A Small Entity Compliance Guide[1]

This compliance guide is divided into the following parts:

Introduction

Who is covered by Rule 12d1-4?

What exemptive relief does Rule 12d1-4 provide?

What conditions are required to rely on Rule 12d1-4?

What disclosure requirements apply?

What recordkeeping requirements apply?

Effective date

Other resources

Contacting the Commission

Introduction

On October 7, 2020, the Securities and Exchange Commission (the “Commission”) adopted new rule 12d1-4 under the Investment Company Act of 1940 (the “Investment Company Act”) and related amendments to rule 12d1-1 and Form N-CEN. The Commission is also rescinding rule 12d1-2 under the Investment Company Act and certain exemptive orders granting relief from sections 12(d)(1)(A), (B), (C), and (G) of the Investment Company Act.

Rule 12d1-4 permits a registered investment company or business development company (referred to as “acquiring funds”) to acquire the securities of any other registered investment company or business development company (referred to as “acquired funds”) in excess of the limits in section 12(d)(1) of the Investment Company Act subject to certain conditions. This rule was designed to streamline and enhance the regulatory framework for funds that invest in other funds (“fund of funds” arrangements).

Who is covered by Rule 12d1-4?

Funds that fall within the scope of rule 12d1-4 as both acquiring and acquired funds are:

• Open-end management investment companies, including those organized as exchange-traded funds (“ETFs”) and exchange-traded managed funds;
• Unit investment trusts (“UITs”);
• Closed-end management investment companies; and
• Business development companies (“BDCs”);

What exemptive relief does Rule 12d1-4 provide?

Rule 12d1-4 permits acquiring funds to acquire the securities of acquired funds in excess of the limits in section 12(d)(1) of the Investment Company Act while applying a consistent set of conditions to such fund of funds arrangements. In addition, the rule sets forth tailored conditions for acquiring and acquired funds that are in the same group of investment companies.

Rule 12d1-4 also provides an exemption from section 17(a) of the Investment Company Act, which would otherwise prohibit an affiliated person of a fund, or any affiliated person of such person, from selling any security or other property to, or purchasing any security or other property from, the fund.[2] Further, rule 12d1-4 provides an exemption from section 17(a) to permit the deposit and receipt of baskets of securities by an acquiring fund that is an affiliated person of an acquired ETF (or who is an affiliated person of such a person) solely by reason of holding with the power to vote 5% or more of the shares of the acquired ETF or one of its investment company affiliates.

What conditions are required to rely on Rule 12d1-4?

Rule 12d1-4 requires funds of funds to comply with certain conditions. Some of these conditions are summarized below.

• Limits on Control and Voting. Rule 12d1-4 requires an acquiring fund to aggregate its investments with the investments of its advisory group when it assesses control of an acquired fund and assesses whether voting restrictions apply to its investments in an acquired fund. An acquiring fund that is part of the same fund group as the acquired fund, or an acquiring fund that has a sub-adviser that acts as adviser to the acquired fund, is not subject to the rule’s control and voting conditions.

  Control

  The rule prohibits an acquiring fund and its advisory group from controlling an acquired fund.

  Voting

  Rule 12d1-4 requires an acquiring fund and its advisory group to use mirror voting if the acquiring fund and its advisory group (in the aggregate) hold more than:

  • 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
  • 10% of the outstanding voting securities of an acquired closed-end fund or BDC.

  In circumstances where acquiring funds are the only shareholders of an acquired fund pass-through voting must be used.

• 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, rule 12d1-4 requires certain evaluations and findings to be made before the acquiring fund invests in an acquired fund in reliance on the rule. These evaluations and findings 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.

  Acquiring Fund Evaluations and Findings

  • For a management company that is an acquiring fund, the acquiring fund’s investment adviser must evaluate the complexity of the structure associated with the acquiring fund’s investment in the acquired fund, and the relevant fees and expenses, and must find that the acquiring fund’s fees and expenses do not duplicate the fees and expenses of the acquired fund.
  • For a UIT that is an acquiring fund, the UIT’s principal underwriter or depositor must find that the fees of the UIT do not duplicate the fees and expenses of the acquired funds that the UIT holds or will hold at the date of deposit.
  • For separate accounts funding variable insurance contracts that invest in an acquiring fund, the final rule requires an acquiring fund to 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 consistent with the standard set forth in section 26(f)(2)(A) of the Investment Company Act.

  Acquired Fund Evaluations and Findings

  • For management companies that are acquired funds, the rule requires the acquired fund’s investment adviser to find that any undue influence concerns associated with the acquiring fund’s investment in the acquired fund are reasonably addressed, after considering:
    1. the scale of contemplated investments by the acquiring fund and any maximum investment limits;
    2. the anticipated timing of redemption requests by the acquiring fund;
    3. whether, and under what circumstances, the acquiring fund will provide advance notification of investment and redemptions; and
    4. 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.
• Required Fund of Funds Investment Agreements. Rule 12d1-4 requires funds that do not share the same investment adviser to enter into a fund of funds investment agreement memorializing the terms of the arrangement. At a minimum, the fund of funds investment agreement must include the following:
  • any material terms regarding the acquiring fund’s investment in the acquired fund necessary to make the required evaluations and findings under the rule;
  • a termination provision whereby either the acquiring fund or acquired fund may terminate the agreement subject to advance written notice no longer than 60 days; and
  • 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.
• Limits on Complex Structures. To limit funds’ ability to use fund of funds arrangements to create overly complex structures, rule 12d1-4 generally prohibits funds from creating three-tier fund of funds structures. However, the rule permits an acquired fund to invest in excess of the section 12(d)(1) limits in securities of another investment company that is:
  • acquired in reliance on section 12(d)(1)(E) of the Investment Company Act (i.e., master-feeder arrangements);
  • acquired in reliance on rule 12d1-1;
  • a subsidiary wholly-owned and controlled by the acquired fund;
  • received as a dividend or as a result of a plan of reorganization of a company; or
  • acquired pursuant to exemptive relief from the Commission to engage in interfund borrowing and lending transactions.

The rule also 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.

What disclosure requirements apply?

A fund will be required to indicate whether it relies on rule 12d1-4 or the statutory exception in section 12(d)(1)(G) in reports on Form N-CEN.

What recordkeeping requirements apply?

Acquiring and acquired funds relying on rule 12d1-4 must maintain and preserve the following records for not less than five years, the first two years in an easily accessible place:

• A copy of each fund of funds investment agreement in effect, or that at any time within the past five years was in effect;
• A written record of the board and adviser evaluations and findings required by the rule and the basis therefore (within the past five years for management companies);
• The certification from each insurance company required by the rule.

Effective date

Funds may begin relying on rule 12d1-4 after the effective date, which is January 19, 2021. The compliance date for the Form N-CEN amendments is January 19, 2022. Also on January 19, 2022, the Commission will rescind rule 12d1-2 and will rescind certain exemptive orders that grant relief from the investment limits of 12(d)(1) of the Investment Company Act.

Other resources

The adopting release can be found on the Commission’s website at https://www.sec.gov/rules/final/2020/33-10871.pdf.

The proposing release can be found on the Commission’s website at https://www.sec.gov/rules/proposed/2018/33-10590.pdf.

Contacting the Commission

The Commission’s Division of Investment Management is happy to assist small entities with questions regarding the Fund of Funds Rule. You may submit a question by email to IMOCC@sec.gov. Additionally, you may contact the Division of Investment Management’s Office of Chief Counsel at (202) 551-6825.