SEC Adopts Changes for Fund of Funds Arrangements

On October 7, 2020, the SEC issued a release (the “Release”) adopting new Rule 12d1-4 and making several related rule and form amendments under the 1940 Act intended to streamline and enhance the regulatory framework applicable to funds that invest in other funds (“fund of funds” arrangements). The Release noted that the current combination of statutory exemptions, SEC rules and exemptive orders has created a regime in which substantially similar fund of funds arrangements are subject to different conditions. The Release is intended to replace the existing regime with “a consistent and efficient rules-based regime for the formation, operation, and oversight of fund of funds arrangements.”

While Rule 12d1-4, as adopted, differs substantially from the version of the rule proposed by the SEC in 2018 (the “Proposed Rule,” described in this Ropes & Gray Alert), and does not include the Proposed Rule’s widely criticized redemption limits, many existing fund of funds arrangements may nonetheless require modifications.

EXECUTIVE SUMMARY

• Rule 12d1-4 (the “Rule”) permits fund of funds arrangements subject to various conditions, including limits on control and voting, required evaluations and findings, required fund investment agreements and limits on complex (i.e., more than two tier) fund of funds structures. The Rule is intended to be a comprehensive exemptive rule and, therefore, the SEC is rescinding Rule 12d1-2, as well as most exemptive orders granting relief from Sections 12(d)(1)(A), (B), (C) and (G) of the 1940 Act and related no-action letters. 
  • Rule 12d1-2 currently provides funds that rely on Section 12(d)(1)(G) with flexibility to invest in securities of funds that are not part of the same group of investment companies when the acquisition is in reliance on Section 12(d)(1)(A) or (F), as well as in stocks, bonds and other securities. The rescission of Rule 12d1-2 will result in the loss of this flexibility.
  • Existing exemptive orders and no-action letters permit multi-tier fund of funds arrangements. The rescission of these orders and letters will result in the elimination of many of these arrangements, including “central funds” (three-tier affiliated fund-of-fund arrangements used to efficiently manage exposure to a specific asset class). 
• In light of the rescission of Rule 12d1-2, the Release amends Rule 12d1-1 to permit funds that rely on Section 12(d)(1)(G) to invest in money market funds that are not part of the same group of investment companies. 
• In general, the Rule is designed to restrict multi-tier fund of funds arrangements, where an acquired fund’s investments in other investment companies or private funds exceed the limits of Section 12(d)(1)(A) of the 1940 Act. The Rule permits some multi-tier structures. 
  • The Rule prohibits an acquired fund in a fund of funds arrangement relying on either Section 12(d)(1)(G) or the Rule from investing in the securities of an investment company or private fund if, subject to limited exceptions, the value of the securities of investment companies and private funds owned by the acquired fund exceeds 10% of the acquired fund’s total assets (the “10% Bucket”).
• The Release adds a requirement to Form N-CEN to require open-end funds, closed-end funds and unit investment trusts (“UITs”) to report whether they relied on Rule 12d1-4 or, instead, the statutory exception in Section 12(d)(1)(G) during the reporting period.
• The Release does not provide additional flexibility for private funds to invest in registered investment companies, including business development companies (“BDCs”).

Effective Date. The Release’s effective date is 60 days after the Rule’s publication in the Federal Register.¹ The rescission of Rule 12d1-2 is effective one year from that date, as is the rescission of various exemptive orders and no-action letters effected by the Release.

The Release is discussed in detail below. The Rule, marked to show changes from the Proposed Rule, appears in this Alert’s Appendix. 

BACKGROUND

In general, Section 12(d)(1)(A) contains the so-called “3-5-10%” limits governing a registered fund’s investments in other funds and a private fund’s² investments in registered funds.³ Section 12(d)(1)(B) addresses the sell-side of such investments by limiting a registered open-end fund’s sales of its securities to other investment companies.⁴ Section 12(d)(1)(C) contains limitations on fund investments in registered closed-end funds.

Rule 12d1-1 allows funds to invest in shares of money market funds in excess of the limits of Section 12(d)(1), and Rule 12d1-2 currently provides funds that rely on Section 12(d)(1)(G)⁵ with flexibility to invest in securities of funds that are not part of the same group of investment companies when the acquisition is in reliance on Section 12(d)(1)(A) or (F), as well as in stocks, bonds and other securities.

INVESTMENTS PERMITTED BY RULE 12d1-4

Subject to specific conditions (described below), and notwithstanding the prohibitions in Sections 12(d)(1)(A), 12(d)(1)(B), 12(d)(1)(C), 17(a), 57(a)(1)-(2) and 57(d)(1)-(2) of the 1940 Act, the Rule allows:

• A registered investment company or BDC (each, an “acquiring fund”) to acquire the securities of any other registered investment company or BDC (collectively, “acquired funds”).
• An acquired fund, its principal underwriter and any broker-dealer to sell the acquired fund’s securities to any acquiring fund.
• An acquired fund to redeem or repurchase its securities issued to an acquiring fund.
• An acquiring fund that is an affiliated person of an ETF (or an affiliated person of such an acquiring fund) solely by reason of holding with the power to vote 5% or more of the outstanding shares of (i) the ETF or (ii) any fund that is an affiliated person of the ETF, to deposit and receive the ETF’s “baskets,”⁶ provided that the acquired ETF is not otherwise an affiliated person (or affiliated person of an affiliated person) of the acquiring fund.⁷ An acquiring fund that transacts with an ETF through an authorized participant (“AP”) that holds 5% or more of the ETF is within this group. 

Currently, permitted fund of funds arrangements vary significantly based on the type of acquiring fund. In some cases, the Rule generally expands the types of permitted fund of funds arrangements. For example, the Rule permits open-end funds to invest in unlisted closed-end funds (including unlisted BDCs) in amounts that exceed the limits specified in Section 12(d)(1). The following chart, which appeared in the underlying 2018 SEC release (the “Proposing Release”), summarizes the types of fund of funds arrangements that the Rule permits.

RULE 12d1-4 CONDITIONS

1. Control

An acquiring fund and its “advisory group”⁸ may not “control” an acquired fund. Control is determined using the definition set forth in Section 2(a)(9) of the 1940 Act, including the definition’s rebuttable presumption of control. Thus, up to 25% of an acquired fund’s shares normally could be acquired by an acquiring fund and its advisory group. 

This condition does not apply if the acquiring fund is within the same “group of investment companies”⁹ as an acquired fund, or the acquiring fund’s investment sub-adviser or any control affiliate of the sub-adviser is the adviser or depositor of the acquired fund.

2. Voting

An acquiring fund and its advisory group must employ mirror voting¹⁰ if they hold more than 25% of the voting securities of an acquired open-end fund or UIT due to a decrease in the number of those shares outstanding,¹¹ or more than 10% of the voting securities of an acquired closed-end fund or BDC.

There are two exceptions to these voting conditions:

1. In situations where all holders of the outstanding voting securities of an acquired fund are required by Rule 12d1-4 or Section 12(d)(1) of the 1940 Act to employ mirror voting, an acquiring fund and its advisory group are instead required to employ pass-through voting to vote securities of the acquired fund.¹² The Release cites as an example an acquired fund that is held only by acquiring funds that are relying on Rule 12d1-4 as a situation in which there may be no other investors to vote the acquired fund’s shares, thereby requiring pass-through voting.
2. As with the control condition, the voting conditions do not apply if the acquiring fund is within the same group of investment companies as an acquired fund, or the acquiring fund’s investment sub-adviser or any control affiliate of the sub-adviser is the adviser or depositor of the acquired fund.

3. Required Findings

The Rule does not include the Proposed Rule’s (i) limitations an acquiring fund’s redemptions of an acquired fund and (ii) requirement that funds disclose whether they are or may be an acquiring fund. Instead, the Rule requires an investment adviser to an open-end fund or closed-end fund (including a BDC) that relies on the Rule to evaluate and make certain findings regarding the arrangement (“Fund Findings”)¹³ discussed in this section, and also requires an acquiring fund and acquired fund to enter into a fund of funds investment agreement (discussed below). The underwriter or depositor of a UIT that is an acquiring fund, and any insurance company a separate account of which that funds variable insurance contracts and invests in acquiring fund must make similar findings and, in the latter case provide the acquiring fund with a related certification. The Fund Findings and related board-reporting requirements are as follows:

1. If the acquiring fund is an open-end fund or closed-end fund (including a BDC), prior to the initial acquisition of an acquired fund in excess of the 3% limit in Section 12(d)(1)(A)(i), the acquiring fund’s investment adviser must evaluate the complexity of the structure and fees and expenses arising from the 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.
2. If the acquired fund is an open-end fund or closed-end fund (including a BDC), before the initial acquisition of an acquired fund in excess of the limits in Section 12(d)(1)(A)(i), the acquired fund’s investment adviser must find that any concerns regarding undue influence arising from the acquiring fund’s investment in the acquired fund are reasonably addressed. At a minimum, as part of this finding, the investment adviser must consider the following items:
   • 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 such redemptions in kind.
3. The investment adviser to each acquiring or acquired fund must report its evaluations and findings, including the adviser’s underlying reasoning, for the required items in (i) and (ii), as applicable, to the fund’s board of directors, no later than the next regularly scheduled board meeting.¹⁴

4. Fund of Funds Investment Agreement

Unless an acquiring fund and an acquired fund share the same investment adviser, the Rule requires the funds to enter into a fund of funds investment agreement before the acquiring fund acquires securities of the acquired fund that exceed Section 12(d)(1)’s limits. The Rule mandates that this fund of funds investment agreement must be effective for the duration of the funds’ reliance on the Rule, and must include the following:

1. Any material terms regarding the acquiring fund’s investment in the acquired fund necessary to make the required Fund Findings.
2. A termination provision permitting either the acquiring fund or the acquired fund to terminate the agreement upon no more than 60 days’ written notice.
3. 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.

The Release stated that, in negotiating the fund of funds investment agreement, the funds could set the terms of the agreement that support the Fund Findings. For example, “an acquired fund could require the acquiring fund to agree to submit redemptions over a certain amount for a given period as a condition to the fund of funds investment agreement.”¹⁵ The Release noted that termination of a fund of funds investment agreement would not, unless the parties agreed otherwise, require the acquiring fund to reduce its holdings of the acquired fund. However, the termination of the agreement will preclude the acquiring fund from purchasing additional shares of the acquired fund beyond the Section 12(d)(1) limits.

The Release also stated that “fund of funds investment agreements are material contracts not made in the ordinary course of business” and, therefore, “they must be filed as an exhibit to each fund’s registration statement.” (Emphasis added).

5. Complex Structures

In general, the Rule is designed to restrict fund of funds arrangements with more than two tiers, where an acquired fund’s investments in other investment companies or private funds exceed the limits of Section 12(d)(1)(A) of the 1940 Act. The Rule permits some multi-tier structures.

The Rule prohibits an acquired fund in a fund of funds arrangement relying on either Section 12(d)(1)(G) or the Rule from purchasing or otherwise acquiring the securities of an investment company or private fund if, immediately after such purchase or acquisition, the value of the securities of investment companies and private funds owned by the acquired fund exceeds 10% of the acquired fund’s total assets (the “10% Bucket”).¹⁶ The 10% Bucket does not include investments by the acquired fund in:

1. Reliance on Section 12(d)(1)(E) of the 1940 Act.
2. Reliance on Rule 12d1-1 (as amended).
3. A subsidiary that is wholly-owned and controlled by the acquired fund.
4. Securities received as a dividend or as a result of a plan of reorganization of a company.
5. Securities of another investment company received pursuant to exemptive relief from the SEC to engage in interfund borrowing and lending transactions.

In short, the Rule requires that an acquired fund’s investments in other investment companies and private funds, other than investments excluded under (i) – (v) above, must not exceed its 10% Bucket. The Rule provides that no investment company may rely on the Rule or Section 12(d)(1)(G) to purchase or otherwise acquire, in excess of the limits in Section 12(d)(1)(A), the outstanding voting securities of an investment company (a “second-tier fund”) that relies on the Rule to acquire the securities of an acquired fund, unless the second-tier fund’s investments in other investment companies and private funds are limited to its 10% Bucket and securities listed in (i) – (v), above. A fund that does not satisfy these conditions may not be an acquired fund under Section 12(d)(1)(G) or the Rule.¹⁷

RESCISSION OF RULE 12d1-2 AND AMENDED RULE 12d1-1

To limit the hardship that the rescission of Rule 12d1-2 could have on existing fund of funds arrangements, the Release provides for a one-year period after the effective date of the Rule before Rule 12d1-2 is rescinded. The Release states that this “one year is adequate time for funds relying on current rule 12d1-2 to bring their future operations into conformity with section 12(d)(1)(G) or rule 12d1-4.”

With the rescission of Rule 12d1-2, fund of funds arrangements that rely on Section 12(d)(1)(G) lose the flexibility to invest in unaffiliated money market fund securities in reliance on Rule 12d1-2(a)(3).¹⁸ To provide funds relying on Section 12(d)(1)(G) with continuing flexibility to invest in money market funds outside of their group of investment companies, the Release amends Rule 12d1-1 to permit such investments.

RESCISSION OF EXEMPTIVE ORDERS AND WITHDRAWAL OF NO-ACTION LETTERS

The Release rescinds 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, effective one year after the Rule’s effective date. The Release also rescinds fund of funds exemptive orders that “fall within the scope of Rule 12d1-4,” effective one year after the Rule’s effective date.

The Release states that certain “[f]und of funds exemptive relief that falls outside the scope of rule 12d1-4, as well as the relevant portions of fund of funds exemptive orders that grant relief for provisions in the Act outside of the scope of this rulemaking, will remain in place.” This includes (i) interfund lending orders, (ii) exemptive orders that provide relief from Sections 17(a) and 17(d) and Rule 17d-1 under the 1940 Act permitting a registered fund to invest in private funds and (iii) portions of fund of funds exemptive orders that provide relief from Section 17(d) and Rule 17d-1 permitting fee-sharing agreements to avoid duplicative fees.

The Release states that no-action letters applicable to specific circumstances related to Section 12(d)(1) will be withdrawn one year from the Rule’s effective date, and that the withdrawn letters will include only those letters that fall within the scope of Rule 12d1-4.¹⁹ The Release does not provide a list of the no-action letters that will be withdrawn but, instead, refers interested persons to the Division of Investment Management’s website. As of the date of this Alert, the Division’s list of Modified or Withdrawn Staff Statements has not been amended to identify withdrawn no-action letters.

AMENDED FORM N-CEN

At present, Item C.7 of Form N-CEN requires funds to report if they relied on certain 1940 Act rules during the reporting period, including if they relied on Rule 12d1-1. The Release amends Form N-CEN to require funds and UITs to report if they relied on the Rule or the statutory exception in Section 12(d)(1)(G) during the reporting period. The effective date for the amended Form N-CEN is 425 days after publication of the Release in the Federal Register.

OBSERVATIONS

1. No Redemption Limits. The Rule eliminates the most controversial and unpopular condition to reliance on the Proposed Rule, which would have capped redemptions by an acquiring fund in excess of 3% of an acquired fund’s shares during any 30-day period. While the conditions included in lieu of the redemption limits impose potentially burdensome new obligations on advisers and boards, the Rule dropped a condition that would have been entirely unworkable for many fund of funds arrangements.
2. Impact on Three-Tier Fund of Funds Arrangements. The Rule prohibits most three-tier fund structures, subject to the limited exceptions described above. Some fund complexes currently employ a multi-tier structure by relying on a combination of Section 12(d)(1)(G) (and Rule 12d1-2 thereunder) and either an ETF or fund of funds exemptive order. The rescission of these orders may require these complexes to restructure their investments. The SEC stated that “[w]e agree with commenters that additional flexibility to enter into multi-tier arrangements could lead to efficiencies and cost savings for fund investors.” However, the SEC ultimately concluded that the “10% Bucket, when combined with the enumerated exceptions discussed above, will provide flexibility for beneficial multi-tier arrangements while limiting the harms that Congress sought to prevent.” Whether the SEC will provide future exemptive relief to permit other multi-tiered structures is unknown and is likely to be contingent on experience with the Rule. In particular, it remains to be seen whether the SEC’s assertion that the Rule and related changes will provide sufficient flexibility for beneficial multi-tier arrangements will be borne out.
3. A Mixed Bag for ETFs. Many funds that are acquired funds in fund of funds arrangements operating under Section 12(d)(1)(G) or Rule 12d1-2 currently invest without limit in ETFs in reliance on the ETFs’ exemptive orders. Under the Rule, acquired funds’ investments in ETFs (and other investment companies and private funds) will be subject to the 10% Bucket. While this imposes a new limit with respect to funds investing in ETFs with exemptive orders, it also creates new flexibility to invest in excess of the limits of Section 12(d)(1)(A) in ETFs without exemptive orders. Separately, the Rule addresses a gap in the ETF Rule (Rule 6c-11); namely, that ETF baskets may be contributed and redeemed by acquiring funds that are technically affiliated with an ETF by virtue of owning 5% or more of the acquired ETF’s shares. However, the Commission also suggests that ETFs should question potential purchasers of the ETF’s shares (including purchasers acting through an authorized participant) to determine whether those persons intend to purchase ETF shares for investment companies, and adds that the ETF may want to consider adopting and implementing policies and procedures to make these inquiries.²⁰
4. Affiliated Fund of Funds Structures. The impact of the Rule on most two-tier affiliated fund of funds structures could be extensive. Advisers to funds relying on the Rule, rather than Section 12(d)(1)(G), will be required to make new findings and provide new reports to fund boards, but will be exempt from the control and investment agreement requirements. Affiliated fund of funds that can operate in compliance with Section 12(d)(1)(G) may opt to do so in order to avoid the Rule’s findings and reporting requirements. Of course, the rescission of Rule 12d1-2 means that funds relying on Section 12(d)(1)(G) will lose the ability to acquire the securities of other funds that are outside of the fund’s group of investment companies (except for money market funds) and invest directly in stocks, bonds and other securities, as now permitted by Rule 12d1-2, and derivatives and other financial instruments that are not securities under the 1940 Act (as now permitted under the Northern Lights Fund Trust no-action letter).
5. Efficacy of Fund of Funds Investment Agreements and Effects on Liquidity Risk Management Programs. The Release specifically contemplates that advance notice requirements and redemption limits might be included in fund of funds investment agreements, but does not indicate whether such limits would actually be enforceable. Even if an acquiring fund were to agree to provide advance notice to an acquired fund and to spread out large redemptions, it may retain the legal right to redeem open-end fund shares on any business day and to receive redemption proceeds within seven days.²¹ The question of whether redemption limits in fund of funds investment agreements are enforceable also has implications for the acquiring fund and acquired fund’s respective liquidity risk management programs adopted under Rule 22e-4 under the 1940 Act.
6. No New Protections for Closed-End Funds. Many closed-end fund sponsors and boards hoped that a final rule would provide additional protections from activist investors, particularly given the SEC’s objective of protecting funds from undue influence exerted by other funds. Many closed-end fund activist investors acquire large positions in closed-end funds by using numerous private funds, each of which acquires up to 3% of a given closed-end fund’s shares. While the Rule’s “control” condition requires mirror voting when an acquiring fund and its advisory group hold more than 10% of a closed-end fund’s outstanding voting securities, this condition would only apply where an activist holds at least some of its shares in a given closed-end fund through a registered fund. Mirror voting would not be required where an activist exclusively uses private funds (most activists’ structure of choice in any case) to acquire large positions in closed-end funds.
7. Disclosure. While the Rule does not require a fund to disclose that it is an acquired fund subject to the Rule’s limitations, the fund may want to consider whether the Rule’s limits on an acquired fund (e.g., complying with 10% Bucket requirements) limit its investment flexibility materially.

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For further information about how the issues described in this Alert may impact your interests, please contact your regular Ropes & Gray attorney.