a regulatory regime where substantially similar fund of funds arrangements are subject to different conditions. For example, an acquiring fund could rely on section 12(d)(1)(G) and rule 12d1-2 when investing in an acquired fund within the same group of investment companies. Alternatively, the acquiring fund could rely on relief provided by an exemptive order, which would allow it to invest in substantially the same investments, but could require the fund to comply with different conditions.2The rationale is reminiscent of the rationale for a single exemptive rule to govern most exchange-traded funds (ETFs) to replace a regulatory regime in which similarly situated ETFs operated under different and sometimes inconsistent conditions imposed by their exemptive orders.3 However, unlike ETFs, fund of funds could choose whether to rely upon statutory provisions and exemptive rules, or seek exemptive relief. Moreover, while the administrative record is replete with references to the harms that Section 12(d)(1) was intended to address – undue influence of the top-tier fund upon the acquired fund, complex fund structures and layering of fees – the SEC failed to identify any actual instances of investor harm that have resulted from any of these harms since Rule 12d1-2 was adopted. In many respects, then, we see Rule 12d1-4 as a solution in search of a problem. As discussed below, Rule 12d1-4 may create problems for certain funds and/or fund structures that did not exist before while it solves problems for other funds that exist currently.
1. Current Regulatory StructureSection 12(d)(1) of the 1940 Act limits the ability of registered investment companies (funds) and unregistered investment companies to invest substantially in securities issued by another fund. Section 12(d)(1)(A) of the Act prohibits a fund (and companies, including funds, it controls), as well as unregistered investment companies, 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.
- 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.
2. Comparison of Rule 12d1-4 with Current Exemptive Relief
|Concern Addressed||Condition Under Existing Exemptive Orders||Final Rule Condition|
|Undue Influence||Voting conditions (including the point at which the voting condition is triggered) differ based on the type of acquired fund. Once an acquiring fund (and any other funds within the advisory group) holds more than 3% of the acquired closed-end fund’s outstanding voting securities, the acquiring fund must vote shares of acquired closed-end funds in the manner required by section 12(d)(1)(E) (i.e., either pass-through or mirror voting), while non-fund entities within the advisory group must use mirror voting. For acquired open-end funds or UITs, an acquiring fund (and its advisory group) must vote their shares using mirror voting only if the acquiring fund and its advisory group become holders of more than 25% of the acquired fund’s outstanding voting securities due to a decrease in the outstanding securities of the acquired fund.||Voting conditions (including the point at which the voting condition is triggered) differ based on the type of acquired fund. Voting conditions will require an acquiring fund and its advisory group to use mirror voting when they hold more than: (i) 25% of the outstanding voting securities of an open-end fund or UIT due to a decrease in the outstanding securities of the acquired fund; or (ii) 10% of the outstanding voting securities of a closed-end fund. In circumstances where acquiring funds are the only shareholders of an acquired fund, however, pass-through voting may be used.|
|Fund boards must make certain findings and adopt procedures to prevent overreaching and undue influence by the acquiring fund and its affiliates. Requires an agreement between acquiring and acquired funds agreeing to fulfill their responsibilities under the exemptive order (so-called participation agreement).||Requires a fund of funds investment agreement between acquiring and acquired funds unless they have the same investment adviser that includes any material terms necessary for each adviser to make the appropriate finding under the rule, a termination provision, and a requirement that the acquired fund provide fee and expense information to the acquiring fund.|
|Complex Structure||Limits the ability of an acquired fund to invest in underlying funds (that is, it limits structures with three or more tiers of funds), subject to certain enumerated exceptions.||Adviser(s) of acquiring and acquired funds that are management companies must make certain findings regarding the fund of funds structure. The principal underwriter or depositor of a UIT must analyze the fund of funds structure and determine that the arrangement does not result in duplicative fees. Allows an acquired fund to invest up to an additional 10% of its assets in other funds.|
|Layering of fees||Caps sales charges and service fees at limits under current FINRA sales rule (rule 2341) even in circumstances where the rule would not otherwise apply. Requires an acquiring fund’s adviser to waive advisory fees in certain circumstances or requires the acquiring fund’s board to make certain findings regarding advisory fees.||Requires an evaluation of the complexity of the fund of funds structure and aggregate fees. The investment adviser to an acquiring management company must find that the aggregate fees and expenses are not duplicative.|
3. Analysis of Rule 12d1-4
a. Scope of RuleOpen-end funds (including ETFs), UITs (including ETFs organized as UITs), and closed-end funds (including BDCs), are permitted to operate in accordance with Rule 12d1-4, as both acquiring and acquired funds. The scope of permissible acquiring and acquired funds under Rule 12d1-4 has been expanded beyond the scope of the SEC’s exemptive orders. For example, the rule will allow open-end funds, UITs, and ETFs to invest in unlisted closed-end funds and unlisted BDCs beyond the limits in section 12(d)(1). The rule similarly will increase permissible investments for closed-end funds beyond ETFs to allow them to invest in open-end funds, UITs, other closed-end funds, and BDCs, in excess of the Section 12(d)(1) limits. BDCs, which currently may invest in ETFs in excess of the section 12(d)(1) limits, also will be permitted to invest in open-end funds, UITs, other BDCs, other closed-end funds and ETMFs. Finally, the rule will allow ETMFs to invest in open-end funds, UITs, BDCs and other closed-end funds. However, the rule will not permit private funds (funds excepted from the definition of investment company under Section 3(c)(1) or Section 3(c)(7) of the 1940 Act) or unregistered investment companies, including foreign funds, to rely upon the rule as acquiring funds. The SEC stated that private funds and unregistered investment companies would not be subject to periodic reporting on Form N-PORT or the new Form N-CEN reporting requirements. Moreover, the SEC argued that private funds and unregistered investment companies do not need to comply with many of the 1940 Act’s governance and compliance requirements intended to protect investors and mitigate conflicts of conflicts of interest.
The SEC stated that private funds and unregistered investment companies that wished to invest in acquired funds in excess of Section 12(d)(1)’s limits could file exemptive applications with it.
b. Conditions of Rulei. Control and Voting Rule 12d1-4 will prohibit an acquiring fund and its advisory group from acquiring, and therefore exercising, control over an acquired fund. “Advisory group,” in turn, is defined in Rule 12d1-4(d) as:
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.The SEC is not requiring funds managed by unaffiliated sub-advisers to be encompassed within the advisory group definition. Therefore, Rule 12d1-4 will not require an acquiring fund to aggregate the ownership of an acquiring fund advisory group with an acquiring fund sub-advisory group. In addition, while Rule 12d1-4 will not impose a lower control limit on acquisitions of closed-end acquired funds than on other acquired funds, it will require advisory groups to mirror vote acquired closed-end fund shares if an acquiring fund and its advisory group hold more than 10% of the voting securities of a closed-end fund (or business development company), whereas advisory groups would not be required to mirror vote shares of other types of acquired funds until acquiring funds and their advisory groups hold more than 25% of the voting securities of those types of funds. In addition, the rule will require an acquiring fund and an acquired closed-end fund that do not share an investment adviser to enter into a fund of funds investment agreement before the acquiring fund exceeds the investment limits of Section 12(d)(1)(A). These provisions together are intended to protect acquired closed-end funds from undue influence by acquiring funds and their advisory groups. With respect to acquired open-end funds or UITs, as noted above, Rule 12d1-4 will require an acquiring fund and its advisory group to vote their shares of the acquired fund using mirror voting if the acquiring fund and its advisory group (in the aggregate) hold more than 25% of the outstanding voting securities of the acquired fund as a result of a decrease in the outstanding securities of the acquired fund. In circumstances in which Rule 12d1-4 or Section 12(d)(1) would require all of the shareholders of an acquired fund to engage in mirror voting, and consequently, it would not be possible for every shareholder to mirror vote, the Rule will require acquiring funds to pass-through their votes to their shareholders. However, Rule 12d1-4 excludes from the control and voting conditions instances in which (i) an acquiring fund is within the same group of investment companies as an acquired fund; or (ii) the acquiring fund’s investment sub-adviser or any person controlling, controlled by, or under common control with such investment sub-adviser acts as the acquired fund’s investment adviser or depositor. Consistent with Section 12(d)(1)(G), Rule 12d1-4 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.” The Adopting Release states that “‘investors’ refers only to potential investors in the acquiring fund because the relevant inquiry is how these funds are holding themselves out to their potential investors.” The SEC stated that if an acquiring fund discloses in its prospectus the names of the acquired funds in which it expects to invest, as well as the control relationship among the advisers to the acquired and acquiring funds, it can satisfy the “holding out” requirement of the definition. ii. Redemption Limits, Fund Findings and Fund of Funds Investment Agreements As proposed, Rule 12d1-4 would have limited an acquiring fund to redeeming 3% of an acquired fund’s total outstanding shares in a 30-day period. Instead, Rule 12d1-4 as adopted requires: (i) an acquired management company’s adviser to make certain findings focused on addressing undue influence concerns, including through redemptions, by considering specific enumerated factors; (ii) an acquiring fund’s adviser, principal underwriter, or depositor to conduct an evaluation of the complexity of the fund of funds structure and the structure’s aggregate fees and expenses and determine that the fees and expenses are not duplicative; and (iii) both the acquiring and acquired funds to enter into a fund of funds investment agreement to memorialize the terms of the arrangement (including terms that serve as a basis for the required findings) when the acquiring and acquired fund do not share an investment adviser. For management companies that are acquired funds, Rule 12d1-4 will require that fund’s investment adviser to determine that any undue influence concerns associated with the acquiring fund’s investment in the acquired fund are reasonably addressed, after considering:
- the scale of the acquiring fund’s contemplated investments and any maximum investment limits;
- the anticipated timing of the acquiring fund’s redemption requests;
- whether, and under what circumstances, the acquiring fund will provide advance notification of investments 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.
- Scale of Investment: Rule 12d1-4 will require the acquired fund’s investment adviser to consider the scale of contemplated investments by the acquiring fund, as well as any maximum investment limits.
- Anticipated Timing of Redemption Requests: The acquired fund’s investment adviser must consider the anticipated timing of redemption requests by the acquiring fund.
- Advance Notification of Investments or Redemptions: The acquired fund’s investment adviser must consider whether and under what circumstances the acquiring fund will provide advance notification of investments and redemptions. For example, the adviser may request or require that the acquiring fund provide advance notice of a large redemption before entering into a fund of funds investment agreement. The SEC cautioned that any agreement related to this factor would need to comply with Section 22(e) of the 1940 Act.
- In-kind Redemptions: The acquired fund’s investment adviser must consider whether it will satisfy redemptions in cash or in kind.
- acquisitions of feeder funds in a master-feeder structure;
- acquisitions of investment companies and private funds in reliance on Rule 12d1-1 (to permit investments in money market funds);
- acquisitions of wholly-owned subsidiaries (e.g., Cayman blockers);
- fund shares received as a dividend or as a result of a plan of reorganization;
- fund shares acquired to engage in interfund lending and borrowing.
c. Conforming Amendmentsi. Amendment to Rule 12d1-1 Because the SEC is rescinding Rule 12d1-2, funds that previously relied upon Rule 12d1-2 to invest in unaffiliated money market funds no longer could avail themselves of that relief. The SEC did not intend to take away the ability of funds, particularly funds that rely upon Section 12(d)(1)(G), to invest in unaffiliated money market funds. Consequently, the SEC amended Rule 12d1-1 to restore the status quo. ii. Disclosures Relating to Fund of Funds Arrangements The SEC is amending Form N-CEN, which must be filed annually, to require acquiring funds to disclose whether they are relying upon Section 12(d)(1)(G) or on Rule 12d1-4 during the fund’s reporting period. The SEC will address acquired fund fees and expenses separately in its proposal to overhaul mutual fund and ETF prospectus and periodic report disclosure,5 which was examined in an earlier Practus Legal Insight.
4. Rescinded Exemptive Relief and No-Action LettersThe SEC is rescinding exemptive relief that permits investments in funds beyond the limits in Sections 12(d)(1)(A), (B), or (C) of the 1940 Act, other than in circumstances that the SEC believes are outside the scope of Rule 12d1-4. The SEC also rescinded 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. The SEC is posting of list of no-action letters that are being withdrawn on the Division of Investment Management’s website.
5. Effective Dates and Compliance DatesRule 12d1-4 will take effect 60 days after publication in the Federal Register, which has not yet happened. Rule 12d1-2 will be rescinded one year after Rule 12d1-4 takes effect, at which point funds relying upon Rule 12d1-2 will have to rely upon either Section 12(d)(1)(G) or upon Rule 12d1-4. The compliance date for the amendment to Form N-CEN will be 425 days after publication in the Federal Register.
ConclusionAs we noted above, we do not believe that the articulated rationale for a single Rule to replace the existing combination of exemptive rules and exemptive orders stands up to close scrutiny – unlike ETFs, the SEC had not created a situation where similarly situated funds were treated differently through no fault of their own. Nor did the administrative record include evidence of actual instances of the types of abuses that Congress attempted to address in 1940 and again in 1970. Nonetheless, the SEC has replaced the existing fund of funds regulatory structure with one that, on the one hand, will impose a more uniform regulatory structure on the industry, but, on the other hand, may paradoxically promote more uneven outcomes. For example, we may find that larger acquired funds will be better able to use central funds than smaller acquired funds, as larger funds can more easily hold a central fund investment within its 10% Bucket. However, the SEC’s initial proposal to impose a 3% limit on redemptions over 30-day periods, if adopted, would have wreaked havoc on many funds’ liquidity risk management programs. The Rule as adopted will not impose artificial restraints on acquiring funds’ liquidity. Moreover, making fund of funds relief available to closed-end funds and UITs should be a positive development. Ultimately, while the SEC sought to bring about uniformity, the industry will continue to be able to choose its fund of funds relief. The difference is that while before, its choice was between Rule 12d1-2 and seeking an exemptive order, its choice now is between Rule 12d1-4 and Section 12(d)(1)(G). Once acquiring funds begin to file their Form N-CENs, the SEC will begin to learn whether Rule 12d1-4 is a success or a Rule that proves to be too cumbersome for funds.
About the AuthorEthan Corey has spent 22 years as an investment management lawyer specializing in distribution issues (including FINRA rules) as well as 1940 Act and Advisers Act issues. He is familiar with ERISA, MSRB and CFTC rules, as well as FCA Conduct of Business Rules and MiFID II. He has been an effective advocate with regulators as a member of industry trade groups.
- Fund of Funds Arrangements, Investment Company Act Rel. No. 34045 (Oct. 7, 2020) (Adopting Release).
- Exchange-Traded Funds, Investment Company Act Rel. No. 33646 (Sept. 25, 2019), 84 FR 57162, 57198 (Oct. 24, 2019).
- 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 Rel. No. 33963 (Aug. 5, 2020), 85 Fed. Reg. 70716, 70749 (Nov. 5, 2020).