SEC Adopts Comprehensive Funds of Funds Rule
On October 7, 2020, the Securities and Exchange Commission (“SEC”) adopted a new rule, Rule 12d1-4, designed to provide a consistent and comprehensive framework governing a registered fund’s ability to invest in another registered fund (a “fund of funds” arrangement). Rule 12d1-4 (the “Rule”) under the Investment Company Act of 1940, as amended (the “1940 Act”), will replace the current cornucopia of statutory exemptions, 1940 Act rules, exemptive orders and informal SEC guidance in the form of no-action letters that presently govern many fund of funds arrangements. In adopting the Rule, the SEC noted that the current fund of funds regulatory framework was both unnecessarily complex and provided an unlevel playing field as it sometimes resulted in differing requirements and conditions among funds depending on which type of registered fund was acting as either acquiring or acquired fund and which regulatory regime was being relied upon. The fund of funds rule was initially proposed in late 2018 and generated significant comment and some concern among commentators. The final Rule addressed many of these concerns and therefore differs in certain key respects from the earlier 2018 proposal. For example, the proposed rule contained a requirement limiting the ability of an acquiring fund from redeeming its shares of an acquired fund and required acquiring fund boards of directors to make certain findings. These requirements were eliminated in the final Rule.
The effective date for the Rule is 60 days after publication in the Federal Register, as discussed further below.
Fund of funds arrangements are generally limited by the “anti-pyramiding” provisions in Section 12(d)(1) of the 1940 Act. Most significant is Section 12(d)(1)(A), which prohibits 1940 Act registered funds from (a) acquiring more than 3% of another investment company’s outstanding voting securities (the “3% Limit”), (b) investing more than 5% of its assets in a single registered investment company (the “5% Limit”), or (c) investing more than 10% of its assets in registered investment companies (the “10% Limit”). Funds of funds often are able to make investments in excess of these limitations due to several statutory exemptions and SEC rules, such as Section 12(d)(1)(G) of the 1940 Act which permits open-end funds and unit investment trusts (“UITs”) to acquire unlimited shares of other open-end funds or UITs in the same group of investment companies. Funds of funds also may operate pursuant to exemptive orders issued by the SEC which typically include requirements that the board of directors of an acquiring fund must make certain findings in connection with fund of funds arrangements, including that the advisory fees paid by the acquiring funds are based on services provided that are in addition to, rather than duplicative of, services provided under the advisory contract(s) of any acquired fund.
Rule 12d1-4 will apply the same uniform standards to all registered investment companies, including open-end funds, exchange traded funds (“ETFs”), UITs and closed end funds (each a “Fund”). Each Fund may act as an acquiring or an acquired fund. The Rule does not apply to unregistered funds such as private equity funds or foreign funds acting as acquiring funds. The Rule will generally permit a Fund to invest in another Fund in excess of the 12(d)(1) limits subject to certain conditions, as discussed below.
As noted, the Rule now treats all registered funds in a uniform manner. Therefore, it allows open-end funds, UITs and ETFs to now invest in unlisted closed-end funds and unlisted business development companies (“BDCs”). It also expands the ability of closed-end funds to invest in funds other than ETFs, allowing them to invest in open-end funds, UITs, other closed-end funds and in BDCs. BDCs will also benefit in that the Rule will permit them to invest beyond ETFs, allowing investments in open-end funds, UITs, closed-end funds or other BDCs. The Rule also provides certain exemptions from Section 17(a) of the 1940 Act, which would otherwise restrict fund of funds arrangements in the scenario where funds were deemed to be affiliated with one another due to owning greater than 5% of that Fund’s shares. This will allow ETFs to engage in in-kind purchase and sale transactions with affiliated persons on the same basis as if the transactions were cash purchases and sales under the Rule.
Conditions: To rely on the Rule, a fund of funds arrangement must satisfy the following conditions:
1. Control and Voting
An acquiring fund and its “advisory group”  may not “control” an acquired fund. Accordingly, in most cases an acquiring fund and its advisory group may purchase up to 25% of an acquired fund’s outstanding shares. However, the 25% cap creates merely a presumption as to lack of control. In no circumstances may an acquiring fund and its advisory group exercise a controlling influence on the acquired fund’s management or policies, regardless of its level of share ownership.
In addition, an acquiring fund and its advisory group must use “mirror voting” if they, in the aggregate, own more than (a) 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 (b) 10% of the outstanding voting securities of an acquired closed-end fund or BDC.
These restrictions on control and voting would not apply if the acquiring fund is in the same group of investment companies as the acquired fund or 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.
2. Fund Findings
In order to address concerns that an acquiring fund could exert undue influence over an acquired fund or that an acquiring fund may be charged duplicative fees and expenses, the Rule requires an investment adviser to an open-end fund, ETF or closed-end fund (including a BDC) that relies on the Rule to evaluate and make certain findings regarding the arrangement before the acquiring fund makes an acquisition in excess of the 3% Limit. These requirements replace the redemption limits and proposed prospectus disclosure requirements that were contained in the proposed rule. Unlike the voting requirements discussed above, these requirements apply to all Funds relying on the Rule, even Funds that are part of the same group of investment companies.
- An acquiring fund’s investment adviser must evaluate the complexity of the fund of funds structure, as well as the relevant fees and expenses and find that the acquiring fund’s fees and expenses do not duplicate the fees and expenses of the acquired fund.
- An 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, after considering certain specific factors. These factors include:
- the scale of contemplated investments by the acquiring fund and any maximum investment limits;
- the anticipated timing of redemption requests by the acquiring fund;
- 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.
- The investment adviser to each of the acquiring and acquired fund must report its evaluations and findings, including the bases for its evaluations and findings, to the applicable fund’s board of directors no later than at the next regularly scheduled board meeting. After the initial report, the Adopting Release indicates that these findings should be reported to the Board annual under the Fund’s compliance program.
The underwriter or depositor of a UIT that is an acquiring fund must make similar findings as the investment adviser to an open-end fund. In addition, before a separate account funding variable insurance contracts invests in an acquiring fund, the acquiring fund must obtain a certification from the insurance company issuing the separate account that it has determined that the fees and expenses borne by the separate account, acquiring fund, and acquired fund, in the aggregate, are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company.
3. Fund of Funds Investment Agreement
An acquiring fund and acquired fund that do not share an investment adviser must enter into a fund of funds investment agreement prior to the acquiring fund acquiring securities of the acquired fund in excess of the Section 12(d)(1) limits in reliance on the Rule. Such an agreement must include the following:
- any material terms necessary for the adviser, underwriter, or depositor to have made the findings regarding the acquiring fund’s investment in the acquired fund;
- a termination provision whereby either party can terminate the agreement with advance written notice within a period of no longer than 60 days; and
- a provision whereby the acquired fund must provide the acquiring fund with fee and expense information to the extent reasonably requested.
The Rule generally limits fund of fund arrangements with more than two tiers. However, the Rule does create a 10% bucket whereby an acquired fund may invest up to 10% of its assets in the securities of another investment company or private fund (the “10% bucket”). The 10% bucket is separate and apart for other investments that may otherwise be permitted by law, such as (a) investments acquired pursuant to Section 12(d)(1)(E) of the 1940 Act, which permits master-feeder arrangements, (b) investments acquired pursuant to Rule 12d1-1 under the 1940 Act, which permits invests in money market funds, (c) a subsidiary wholly-owned and controlled by the acquired fund, (d) investments acquired as a result of a dividend received or as a result of a plan of reorganization of a company, or (e) investments acquired pursuant to exemptive relief from the SEC to engage in interfund borrowing and lending transactions.
Rescission of Exemptive Orders and Withdrawal of No-Action Letter
In connection with the adoption of the Rule, the SEC is rescinding the exemptive relief previously granted to permit fund of funds arrangements that “fall within the scope of [the Rule].” This encompasses all orders granting relief from Sections 12(d)(1)(A), (B), (C), and (G) of the 1940 Act, except for orders permitting certain interfund lending arrangements. This includes relief provided in ETFs’ exemptive orders that permit acquiring funds to invest in ETFs in excess of the Section 12(d)(1) limits. Going forward, funds will have to invest in ETF shares in reliance on a statutory exemption or the Rule. 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 and Amended Rule 12d1-1
The SEC is also rescinding Rule 12d1-2, which permits an acquiring fund relying on Section 12(d)(1)(G) of the 1940 Act to invest in shares of unaffiliated funds and other securities. As a result, going forward, these types of arrangements must be done in accordance with the requirements of the Rule. Similarly, with the rescission of Rule 12d1-2, acquiring funds that rely on Section 12(d)(1)(G) will lose the ability to invest in unaffiliated money market funds without limit. Accordingly, Rule 12d1-1 is being amended to permit acquiring funds relying on Section 12(d)(1)(G) to invest in unaffiliated money market funds without limit.
Amended Form N-CEN
The SEC is amending Form N-CEN to require funds to report whether they relied on the Rule or the statutory exemption in Section 12(d)(1)(G) of the 1940 Act during the applicable reporting period.
The Rule and the accompanying SEC rule and form amendments will take effect 60 days after publication in the Federal Register. In order to provide a transition period, the rescission of Rule 12d1-2 and the SEC’s existing exemptive orders will be effective one year after the Rule’s effective date, and the compliance date for the amendments to Form N-CEN will be 425 days after publication in the Federal Register.
The Rule provides a comprehensive regime that would impose a substantially uniform set of requirements on all fund of funds arrangements. This will have a particular effect on affiliated fund of funds arrangements, which currently can often rely on the statutory exemption provided by Section 12(d)(1)(G) and Rule 12d1-2 to invest in non-affiliated funds, as well as in stocks, bonds and other securities. Because of the rescission of Rule 12d1-2, acquiring funds that rely on Section 12(d)(1)(G) and Rule 12d1-2 for these purposes will have to modify their operations to rely on the Rule.
Many fund complexes also rely on a combination of Section 12(d)(1)(G) and an exemptive order to create three-tier fund of funds arrangements. The rescission of the exemptive orders may cause these arrangements to be restructured because of the limits on the portion of an acquired fund’s assets that can be invested in other registered funds. It remains to be seen whether the SEC would consider new exemptive orders that would permit three-tier fund of funds arrangements.
ETFs may also be particularly impacted by certain of the requirements of the Rule. Many acquired funds in affiliated fund of funds arrangements invest in ETFs without limit pursuant to the ETFs’ own exemptive orders. When these exemptive orders are rescinded, the Rule will limit acquired funds’ investments in other funds, including in ETFs, to the 10% bucket.
If you have any questions or would like to discuss the new Rule, please feel free to contact any Sullivan lawyer with whom you regularly work or either of the lawyers listed below:
212 660 3073
202 775 1232
 Section 12(d)(1)(B) of the 1940 Act prohibits a registered open-end fund, any principal underwriter therefor, or any broker or dealer from selling or otherwise disposing of any security issued by the acquired company to any other investment company or any company or companies controlled by the acquiring company in excess of the 3% Limit or 10% Limit.
Section 12(d)(1)(C) of the 1940 Act prohibits an investment company from acquiring any security issued by 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 per centum of the total outstanding voting stock of such closed-end fund.
 The term ‘‘group of investment companies’’ means any two or more registered investment companies that hold themselves out to investors as related companies for purposes of investment and investor services. See Section 12(d)(1)(G)(ii) of the 1940 Act. Under Section 12(d)(1)(G), funds may invest in only government securities and short-term paper, in addition to shares of other affiliated open-end funds and UITs.
 With respect to BDCs, the rule provides exemptions from Sections 57(a)(1)-(2) and 57(d)(1)-(2) of the 1940 Act for arrangements that comply with the Rule. These Sections are the analogous provisions to Section 17(a) that regulate affiliated transactions by BDCs.
 The Rule defines “advisory group” to mean “either: (a) 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 (b) an acquiring fund’s investment sub-adviser and any person controlling, controlled by, or under common control with such investment sub-adviser.” An acquiring fund would not combine the entities listed in clause (a) with those in clause (b).
 Section 2(a)(9) of the 1940 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 1940 Act 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 “mirror" vote” is a vote by an acquiring fund of its shares in an acquired fund in in the same proportion as the vote of all other holders of the acquired fund’s shares.
 Pass-through voting is to be used when mirror voting is not possible, such as when all shares of an acquired fund are held by acquiring funds that are required to mirror vote. In such cases, the shareholders of the acquiring fund would vote the shares held by the acquiring fund.
 The Rule defines “group of investment companies” the same way as the term is defined in Section 12(d)(1)(G) of the 1940 Act.
 In a change from current practice, the Fund’s board is not required to make any findings in order to rely on the Rule.
 The list of no-action letters to be withdrawn will be available on the SEC’s website.
 As of the date of this memorandum, the Rule has not been published in the Federal Register.