UNITED STATES: SEC Updates Regulatory Framework for Fund of Funds Arrangements

Wednesday October 7 2020

The Securities and Exchange Commission has voted to adopt a new rule and related amendments designed to put in place a comprehensive regulatory framework for fund of funds arrangements.  The rule also reflects the Commission’s decades of experience with fund of funds arrangements and will create a consistent and efficient rules-based regime for the formation and oversight of funds of funds.

According to staff estimates, approximately 40% of all registered funds hold an investment in at least one other fund.  Total net assets in mutual funds that invest primarily in other mutual funds have grown to $2.54 trillion in 2019.  Retail investors similarly use fund of funds arrangements as a convenient way to allocate and diversify their portfolio through a single, professionally managed investment.  Rule 12d1-4 will allow 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 from the Commission if the funds comply with conditions designed to enhance investor protection.

The Commission is also rescinding rule 12d1-2 as well as most exemptive relief permitting fund of funds arrangements because the rule will create a new, comprehensive exemptive rule on which funds of funds can rely.  The Commission is not rescinding exemptive relief granted to funds of funds that is outside the scope of the rule.

The rule will be effective 60 days after publication in the Federal Register, but, in order to facilitate a transition period, the compliance date for the amendments to Form N-CEN will be 425 days after publication in the Federal Register.  Further, the rescission of rule 12d1-2 and the Commission’s exemptive orders will be effective one year from the effective date of the rule.

Highlights of the Action : Rule 12d1-4

Limits on Control and Voting

Rule 12d1-4 will prohibit an acquiring fund from controlling an acquired fund and 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 prescribed manner in order to minimize the influence that an acquiring fund may exercise over an acquired fund.  An acquiring fund that is part of the same fund group as the acquired fund and an acquiring fund that has a sub-adviser that acts as adviser to the acquired fund will not be subject to the control and voting conditions.

Required Evaluations and Findings

To address concerns that an acquiring fund could exert undue influence over an acquired fund or charge duplicative fees and expenses, the rule will require certain evaluations and findings be made before the acquiring fund invests in an acquired fund.  These differ depending upon whether a fund is the acquiring or acquired fund and whether it is a management company, unit investment trust, or a separate account funding variable insurance contracts.

Required Fund of Funds Investment Agreements

In addition, the rule will require funds that do not share the same investment adviser to enter into a fund of funds investment agreement memorializing the terms of the arrangement.  This and the evaluation and finding requirements replace a proposed requirement that would have prohibited an acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares from redeeming more than 3% of the acquired fund’s total outstanding shares in any 30-day period.

Limits on Complex Structures

To limit funds’ ability to use fund of funds arrangements to create overly complex structures, rule 12d1-4 generally will prohibit funds from creating three-tier fund of funds structures, except in certain circumstances, including 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”).  The 10% bucket will provide flexibility for fund of funds arrangements to evolve, while permitting certain structures that could benefit investors through greater efficiency.

Amendments to Form N-CEN

The Commission is also amending Form N-CEN to require funds to report whether 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.

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