Monday, October 12. 2020
The SEC estimates that approximately 40% of all registered funds invest in at least one other fund. Total net assets in mutual funds that invest primarily in other mutual funds have increased to $2.54 trillion in 2019. Similarly, retail investors often use fund of funds arrangements as a convenient way to allocate and diversify portfolios through a single, professionally managed investment. New Rule 12d1-4 permits a fund to acquire the shares of another fund in excess of the limits of the Investment Company Act without obtaining an individual exemptive order if the funds comply with certain conditions that provide investor protection.
Rule 12d1-4 allows a registered investment company or business development company (BDC) (the “acquiring funds”) to acquire the securities of any other registered investment company or BDC (the “acquired funds”) beyond the limits in section 12(d)(1) of the Investment Company Act of 1940. The SEC’s current approach depends on the its exemptive orders and varies based on an acquiring fund’s type, while the new rule creates a consistent framework for fund of funds arrangements. 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.
The new rule contains some aspects from the SEC’s current exemptive orders that permit fund of funds arrangements, but the changes will enhance investor protections while providing funds with flexibility to meet their investment objectives in an efficient manner. The following conditions are specified:
- Limits on Control and Voting. Rule 12d1-4 prohibits an acquiring fund from controlling an acquired fund and has provisions to minimize the acquiring fund’s influence. The rule 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 specified manner, with some conditional exceptions.
- Required Evaluations and Findings. The new rule will require certain evaluations and findings be made before the acquiring fund invests in an acquired fund. This should reduce any undue influence an acquiring fund may exert over an acquired fund. The evaluations and findings differ depending upon the fund’s role in the arrangement and whether it is a management company, unit investment trust, or a separate account funding variable insurance contracts.
- Required Fund of Funds Investment Agreements. The rule also will mandate that funds enter into a fund of funds investment agreement memorializing the terms of the arrangement when they do not share the same investment adviser.
- Limits on Complex Structures. Rule 12d1-4 generally will prohibit funds from creating three-tier fund of funds structures, except in certain circumstances. This includes 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”). This condition limits funds’ use fund of funds arrangements to create overly complex structures while permitting for some flexibility for such arrangements to evolve and offer greater efficiency to investors.
Rescission of Rule 12d1-2 and Certain Exemptive Relief
In addition to new Rule 12d1-4, the SEC is rescinding Rule 12d1-2. This rule allows funds that primarily invest in funds within the same fund group to invest in unaffiliated funds and non-fund assets. The SEC also is removing its exemptive orders permitting fund of funds arrangements with limited exceptions. Therefore, funds attempting to create certain types of fund of funds arrangements exceeding the statutory limitations will be required to rely on rule 12d1-4 and abide by its conditions.
Amendments to Rule 12d1-1
The SEC is changing Rule 12d1-1 such that funds that primarily invest in funds within the same fund group are permitted to continue to invest in unaffiliated money market funds.
Amendments to Form N-CEN
Finally, the SEC intends to amend Form N-CEN such that funds must report if 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 rule will be effective 60 days after publication in the Federal Register. There will be a transition period regarding the changes to Form N-CEN; the compliance date for these amendments will be 425 days after publication in the Federal Register. Finally, the rescission of Rule 12d1-2 and the SEC’s exemptive orders will be effective one year from the effective date of the new rule.