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Investment Company Act of 1940 — Section 12(d)(1)(E)
Dechert LLP
March 8, 2017
RESPONSE OF CHIEF COUNSEL'S OFFICE
DIVISION OF INVESTMENT MANAGEMENT
Your letter dated March 8, 2017 requests assurance that we would not recommend enforcement action to the Securities and Exchange Commission (“Commission”) under Section 12(d)(1)(A) or (B) of the Investment Company Act of 1940 (“1940 Act”) against: (i) a foreign investment company (a “Foreign Feeder Fund”) that acquires securities of an open-end investment company registered under the 1940 Act (a “U.S. Master Fund”) in excess of the limits in Section 12(d)(1)(A) of the 1940 Act; or (ii) the U.S. Master Fund, its principal underwriter (“Master Fund Principal Underwriter”) and any broker or dealer, that sells the U.S. Master Fund’s securities to the Foreign Feeder Fund in excess of the limits in Section 12(d)(1)(B) of the 1940 Act, if it does so in compliance with the conditions of Section 12(d)(1)(E) of the 1940 Act, modified as described in your letter.
Section 12(d)(1)(E) is a conditional exemption from the restrictions in Sections 12(d)(1)(A) and (B) that is relied upon by, among others, private funds and foreign investment companies to invest in U.S.-registered funds. In sum, your proposed structure (the “Proposed Structure”) would deviate from the conditions of Section 12(d)(1)(E) in that a Foreign Feeder Fund:
- may not have a principal underwriter or depositor that is a broker or dealer registered under the Securities Exchange Act of 1934 (“1934 Act”) or a person controlled by such broker or dealer, as required by Section 12(d)(1)(E)(i), but: (a) may have a principal underwriter that either controls or is under common control with a broker or dealer registered under the 1934 Act (“Foreign Principal Underwriter”); and (b) will have as its investment adviser an investment adviser that (i) controls, is controlled by, or is under common control with (“Control Affiliate”), the investment adviser to the U.S. Master Fund (“Master Fund Adviser”) and the Master Fund Principal Underwriter and (ii) may be registered under the Investment Advisers Act of 1940 (“Advisers Act”) (“Feeder Fund Adviser”);
- may hold certain investment securities that are not limited to the securities of the U.S. Master Fund, as required by Section 12(d)(1)(E)(ii), but will do so solely for purposes of hedging either: (a) the performance of the U.S. Master Fund, measured in the U.S. dollar, against the currency of the foreign jurisdiction in which the Foreign Feeder Fund’s securities are primarily offered and sold (“Designated Currency”); or (b) if the U.S. Master Fund seeks to approximate the return of an index, the U.S. dollar and/or foreign currency exposure of the U.S. Master Fund to the Foreign Feeder Fund’s Designated Currency; and
- may either abstain from voting or withhold voting the U.S. Master Fund’s shares, rather than pass through such vote to the Foreign Feeder Fund’s shareholders or vote proportionately to the vote of the U.S. Master Fund’s other shareholders, which is a condition of Section 12(d)(1)(E)(iii)(aa).
Based on the representations in your letter, and for the reasons set forth below, we are providing such assurance.
BACKGROUND
You state the following:
- A number of global investment managers are seeking to offer Foreign Feeder Funds in various foreign jurisdictions as vehicles for investing in a U.S. Master Fund using a master-feeder fund arrangement. The Proposed Structure potentially could help attract significant assets to the benefit of all investors in the U.S. Master Fund. The Master Fund Adviser will be registered under the Advisers Act and the U.S. Master Fund will have a Master Fund Principal Underwriter that is a broker-dealer registered under the 1934 Act.
- A Foreign Feeder Fund will be a foreign publicly offered investment company whose securities are generally redeemable upon demand to the fund (i.e., a foreign mutual fund) or whose securities are listed on one or more foreign securities exchanges (i.e., a foreign exchange traded fund or foreign closed-end fund).[1] The Foreign Feeder Fund will have as its investment adviser a Feeder Fund Adviser that is a Control Affiliate of the Master Fund Adviser and the Master Fund Principal Underwriter.
- A Foreign Feeder Fund may: (i) have a principal underwriter that is a broker or dealer registered under the 1934 Act or a person controlled by such broker or dealer; (ii) have a Foreign Principal Underwriter that controls or is under common control with a broker or dealer registered under the 1934 Act; or (iii) not have a principal underwriter or depositor at all. Any Foreign Principal Underwriter to the Foreign Feeder Fund will be a Control Affiliate of the Feeder Fund Adviser, Master Fund Adviser, and Master Fund Principal Underwriter.
- Each Foreign Feeder Fund will invest in the securities of a single U.S. Master Fund and may hold cash and other assets that are not investment securities. The Foreign Feeder Fund also may invest in foreign currency and certain foreign currency-related instruments (“Foreign Currency Instruments”)[2] to mitigate the effects of currency fluctuations in two situations.[3] First, a Foreign Feeder Fund may hedge the performance of the U.S. Master Fund, as measured in the U.S. dollar, against the Foreign Feeder Fund’s Designated Currency (“Feeder-level Hedging”).[4] Second, a Foreign Feeder Fund that invests in a U.S. Master Fund that seeks to approximate the return of an index, may hedge the U.S. dollar and/or foreign currency exposure associated with the U.S. Master Fund’s portfolio to the Foreign Feeder Fund’s Designated Currency[5] (“Master-level Hedging”).[6]
LEGAL ANALYSIS
Sections 12(d)(1)(A) and (B) of the 1940 Act
Section 12(d)(1)(A), in relevant part, prohibits a Foreign Feeder Fund from: (i) acquiring more than three percent of the total outstanding voting stock of a U.S. Master Fund; (ii) investing more than five percent of the value of its total assets in the U.S. Master Fund; or (iii) investing more than ten percent of the value of its total assets in investment companies registered under the 1940 Act.
Section 12(d)(1)(B), in relevant part, prohibits a U.S. Master Fund, Master Fund Principal Underwriter and any broker or dealer registered under the 1934 Act from knowingly selling the U.S. Master Fund’s securities to a Foreign Feeder Fund if immediately after such sale the Foreign Feeder Fund would own more than three percent of the U.S. Master Fund’s total outstanding voting stock, or more than ten percent of the U.S. Master Fund’s total outstanding voting stock would be owned by the Foreign Feeder Fund and other investment companies.
These prohibitions were enacted out of concerns about undue influence by the acquiring fund and its affiliates over the acquired fund and its affiliates, the pyramiding of control, the layering of fees, and overly complex fund structures.[7] Specifically with respect to foreign funds investing in U.S. funds, it was also noted that “redemptions could be unduly escalated by the instability of certain foreign economies, political upheaval, currency reform, or other factors which are not really relevant to investment in domestic mutual funds.”[8]
Section 12(d)(1)(E) of the 1940 Act
Section 12(d)(1)(E) provides an exemption from the prohibitions in Sections 12(d)(1)(A) and (B) of the 1940 Act, subject to the following conditions designed to address the concerns underlying those prohibitions:
- the principal underwriter for the Foreign Feeder Fund must be a broker or dealer registered under the 1934 Act, or a person controlled by such broker or dealer;
- the U.S. Master Fund’s securities are the only investment security held by the Foreign Feeder Fund; and
- the Foreign Feeder Fund purchases or otherwise acquires securities issued by the U.S. Master Fund pursuant to an arrangement with the U.S. Master Fund or its principal underwriter whereby the Foreign Feeder Fund is obligated:
- either to seek instructions from its security holders with regard to the voting of all proxies with respect to the U.S. Master Fund’s securities and to vote such proxies only in accordance with such instructions, or to vote the shares held by it in the same proportion as the vote of all other holders of the U.S. Master Fund’s securities; and
- to refrain from substituting the U.S. Master Fund’s securities unless the Commission shall have approved such substitution in the manner provided in Section 26 of the 1940 Act.
You state that in the Proposed Structure a Foreign Feeder Fund would deviate from the conditions set forth in Section 12(d)(1)(E) in the following manner.[9]
Foreign Feeder Fund Might Not Have a Principal Underwriter or Depositor
You state that a Foreign Feeder Fund might not have a principal underwriter or depositor at all, or have a Foreign Principal Underwriter, and therefore would not meet the condition in Section 12(d)(1)(E) that the principal underwriter or depositor be a broker or dealer registered under the 1934 Act or a person controlled by such broker or dealer. You state that this condition appears to have been designed to ensure that the Commission has jurisdiction over and the ability to pursue claims against the principal underwriter or depositor of the acquiring fund in connection with their activities relating to the master-feeder fund structure.
You argue that the following factors in the Proposed Structure serve to address these jurisdictional concerns:
- the Foreign Feeder Fund will have an investment adviser[10] that is a Control Affiliate of the Master Fund Adviser and Master Fund Principal Underwriter;[11]
- to the extent the Feeder Fund Adviser is not registered under the Advisers Act, such Feeder Fund Adviser will make its books and records with respect to the activities of the Foreign Feeder Fund available to the Commission and its staff, designate the Master Fund Adviser as its agent for service of process in the United States with respect to the Foreign Feeder Fund, and consent to the jurisdiction of the U.S. courts and the Commission with respect to its activities in connection with the Foreign Feeder Fund;[12]
- the Foreign Feeder Funds will be organized in, and regulated under the laws of, jurisdictions whose securities regulators have entered into a cooperation arrangement with the Commission;[13] and
- no Foreign Feeder Fund will offer or sell its securities in the United States, either publicly or privately, or sell its securities to any “U.S. person,” as defined in Rule 902(k) of Regulation S under the 1933 Act (“Regulation S”); each Foreign Feeder Fund’s transactions with its shareholders will be consistent with the definition of “offshore transactions” in Rule 902(h) of Regulation S; and no Foreign Feeder Fund, Feeder Fund Adviser, Foreign Principal Underwriter, any of their respective affiliates, or any person acting on behalf of any of the foregoing, will engage in any “directed selling efforts,” as defined in Rule 902(c) of Regulation S, with respect to securities of the Foreign Feeder Fund in the United States.[14]
Currency Hedging by a Foreign Feeder Fund
You state that, because a Foreign Feeder Fund might hold Foreign Currency Instruments, it might not meet the requirement in Section 12(d)(1)(E) that the U.S. Master Fund’s securities be the only investment security held by the Foreign Feeder Fund.[15] You note that, under the Proposed Structure, Foreign Currency Instruments may be held by a Foreign Feeder Fund solely in order to engage in either Feeder-level Hedging or Master-level Hedging.
With respect to Feeder-level Hedging, you argue that the Foreign Feeder Fund's proposed use of Foreign Currency Instruments would not create any incentive to exercise any improper influence over the U.S. Master Fund and is the only efficient way for the Foreign Feeder Fund to accomplish the foreign currency management objective that you describe in your letter (i.e., the Foreign Feeder Fund, by entering into the Foreign Currency Instruments, would be able to isolate the effects of the fluctuations in the exchange rate between the Designated Currency and the U.S. dollar for its shareholders, without affecting the return for other shareholders of the U.S. Master Fund).[16]
With respect to Master-level Hedging, you acknowledge that the potential for improper influence might exist. For example, as a Foreign Feeder Fund seeks to hedge the currency exposure of the U.S. Master Fund’s portfolio to the Foreign Feeder Fund’s Designated Currency, the investment interests of the Foreign Feeder Fund and the U.S. Master Fund could diverge because the Foreign Feeder Fund might be more or less affected by the currency exposure of the U.S. Master Fund’s portfolio. A Foreign Feeder Fund might seek to influence the U.S. Master Fund’s choice of currency exposure for its own interest, to the potential detriment of the U.S. Master Fund and its other shareholders.
You argue, however, that the Proposed Structure mitigates this concern by limiting Master-level Hedging solely to a Foreign Feeder Fund that invests in a U.S. Master Fund that seeks to approximate the return of an index. In such case, the U.S. Master Fund would have very limited ability to vary its currency exposure to benefit a Foreign Feeder Fund and would not be susceptible to potential undue influence by a Foreign Feeder Fund.[17]
Voting of U.S. Master Fund’s Shares Held by the Foreign Feeder Fund
Under Section 12(d)(1)(E)(iii)(aa), a Foreign Feeder Fund is required to either: (i) seek instructions from its security holders with regard to the voting of all proxies with respect to the securities of the U.S. Master Fund and to vote such proxies only in accordance with such instructions; or (ii) vote the securities held by it in the same proportion as the vote of all other holders of the U.S. Master Fund’s securities. You state that these voting requirements were intended to address the concern about undue influence that may be exercised by the acquiring fund and its affiliates over the acquired fund.[18]
You state that the laws and/or market practices of a foreign jurisdiction in which a Foreign Feeder Fund operates might not permit, or may be interpreted as prohibiting, voting in the manner required by Section 12(d)(1)(E)(iii)(aa). In such case, under the Proposed Structure, the Foreign Feeder Fund will either abstain from voting or withhold voting the shares of the U.S. Master Fund. You state that this alternative neutralizes the vote of the Foreign Feeder Fund in the same manner as voting in the same proportion as the vote of all holders of the U.S. Master Fund’s securities and therefore accomplishes the objective of the requirement in Section 12(d)(1)(E)(iii)(aa).
CONCLUSION
Based on the facts and representations set forth in your letter, we would not recommend enforcement action to the Commission under Section 12(d)(1)(A) or (B) of the 1940 Act against a Foreign Feeder Fund that acquires securities of a U.S. Master Fund in excess of the limits in Section 12(d)(1)(A) of the 1940 Act, or against the U.S. Master Fund, Master Fund Principal Underwriter and any broker or dealer, that sells the U.S. Master Fund’s securities to the Foreign Feeder Fund in excess of the limits in Section 12(d)(1)(B) of the 1940 Act, if it does so in compliance with the conditions of Section 12(d)(1)(E) of the 1940 Act, modified as described in your letter. Because this position is based on all of the facts and representations made in your letter, any different facts or circumstances might require a different conclusion. This letter expresses our position only with respect to enforcement action, and does not express any legal conclusions on the issues presented.
Kay-Mario Vobis
Senior Counsel
[1] The Foreign Feeder Fund would not be registered under the 1940 Act consistent with Section 7(d) of the 1940 Act and prior SEC and Staff guidance. See, e.g., Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Release No. 3222 (Jun. 22, 2011) [76 FR 39645 (Jul. 6, 2011)], at n.294.
[2] Such Foreign Currency Instruments may include foreign currency futures contracts, options on foreign currency futures contracts, forward foreign currency contracts, options on foreign currency and foreign currency swap agreements.
[3] The Foreign Feeder Fund may invest in Foreign Currency Instruments only for the specific hedging purposes described in your letter and not for speculative purposes (i.e., generating excess investment returns). A Foreign Feeder Fund that does not engage in any currency hedging would not invest in Foreign Currency Instruments.
[4] The Feeder-level Hedging would enable the security holders of the Foreign Feeder Fund to achieve a return on their investment, as measured in the Designated Currency, similar to that of the security holders of the U.S. Master Fund, as measured in the U.S. dollar.
[5] The Master-level Hedging would enable the security holders of the Foreign Feeder Fund to achieve a return on their investment, as measured in the Designated Currency, similar to that of the index whose returns the U.S. Master Fund seeks to approximate, by reducing the impact of currency fluctuations between or among the Designated Currency and the U.S. Dollar or other foreign currency exposure of the index.
[6] Such Foreign Feeder Fund may engage in Master-level Hedging only so long as: (i) the provider of the index is not an affiliated person or an affiliated person of an affiliated person, of the U.S. Master Fund, the Master Fund Adviser, any subadviser or promoter of the U.S. Master Fund, or the Master Fund Principal Underwriter; (ii) the currency exposure of the U.S. Master Fund does not materially deviate from the currency exposure of the index, whether through sampling or otherwise; and (iii) the investment objectives of the Foreign Feeder Fund and the U.S. Master Fund are substantially the same, except to the extent necessary to permit the currency hedging as described in your letter.
[7] See Report of the Securities and Exchange Commission on the Public Policy Implications of Investment Company Growth, H.R. Report No. 2337, 89th Cong., 2d Sess., at 311-324 (1966) (“PPI Report”). Moreover, with respect to protecting foreign acquiring funds and their security holders, you point out that the SEC generally has no significant U.S. regulatory interest in protecting such foreign acquiring funds and their security holders from certain potential abuses that Sections 12(d)(1)(A) and (B) were designed to address (i.e., duplicative fees and unnecessary complexity). See Dechert LLP, SEC No-Action Letter (pub. avail. Aug. 4, 2009).
[8] PPI Report, supra note 7, at 318.
[9] You represent that, in complying with Section 12(d)(1)(E)(iii)(bb), a Foreign Feeder Fund will not substitute its investment in the U.S. Master Fund unless the Commission shall have approved such substitution by order issued to the Foreign Feeder Fund.
[10] In the case of a Foreign Feeder Fund that also has a Foreign Principal Underwriter, you note that the Commission previously has viewed such relationship as addressing the jurisdictional concern. See World of Technology, Inc. and Financial Programs, Inc., Investment Company Act Release No. 13459 (Aug. 23, 1983) (notice) (“Applicants assert that Section 12(d)(1)(E)(i) insures that the Commission has administrative recourse under the [1934 Act] against principal underwriters of fund holding companies. Applicants contend that such recourse remains where the principal underwriter is a foreign dealer under common control with a registered broker-dealer….”).
[11] Your letter details the manner in which these relationships would address the jurisdictional concerns.
[12] You state that a Foreign Principal Underwriter to a Foreign Feeder Fund will do the same. The details of these arrangements are set forth in your letter.
[13] These jurisdictions will be limited to the following: France, Germany, Ireland, Luxembourg, Switzerland, United Kingdom, Canada, Mexico, Brazil, Australia, Hong Kong, Japan, Singapore, and South Africa.
[14] You state that, over time, a Foreign Feeder Fund may include investors that are U.S. Persons, consistent with Section 7(d) of the 1940 Act and SEC and Staff guidance thereunder.
[15] In this letter, we are not interpreting what constitutes “investment securities” under Section 12(d)(1)(E)(ii).
[16] You note that the Feeder-level Hedging is similar to that addressed in PIMCO Funds, SEC No-Action Letter (pub. avail. Jul. 9, 2002).
[17] See also supra note 6.
[18] See PPI Report, supra note 7, at 314-315. See also, e.g., H.R. Rep. 622, 104th Cong., 2d Sess., at 41 (1996) (noting that originally “this voting requirement [under Section 12(d)(1)(E)(iii)] […] was enacted to address abusive practices of the 1970s involving off-shore […] funds that invested in U.S. funds.”).
Incoming Letter
The Incoming Letter is in Acrobat format.
http://www.sec.gov/divisions/investment/noaction/2017/dechert-030817-12d1.htm
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