Newsflash: SEC Proposes Changes to Regulatory Framework of Fund of Funds Arrangements

December 21, 2018

On December 19, 2018, the Securities and Exchange Commission (SEC) voted to propose Rule 12d1-4 (proposed rule) and related amendments to the regulatory framework governing funds that invest in other funds (“fund of funds” arrangements). The SEC is also proposing to rescind Rule 12d1-2 under the Investment Company Act of 1940 (1940 Act) and most exemptive orders granting relief from sections 12(d)(1)(A), (B), (C) and (G) of the 1940 Act, and to make related amendments to Rule 12d1-1 and Form N-CEN. 

The proposed rule would allow a registered investment company or a business development company (acquiring fund) to acquire shares of any other registered investment company or business development company (acquired fund) in excess of the limitations currently imposed by the 1940 Act without obtaining individual exemptive relief from the SEC. 

The comment period for the proposed rule is 90 days following its publication in the Federal Register. 

This Newsflash provides a brief overview of fund of funds arrangements and the components of the SEC’s proposals. 

Fund of Funds Arrangements 

Registered investment companies, such as mutual funds, exchange-traded funds, closed-end funds and other types of funds, have increasingly invested in other funds for a variety of reasons (e.g. to achieve asset allocation or diversification, to target exposure to a particular market, or to equitize cash). In the proposed rule release, the SEC estimates that nearly half of all registered funds are invested in other funds. 

Section 12(d)(1) of the 1940 Act places limits on the size of investments that funds may make in other funds. Specifically, section 12(d)(1)(A) of the 1940 Act prohibits a registered fund from: (i) acquiring more than 3% of another fund’s outstanding voting securities; (ii) investing more than 5% of its total assets in any one fund; or (iii) investing more than 10% of its total assets in funds generally.1 However, over the years, the SEC has issued many exemptive orders permitting fund of funds arrangements in excess of these limits. The process of obtaining exemptive relief may be costly and time consuming, and, together with the ability to rely on various statutory exemptions and exemptive rules, has resulted in a regulatory regime whereby similarly managed funds of funds are operated subject to differing conditions. The proposed rule would obviate the need for a fund to obtain an individual exemptive order from the SEC in order to acquire shares of another fund in excess of the limits of the 1940 Act. 

Proposed Rule 12d1-4 

The proposed rule would permit an acquiring fund to acquire the shares of any acquired funds in excess of the limits described above, subject to certain conditions. Importantly, the proposed rule would expand the scope of permissible fund investments for all types of registered investment companies and business development companies beyond what is currently allowed under existing exemptive orders (although private funds and foreign funds would not be able to rely on the proposed rule). 

The proposed rule includes certain conditions, largely based on the existing fund of funds exemptive relief, which are designed to address the concerns that led to the enactment of section 12(d)(1): 

  • Control. The proposed rule would prohibit an acquiring fund (and its “advisory group”) from controlling an acquired fund. The 1940 Act defines “control” to mean the power to exert a controlling influence on the management or policies of a company. In addition, the 1940 Act creates a rebuttable presumption that any person who beneficially owns (directly or indirectly) more than 25% of the voting securities of a company controls that company, and any person who does not own that amount does not control the company. 

  • Voting. The proposed rule would require an acquiring fund that holds more than 3% of an acquired fund’s outstanding voting securities to vote those securities in the manner prescribed by section 12(d)(1)(E)(iii)(aa) (i.e., pass-through and mirror voting) in order to minimize the influence that an acquiring fund may exercise over an acquired fund. The control and voting conditions would not apply to: (i) an acquiring fund that is part of the same “group of investment companies” as the acquired fund; or (ii) an acquiring fund that has a sub-adviser that acts (or whose control affiliate acts) as adviser to the acquired fund. 

  • Limits on Redemptions. In order to address the concern that an acquiring fund could threaten an acquired fund with large-scale redemptions as a means of exerting control over the acquired fund, the proposed rule would impose a condition limiting an acquiring fund’s ability to quickly redeem or tender a large volume of acquired fund shares. The proposed rule would prohibit an acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares from redeeming (or tendering for repurchase) more than 3% of the acquired fund’s total outstanding shares in any 30-day period.2 Importantly, this limit does not apply to an acquiring fund’s secondary market sales of acquired fund shares that are listed on an exchange. Acquiring funds that invest in ETFs, listed closed-end funds or listed BDCs accordingly would be permitted to sell shares of those acquired funds in the secondary market without regard to this 3% volume limit. 

  • Duplicative and Excessive Fees. The proposed rule contains certain conditions designed to prevent duplicative and excessive fees in fund of funds arrangements by requiring an evaluation of aggregate fees associated with the acquired fund investment and the complexity of the fund of funds arrangement. The proposed rule would require the acquiring fund’s adviser (rather than its board of trustees/directors) to find that the investment is in the best interests of the acquiring fund – and report its analysis to the acquiring fund’s board of trustees/directors – before investing in acquired funds in reliance on the rule. The proposed rule would not require that this evaluation be made in connection with every investment in an acquired fund, but rather with such frequency as the board of the acquiring fund deems reasonable and appropriate thereafter (but no less frequently than annually).
    The SEC is also requesting comments on “acquired fund fees and expenses” (AFFE) disclosures, a topic of particular importance to BDCs.3 

  • Complex Structures. The proposed rule would limit: (i) the ability of other funds to acquire a fund that relies on the proposed rule; and (ii) the ability of an acquired fund to itself invest in other funds, except in limited circumstances (e.g. for short-term cash management purposes, certain interfund lending or borrowing transactions, or investments in funds that are wholly owned and controlled subsidiaries). These conditions would limit the ability to structure a three-tiered fund of funds arrangement. 

Amendments to Existing Regulatory Regime 

The SEC is also proposing to modify its current rules with respect to fund of funds arrangements in order to facilitate a more cohesive regulatory framework for such arrangements. 

Specifically, the SEC is proposing to rescind Rule 12d1-2, which permits funds that primarily invest in other funds within the same “group of investment companies” in reliance on section 12(d)(1)(G) to invest in: (i) unaffiliated funds (up to the limits in section 12(d)(1)(A) or (F)); and (ii) non-fund assets (e.g. corporate stocks, bonds). The SEC is also proposing to rescind the exemptive relief it has granted with respect to fund of funds arrangements (other than exemptive relief related to interfund lending arrangements). Accordingly, any fund wishing to acquire the shares of another fund in excess of the limitations imposed by the 1940 Act would be required to rely on the proposed rule and the conditions set forth therein. 

In addition, the SEC is proposing to amend Rule 12d1-1 to allow funds that invest primarily in affiliated funds in reliance on section 12(d)(1)(G) to continue to invest in unaffiliated money market funds. 

Finally, the SEC stated that the Division of Investment Management “is reviewing staff no-action and interpretative letters relating to section 12(d)(1) to determine whether any such letters should be withdrawn in connection with any adoption of this proposal.” However, the SEC did not identify which no-action letters could be withdrawn. 

Amendments to Form N-CEN 

Form N-CEN requires registered investment companies to annually report certain census-type information to the SEC in a structured data format. The SEC is proposing to amend Form N-CEN to require funds to report whether they relied on Rule 12d1-4 or section 12(d)(1)(G) of the 1940 Act during the applicable reporting period. 

An upcoming Dechert OnPoint will provide further analysis of the proposed rule, as well as potential issues for fund sponsors. 


1) Section 60 of the 1940 Act makes these limits applicable to a business development company (BDC) to the same extent as it if were a registered closed-end fund.
2) This condition may impact the liquidity classification of the acquired fund’s shares under Rule 22e-4 under the 1940 Act (liquidity risk management rule).
3) Among other things, the SEC asked whether “AFFE disclosure [is] appropriate for every type of fee and expense of every type of acquired fund or [whether] specific types of acquired fund fees or expenses [should] be excluded from the disclosure?”

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