power to vote 5% or more of any investment company that is an affiliated person of the ETF. The relief granted by the Rule from Section 17(a) is consistent with the relief previously granted by the SEC in fund of funds exemptive orders.
AMENDMENTS TO FORM N-CEN
Form N-CEN is a structured form that requires registered funds to provide census-type data to the SEC on an annual basis. The SEC is also amending Form N-CEN to require a fund to report whether it relied on the Rule or on the statutory exemption in Section 12(d)(1)(G) of the Act during the relevant reporting period.
The Rule requires the acquiring and acquired funds that participate in fund of funds arrangements in accordance with the rule to maintain and preserve certain written records for a period of not less than five years, the first two years in an easily accessible place. These records include: (1) a copy of each fund of funds investment agreement that is in effect, or was in effect in the past five years, and any amendments thereto; and (2) a written record of the relevant findings (discussed in the “Evaluations and Fund Findings” section above) made under the Rule and the basis therefor within the past five years.
 See Fund of Funds Arrangements, Rel. No. IC-34045 (Oct. 7, 2020).
 See Fund of Funds Arrangements, Rel. No. IC-33329 (Dec. 19, 2018).
 The SEC noted that it would be more appropriate for it to consider designing protective conditions through the exemptive application process before permitting private funds to be acquiring funds.
 Similarly, Section 60 of the Act makes these limits applicable to a BDC to the same extent as if it were a registered closed-end fund.
 See Sections 12(d)(1)(F) and (G) of the Act.
 Any fund that seeks to invest in money market funds beyond the Section 12(d)(1) limits would also still be able to rely on Rule 12d1-1.
 Subsection (d) of the Rule defines “advisory group” to mean “either: (1) an acquiring fund’s investment adviser or depositor, and any person controlling, controlled by, or under common control with such investment adviser or depositor; or (2) an acquiring fund’s investment sub-adviser and any person controlling, controlled by, or under common control with such investment sub-adviser.” Under the Rule, an acquiring fund would not combine the entities listed in clause (1) with those in clause (2).
 Section 2(a)(9) of the Act defines “control” to mean 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 such company. The Act also creates a rebuttable presumption that any person who, directly or indirectly, beneficially owns more than 25% of the voting securities of a company controls the company and that any person who does not own that amount does not control it. A determination of control is not based solely on ownership of voting securities of a company and depends on the facts and circumstances of the particular situation. Further, a “controlling influence” includes, in addition to voting power, 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.
 Mirror voting requires the acquiring fund and its advisory group to vote shares of an acquired fund in the same proportion as the vote of all other holders of the acquired fund.
 Subsection (d) of the Rule defines “group of investment companies” as “any two or more registered investment companies or business development companies that hold themselves out to investors as related companies for investment and investor services.”
 Pass-through voting means that the acquiring fund will obtain instructions from its shareholders on how to vote an acquired fund’s proxies.
 As proposed, the Rule would have prohibited an acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares (i.e., the statutory limit) from redeeming or submitting for redemption, or tendering for repurchase, more than 3% of an acquired fund’s total outstanding shares in any 30-day period. Many commenters opposed the proposed redemption limit and they raised a number of concerns, including: (1) operational or administrative challenges; (2) the redemption limit’s potential effects on the acquiring fund’s investment objectives and its ability to respond timely to changing economic or market conditions; (3) the impact on competition and innovation; (4) whether funds in the same group of investment companies should be subject to the requirements; (5) concerns relating to liquidity; and (6) the cost of the proposed limits.
 However, the Rule would not limit the ability of a fund of funds relying on Section 12(d)(1)(F) of the Act from investing in other funds of funds.
 However, if an acquired fund were to invest in a single underlying fund in excess of the Section 12(d)(1) 3% or 5% limits, the acquired fund and underlying fund must comply with the conditions of the Rule as acquiring and acquired fund, respectively, or operate pursuant to another exemption from the Section 12(d)(1) limits.
 The list of no-action letters to be withdrawn will be available on the SEC’s website.
 The SEC noted that there are 954 acquiring funds, or 20% of all funds of funds, that rely on Section 12(d)(1)(G) and Rule 12d1-2 and will now be required to modify their operations to come into compliance with the Rule.