On October 7, 2020, the US Securities and Exchange Commission (“SEC”) adopted a new rule under the Investment Company Act of 1940 (the “Investment Company Act”) with respect to fund of fund arrangements.1 New Rule 12d1-4 would permit registered investment companies to invest in other registered investment companies beyond certain statutory limits set forth in Section 12(d)(1) and without obtaining an exemptive order, provided certain conditions are met. In light of this new rule, the SEC is rescinding most exemptive orders and certain no-action letters granting relief under Sections 12(d)(1)(A), (B), (C) and (G) of the Investment Company Act related to fund of funds arrangements that are within the scope of Rule 12d1-4; is rescinding Rule 12d1-2 under the Investment Company Act; and is adopting certain Form N-CEN and recordkeeping requirements associated with the new rule.
This Legal Update provides a high-level summary of new Rule 12d1-4 and also shares some initial takeaways with respect to this new rule.
A. Regulatory Context and Scope of the Rule
The Investment Company Act includes certain statutory limitations that are meant to prevent fund of fund arrangements that permit an acquiring fund to control the assets of the acquired fund. These limitations are meant to address regulatory concerns that an acquiring fund may use such assets to enrich the acquiring fund at the expense of the acquired fund and its shareholders. Under Section 12(d)(1)(A) of the Investment Company Act, a registered fund (and companies, including funds, it controls) is prohibited from:
- acquiring more than 3% of the 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.
This prohibition together with Section 12(d)(1)(B)2 is meant to address the above regulatory concerns as well as Congress’ concerns about the potential for duplicative and excessive fees in fund of funds arrangements and the formation of overly complex structures that could confuse investors.3 Funds previously wishing to enter into fund of fund arrangements exceeding these thresholds have had to rely on certain limited exceptions under the statute, certain related rules under the Investment Company Act4 or have obtained exemptive relief from the SEC.
New Rule 12d1-4 sets forth a new regulatory framework that would permit certain registered funds (specifically, open-end funds, closed-end funds, exchange traded funds (“ETFs”) and unit investment trusts (“UITS”)) as well as business development companies (“BDCs”) to invest in other registered funds and BDCs beyond Section 12(d)(1)’s limits, provided it complies with certain requirements (as discussed in more detail below). The Adopting Release noted that the scope of permissible acquiring and acquired funds under new Rule 12d1-4 is greater than prior exemptive orders that granted relief from Section 12(d)(1)’s limits by now permitting the above registered funds and BDCs to invest in unlisted closed-end funds and unlisted BDCs, and also permitting closed-end funds to invest in open-end funds, UITs, other closed-end funds and BDCs (previous 12(d)(1) exemptive orders generally limited closed-end fund permissible investments to ETFs).5
However, the Adopting Release noted that Rule 12d1-4 will not be available for private funds and other unregistered investment companies (such as foreign funds) that wish to invest in registered funds beyond Section 12(d)(1)’s limits (effectively limiting these private funds and other unregistered funds from acquiring no more than 3% of a registered fund or BDC, absent relief or reliance on a statutory exception under Section 12). Because these funds will not be subject to certain protective requirements under the Investment Company Act, the SEC believed that such funds must instead seek exemptive relief in order to exceed the Section 12(d) limits applicable to such funds under the Investment Company Act.6
B. Conditions under Rule 12d1-4
Registered funds and BDCs that wish to enter into fund of fund arrangements that exceed the Section 12(d)(1) limits must comply with the following conditions under Rule 12d1-4.7 These conditions are designed to address regulatory concerns associated with these fund of funds arrangements.
- Control and Voting
Control: Rule 12d1-4 prohibits an acquiring fund and its “advisory group” from “controlling” individually or in the aggregate an acquired fund, except under certain limited circumstances.
- “Control” under the Investment Company Act generally means the power to exercise a controlling influence over the management and policies of a company; however, the Act also includes a rebuttable presumption that any person who, directly or indirectly, beneficially owns more than 25% of the company’s voting securities “controls” the company.8 Accordingly, the Adopting Release stated that an acquiring fund and its advisory group’s beneficial ownership of up to 25% of the voting securities of an acquired fund would be presumed not to constitute control over the acquired fund. However, the Adopting Release noted that a determination of control under the Investment Company Act is not based solely on ownership of voting securities of a company and depends on the facts and circumstances of the particular situation. Thus, it stated that if such facts and circumstances gave an acquiring fund and its advisory group the power to exercise a controlling influence over the acquired fund’s management or policies, the acquiring fund and other funds in its advisory group would not be able to rely on Rule 12d1-4 even if the fund and its advisory group owned 25% or less of the acquired fund’s voting securities.9
- In assessing control, the rule requires an acquiring fund to aggregate its investment in an acquired fund with any investments in the same acquired fund made by its “advisory group.” An “advisory group” means 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.10
The Adopting Release states that Rule 12d1-4’s control limitation is an acquisition test (the same as applied under Section 12(d)(1)). However, it also stated that under some circumstances, an acquiring fund’s holdings may trigger the Investment Company Act’s control presumption through no action of its own. The Adopting Release noted that if the acquiring fund and its advisory group become a holder of more than 25% of the outstanding voting securities of an acquired fund as a result of net redemptions and a decrease in the outstanding voting securities of the acquired fund, Rule 12d1-4 does not require the acquiring fund to dispose of acquired fund shares. However, the Adopting Release stated that such acquiring fund and other entities within its advisory group may not rely on Rule 12d1-4 to acquire additional securities of the acquired fund when the acquiring fund and other entities within its advisory group, in the aggregate, hold more than 25% of the acquired fund’s voting securities.11
Voting Requirements: Rule 12d1-4 will require an acquiring fund and its advisory group to use mirror voting (i.e., vote in the same proportion as the vote of all other holders of such securities) if: (i) it holds 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, OR (ii) it holds more than 10% of the outstanding voting securities of a acquired closed-end fund or BDC. In circumstances where acquiring funds are the only shareholders of an acquired fund, pass-through voting may be used (i.e., it may seek instructions from its security holders with regard to the voting of all proxies with respect to such acquired fund securities and vote such proxies only in accordance with such instructions).
Exception to Control and Voting Requirements: The above control and voting requirements do not apply if either: (a) the acquiring fund is in the same group of investment companies as the acquired fund;12 or (b) the acquiring fund’s investment sub-adviser or any person controlling, controlled by, or under common control with such investment sub-adviser acts as an acquired fund’s investment adviser or depositor.
- Required Findings
Management Companies: Rule 12d1-4 will require investment advisers to acquiring and acquired funds that are management companies (i.e., open-end and closed-end funds as opposed to UITs) to make certain findings regarding the fund of funds arrangement, after considering specific factors, prior to the initial acquisition of an acquired fund in excess of the Section 12(d)(1) limits. Specifically:
- The acquiring fund’s investment adviser must evaluate the complexity of the structure and fees and expenses associated with the acquiring fund’s investment in the acquired fund and find that the acquiring fund’s fees and expenses do not duplicate the fees and expenses of the acquired fund.
- The acquired fund’s investment adviser must find that any undue influence concerns associated with the acquiring fund’s investment in the acquired fund are reasonably addressed and, as part of this finding, the investment adviser must consider at a minimum the following items:
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 such redemptions in kind.
In addition, the investment adviser to each acquiring or acquired management company must report its evaluation, findings, and the basis for its evaluations or findings to the fund’s board of directors no later than the next regularly scheduled board of directors meeting.
UITs: Rule 12d1-4 requires more streamlined findings with respect to UITs, as the rule takes into account the unique structural characteristics of such entities. In addition, UITs that serve as separate account vehicles funding variable annuity and variable life insurance contracts will be subject to additional requirements as highlighted below.
- For UITs, its principal underwriter or depositor must evaluate the complexity of the structure associated with the UIT’s investment in acquired funds and, on or before such date of initial deposit, find that the UIT’s fees and expenses do not duplicate the fees and expenses of the acquired funds that the UIT holds or will hold at the date of deposit.
- For a separate account that funds variable insurance contracts and invests in an acquiring fund, the acquiring fund must obtain a certification from the insurance company offering the separate account that the insurance company has determined that the fees and expenses borne by the separate account, the acquiring fund, and the acquired fund, in the aggregate, are consistent with the standard set forth in Section 26(f)(2)(A) of the Investment Company Act (which generally requires that the fees must be reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company).
- Fund of Funds Investment Agreement
If the acquiring fund and the acquired fund do not have the same investment adviser and such adviser is not acting as the sub-adviser to either fund,13 the funds must enter into an agreement prior to the acquiring fund’s initial purchase of acquired fund shares in excess of Section 12(d)(1)’s limits (a “fund of funds investment agreement”). The Adopting Release stated that this requirement is meant to work in tandem with the above findings requirements by providing a method to hold the parties to the arrangement to the terms that led each fund’s investment adviser to agree to such arrangement.14 This fund of funds investment agreement must include:
- any material terms regarding the acquiring fund’s investment in the acquired fund necessary to make the findings required above;
- a termination provision whereby either the acquiring fund or acquired fund may terminate the agreement subject to advance written notice no longer than 60 days; and
- a requirement that the acquired fund provide the acquiring fund with information on the fees and expenses of the acquired fund reasonably requested by the acquiring fund.
- Complex Structures
Rule 12d1-4 imposes a general three-tier prohibition in which an acquiring fund relying on the rule or Section 12(d)(1)(G) could not exceed Section 12(d)(1)’s limits by investing in an acquired fund that was itself relying on the rule (e.g., another fund of funds) unless certain enumerated exceptions applied. This essentially limits reliance on Rule 12d1-4 to two-tier fund of funds arrangements.
Exceptions to the above general prohibition include: acquiring funds relying on Section 12(d)(1)(E) (certain master-feeder funds);15 acquiring funds relying on Rule 12d1-1 (investments in certain money market funds); acquiring funds that invest in a subsidiary that is wholly-owned and controlled by the acquired fund; funds that invest in securities received as a dividend or as a result of a plan of reorganization of a company; or funds that invest in securities of another investment company received pursuant to SEC exemptive relief to engage in interfund borrowing and lending transactions.
However, in addition to these exceptions, Rule 12d1-4 allows an acquired fund to invest up to 10% of its total assets in other funds (including private funds), without regard to the purpose of the investment or types of underlying funds.
C. Rescission of Rule 12d1-2 and Certain Exemptive Orders and No-Action Letters
In order to create a more consistent and efficient framework for fund of funds arrangements, the SEC is rescinding Rule 12d1-2, which permitted funds of affiliated funds relying on Section 12(1)(G) to also invest under certain conditions in: unaffiliated funds in accordance with Section 12(d)(1)(A) or (F); direct investments in securities; and money market funds in reliance on Rule 12d1-1. The Adopting Release stated that the SEC believes the rescinding of this rule will harmonize the fund of funds structure by requiring Section 12(d)(1)(G) funds to rely on Rule 12d1-4 instead but acknowledges that the recession will eliminate some of the flexibility these funds enjoyed under the prior rule.16 However, Rule 12(d)(1)(G) funds will retain the ability to also invest in certain money market funds under Rule 12d1-1 as this rule was amended to preserve this ability previously available under Rule 12d1-2. The rescission of Rule 12d1-2 and the change to Rule 12d1-1 will be effective one year after the effective date of Rule 12d1-4.
In addition, the SEC in the Adopting Release is rescinding, one year from the effective date of Rule 12d1-4, exemptive relief permitting fund of funds arrangements that fall within the scope of Rule 12d1-4. Section III of the Adopting Release provides a more detailed explanation of the specific exemptive orders being rescinded. Generally, the Adopting Release stated that the SEC is rescinding exemptive relief that permits investments in funds beyond the limits in 12(d)(1)(A), (B), or (C) of the Investment Company Act, other than in circumstances that it believes are outside the scope of Rule 12d1-4, as well as exemptive relief under Section 12(d)(1)(G) that permits an affiliated fund of funds to invest in assets that are beyond the scope of that statutory provision. Topical areas outside the scope of Rule 12d1-4 that are not being rescinded include interfund lending, affiliated insurance fund relief, transaction-specific relief, grantor trust relief, and fund of funds arrangements with managed risk provisions and other relief related to Section 12(d)(1)(E). Similarly, SEC staff no-action letters stating that the staff would not recommend an enforcement action under specific circumstances related to Section 12(d)(1) that fall inside the scope of Rule 12d1-4 (which are also described in more detail in Section III of the Adopting Release) will be withdrawn one year from the effective date of Rule 12d1-4.
D. Form N-CEN Changes and Recordkeeping Requirements
The SEC is also amending Form N-CEN to require funds to report whether they relied on Rule 12d1-4 or Section 12(d)(1)(G) of the Investment Company Act during the applicable reporting period. Rule 12d1-4 also imposes certain recordkeeping and related retention requirements to certain books and records related to the rule.17
E. Initial Takeaways and Effective Date
According to SEC staff estimates, approximately 40% of all registered funds hold an investment in at least one other registered fund.18 Therefore, the adoption of Rule 12d1-4 may be welcome relief to funds that pursue fund of fund arrangements given the time and expense involved in pursuing and obtaining exemptive relief from the SEC. In addition, the final adopted version of Rule 12d1-4 resulted in a significant change from the original 2018 proposal, which initially included certain redemption limitations that were subject to critique from the industry during the proposed rule’s comment process. However, funds and advisers that intend to rely on the fund of funds relief under Rule 12d1-4 should carefully review and evaluate the more technical conditions of the rule, including the control determination requirements, required findings and fund of fund investment agreement requirements, which may prove to be more challenging in practice than on paper. In addition, the advisory group aggregation calculation requirements may present operational, organizational and monitoring challenges to certain fund advisers with multiple entities or affiliates that are run independently of each other and that may not already have processes in place to share necessary information among affiliates for compliance purposes.
The effective date for Rule 12d1-4 will be 60 days following publication of the rule in the Federal Register. As of the date of this Legal Update, the rule has not yet been so published.
1 Fund of Fund Arrangements, Investment Company Act Release No. 34045 (Oct. 7, 2020), available at https://www.sec.gov/rules/final/2020/33-10871.pdf (the “Adopting Release”).
2 Section 12(d)(1)(B) prohibits a registered open-end fund and its principal underwriter from knowingly selling securities to any other investment company if, after the sale, the acquiring fund would: together with companies it controls, own more than 3% of the acquired fund’s outstanding voting securities; or together with other funds (and companies they control), own more than 10% of the acquired fund’s outstanding voting securities. On a related note, Section 12(d)(1)(C) prohibits an acquiring fund (and companies, including funds, it controls) from acquiring shares in a registered closed-end fund if immediately after such purchase or acquisition the acquiring company, other investment companies having the same investment adviser, and companies controlled by such investment companies, own more than 10% of the total outstanding voting stock of such closed-end company.
3 Adopting Release at 7.
4 For example, Section 12(d)(1)(E) permits master-feeder arrangements whereby an acquiring fund (either registered or unregistered) invests all of its assets in a single fund (subject to certain conditions), Section 12(d)(1)(F) permits a registered fund to take small positions (up to 3% of another fund’s securities) in an unlimited number of other registered funds), Section 12(d)(1)(G) permits a registered open-end fund or unit investment trust to invest in other registered open-end funds and UITs that are in the “same group of investment companies,” and Rule 12d1-1 provides an exemption permitting funds to invest in certain registered and unregistered money market funds in excess of the Section12(d)(1) limitations (subject to certain conditions).
5 Adopting Release at 12.
6 Adopting Release at 17-24. Unregistered investment companies are subject to Section 12(1)(A)’s limits with respect to their investments in a registered investment company. Registered investment companies are also subject to these same limits with respect to their investment in an unregistered investment company. Sections 3(c)(1) and 3(c)(7) also subject private funds to the 3% limitation on investments in registered funds (a “private fund” is an issuer that would be an investment company, as defined in section 3 of the Investment Company Act, but for section 3(c)(1) or 3(c)(7) of such Act). In addition, Section 60 of the Investment Company Act makes section 12(d) applicable to a BDC to the same extent as if it were a registered closed-end fund. Adopting Release at 6, footnote 16.
7 Rule 12d1-4 will also provide an exemption from the prohibition in Section 17(a) of the Investment Company Act on certain affiliated transactions. Absent an exemption, the Adopting Release noted that 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. The SEC noted that fund of funds arrangements involving funds that are part of the same group of investment companies or that have the same investment adviser (or affiliated investment advisers) also implicate the Investment Company Act’s protections against affiliated transactions, regardless of whether an acquiring fund exceeds the 5% threshold, though the rule as adopted will not address all of these situations. Adopting Release at 25.
8 Section 2(a)(9) of the Investment Company Act. The power to control is not present if such power is solely the result of an official position within the company. In addition, a person who owns less than 25% of a company’s voting securities is presumed not to control such company unless particular facts and circumstances indicated otherwise (see footnote 9 below and accompanying text). Section 2(a)(42) defines “voting security” and generally means any security presently entitling the owner or holder thereof to vote for the election of directors of a company.
9 The Adopting Release noted that the SEC has long held that “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. Adopting Release at 36-37.
10 Under Rule 12d1-4, an acquiring fund would not combine the entities listed in clause (1) with those in clause (2). Each of these groups will consider its ownership percentage separately. Adopting Release at 38, footnote 105, and at 41-42.
11 Adopting Release at 37-38, footnote 103.
12 “Group of investment companies” means any two or more registered investment companies or BDCs that hold themselves out to investors as related companies for purposes of investment and investor services.
13 The Adopting Release stated that this exception to the fund of funds agreement will not be available when an investment adviser acts as an adviser to one fund and a sub-adviser to the other fund in a fund of funds arrangement relying on the rule or as sub-adviser to both funds. Adopting Release at 102.
14 Adopting Release at 97-98.
15 The SEC noted in Rule 12d1-4’s proposing release that most insurance product separate accounts are organized as UITs and rely on section 12(d)(1)(E) to invest proceeds from the sale of interests in variable annuity and variable life insurance contracts in shares of a mutual fund. Fund of Fund Arrangements, Investment Company Act Release No. 33329 at 37 (Dec. 19, 2018), available at https://www.sec.gov/rules/proposed/2018/33-10590.pdf. The Adopting Release noted (as an example) that a three-tier structure involving an exempted Section 12(d)(1)(E) fund would permit a target date fund (itself an acquiring fund) to simply act as a conduit through which an insurance product separate account invests.
16 Adopting Release at 129.
17 For example, under Rule 12d1-4(c), the acquiring and acquired funds relying upon this section must maintain and preserve for a period of not less than five years, the first two years in an easily accessible place, as applicable: (1) a copy of each fund of funds investment agreement that is in effect, or at any time within the past five years was in effect, and any amendments thereto; (2) a written record of the evaluations and findings required by paragraph (b)(2)(i) of the rule and the basis therefor within the past five years; (3) a written record of the finding required by paragraph (b)(2)(ii) of the rule and the basis for such finding; and (4) the certification from each insurance company required by paragraph (b)(2)(iii) of the rule.
18 Adopting Release at 3.