SEC Updates Regulatory Framework for Fund of Funds Arrangements

The Securities and Exchange Commission today 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.

“Main Street investors have increasingly used mutual funds, exchange-traded funds (ETFs) and other types of funds to access our markets and invest for their future,” said SEC Chairman Jay Clayton.  “To achieve asset allocation, diversification and other objectives, many funds have also invested in other funds.  Today’s action will enhance and modernize the regulatory framework for these arrangements.”

“The framework adopted today will provide flexibility to fund managers to allocate and structure investments efficiently, without the costs and delays of seeking individualized exemptive orders, as long as the arrangements satisfy a number of conditions designed to enhance investor protection,” said Chairman Clayton.  “I thank the Commission’s staff for their work in advancing this important framework.”

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.

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FACT SHEET
Fund of Funds Rule
October 7, 2020

Action

The Commission is adopting a new rule and amendments under the Investment Company Act of 1940 designed to streamline and enhance the regulatory framework for funds that invest in other funds (“fund of funds” arrangements).  The Commission also is rescinding rule 12d1-2 under the Act and most exemptive orders granting relief from sections 12(d)(1)(A), (B), (C), and (G) of the Act.  Finally, the Commission is adopting related amendments to rule 12d1-1 under the Act and Form N-CEN.  These modifications reflect 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.

Highlights of the Action

Rule 12d1-4

Rule 12d1-4 will permit a registered investment company or business development company or “BDC” (referred to as “acquiring funds”) to acquire the securities of any other registered investment company or BDC (referred to as “acquired funds”) in excess of the limits in section 12(d)(1) of the Investment Company Act of 1940.  The rule will create a consistent framework for fund of funds arrangements to replace the existing approach, which depends on the Commission’s exemptive orders and varies based on an acquiring fund’s type. Open-end funds, unit investment trusts, closed-end funds (including BDCs), exchange-traded funds and exchange-traded managed funds will all be able to rely on rule 12d1-4 as both acquiring and acquired funds.

While the rule contains elements from the Commission’s current exemptive orders permitting fund of funds arrangements, it is tailored to enhance investor protections while providing funds with flexibility to meet their investment objectives in an efficient manner.  The rule’s conditions include the following:

• 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. 

Rescission of Rule 12d1-2 and Certain Exemptive Relief, and Amendments to Rule 12d1-1

To help create a consistent and streamlined regulatory framework for fund of funds arrangements, the Commission is also taking several related actions:

• Rescission of Rule 12d1-2 and Certain Exemptive Relief.  The Commission is rescinding rule 12d1-2, which permits funds that primarily invest in funds within the same fund group to invest in unaffiliated funds and non-fund assets.  The Commission also is rescinding the Commission’ exemptive orders permitting fund of funds arrangements, with limited exceptions.  As a result, funds wishing to create certain types of fund of funds arrangements that exceed the statutory limitations will be required to rely on rule 12d1-4 and comply with its associated conditions.
   
• Amendments to Rule 12d1-1.  The Commission is amending rule 12d1-1 to allow funds that primarily invest in funds within the same fund group to continue to invest in unaffiliated money market funds.

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.

What’s Next?

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.