On December 19, 2018, the SEC released a set of rule proposals (the “Proposals”) intended to streamline the regulatory framework for fund-of-funds (“FOF”) arrangements under the Investment Company Act of 1940 (the “1940 Act”). Investment advisers managing FOFs should consider looking closely with counsel at the impact these Proposals could have on their businesses and compliance programs. They might also consider responding to the substantive comment requests included in the Proposals.
Section 12(d)(1) of the 1940 Act generally limits the percentage of assets that registered investment companies (mutual funds, ETFs and closed-end funds) and BDCs may invest in other funds, and to the percentage of their shares that may be held by other funds, unless the funds can rely on a statutory or rule-based exemption or SEC exemptive order. In the Proposal, the SEC estimates that nearly half of all registered funds currently rely on a mosaic of different rules and exemptive orders with varying conditions to invest in other funds. The Proposals are an effort to make the FOF regulation more consistent and efficient, particularly for similarly situated funds.
In with the New
Proposed new Rule 12d1-4 under the 1940 Act would allow registered funds to go beyond the limits of Section 12(d)(1) as acquiring or acquired funds, and to invest in new types of products and securities, without obtaining an exemptive order. Rule 12d1-4 would also exempt investments in an affiliated fund from the prohibitions of Section 17(a) under the 1940 Act.
The “tailored” conditions included in proposed new Rule 12d1-4 are designed to protect shareholders by mitigating potential conflicts of interest and risks related to FOFs. They address:
- Control: Acquiring funds would be able to beneficially own up to 25% of an acquired fund’s shares. However, if facts and circumstances demonstrate that an acquiring fund and its advisory group has the power to exercise a controlling influence over the acquired fund’s management or policies, then the acquiring fund would not be able to rely on proposed Rule 12d1-4.
- Voting: Acquiring funds would be required to either use “pass-through voting” (voting proxies in accordance with shareholder instructions) or “mirror voting” (voting its shares in proportion with shareholders of the acquired fund).
- Redemptions: An acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares would be prohibited from attempting to redeem more than 3% of the acquired fund’s outstanding shares in any 30-day period.
- Duplicative and Excessive Fees: An acquiring fund’s investment adviser would be required to determine it to be in the best interest of the acquiring fund to invest in an acquired fund and to document in writing and submit to the acquiring fund’s board an evaluation of the complexity of the FOF structure and the aggregate fees associated with the investment in the acquired fund.
- Complex Structures: FOF structures would be restricted to two tiers, except that acquiring funds could sell and acquired funds purchase shares to or from other funds in compliance with Section 12(d)(1)’s limitations. FOFs in more highly tiered investment arrangements would likely need to restructure if the SEC’s changes are adopted as proposed.
- Disclosure: Funds would be required to disclose on Form N-CEN that they are or could be an acquiring fund. The Proposal contains related amendments to Form N-CEN.
The Proposals also include amendments to existing Rule 12d1-1 allowing FOFs investing within the same group of investment companies to invest in unaffiliated money market funds.
Out with the Old?
The SEC would rescind Rule 12d1-2, which most FOFs investing within the same group of investment companies under Section12(d)(1)(G) rely upon, and most existing exemptive orders under Sections 12(d)(1)(A), (B), (C), and (G). As the conditions of Rule 12d1-4 differ substantially from Rule 12d1-2 and most exemptive orders, managers of existing FOFs should compare their current compliance procedures to the conditions of the Proposals. If the Proposals could seriously disrupt an FOF’s operations, it may be worthwhile to comment on the Proposals. Managers planning to use an FOF structure for new products should also consider whether the Proposals would be compatible with their plans.
As is typical, the SEC will be accepting comments on the Proposals for ninety days after they are published in the Federal Register.