News Flash: SEC Adopts Changes to Regulatory Framework for Fund-of-Fund Agreements | Dechert LLP


On October 7, 2020, the Securities and Exchange Commission voted to adopt Rule 12d1-4 under the Investment Companies Act of 1940 and related amendments to the regulatory framework governing funds that invest in other funds (“fund-of-funds” arrangements).1 The changes were originally proposed on December 19, 2018 (proposed rule).2 In addition, the SEC rescinds Rule 12d1-2 and most exemption orders granting relief from Sections 12(d)(1)(A), (B), (C) and (G) of the 1940, and related amendments to Rule 12d1-1 and Form N-CEN.3

Rule 12d1-4 will allow a registered investment company or business development company (acquiring fund) to acquire shares of any other registered investment company or BDC (acquiring fund) beyond the limits currently imposed by the 1940 Act without obtaining an individual exemption from the SEC, under certain conditions.4

Rule 12d1-4 will be effective 60 days after publication in the Federal Register and the compliance date for changes to Form N-CEN will be 425 days after publication in the Federal Register. The cancellation of Rule 12d1-2 and existing exemption orders will be effective one year after the effective date of Rule 12d1-4.

This Dechert Newsflash provides a brief overview of fund-of-fund arrangements and components of the SEC’s final regulatory package. Rule 12d1-4, as adopted, reflects several significant changes from the proposed rule (specifically, Rule 12d1-4 will not include the proposed limitation on redemptions by an acquiring fund).5 These changes will be discussed in a future Dechert OnPoint.

Fund of funds provisions

Registered investment companies, such as mutual funds, exchange-traded funds, closed-end funds, and other types of funds, are increasingly investing in other funds for a variety of reasons (for exampleto achieve asset allocation or diversification, to target exposure to a particular market or to capitalize cash).

Section 12(d)(1) of the 1940 Act imposes limits on the investments the funds may make in other funds. Specifically, Section 12(d)(1)(A) prohibits a registered fund from: (i) acquiring more than 3% of the outstanding voting securities of another fund; (ii) invest more than 5% of its total assets in a single fund; or (iii) invest more than 10% of its total assets in funds generally.6 However, over the years, the SEC has adopted rules and issued numerous exemption orders permitting fund-of-fund arrangements that exceed these limits. The various statutory exemptions, waiver rules and waiver orders have resulted in a regulatory regime in which similarly managed funds of funds operate subject to different conditions. By adopting Rule 12d1-4, the SEC seeks to harmonize the terms of operation of funds of funds.

Rule 12d1-4

Rule 12d1-4 will permit an acquiring fund to acquire the shares of any acquired fund in excess of the limits described above, subject to certain conditions. Rule 12d1-4 will expand the scope of permitted fund investments for all types of registered investment companies and BDCs beyond what is currently permitted under existing exemption orders (although private funds and foreign funds cannot rely on rule 12d1-4 as a fund acquirer).

Rule 12d1-4 includes the following terms designed to address the concerns that led to the enactment of Section 12(d)(1).

  • Control and voting. Rule 12d1-4 will prohibit an acquiring fund (and its “advisory group”, individually or collectively)7 from control an acquired fund. The 1940 Act defines “control” as the power to exercise decisive influence over the management or policies of a company, and creates a rebuttable presumption that any person who beneficially owns (directly or indirectly) more than 25% of the voting securities of a company a company controls that company.

    Rule 12d1-4 will require an acquiring fund (and its advisory group) to use mirror voting where the acquiring fund (and its advisory group, in aggregate) owns more than: (i) 25% of the voting securities in circulation of a – final fund (or UIT) due to a decrease in the outstanding voting securities of the acquired fund; or (ii) 10% of the outstanding voting securities of a closed-end fund (or BDC). Rule 12d1-4 prescribes the use of direct voting in certain circumstances (for example, if an acquired fund is offered only to acquiring funds relying on Rule 12d1-4).

    As proposed, the control and voting requirements will not apply: (i) to an acquiring fund that is part of the same “group of investment companies” as the acquiring fund; or (ii) an acquiring fund that has a sub-advisor who acts (or whose controlling affiliate acts) as an advisor (or depositor) to the acquired fund.

  • Requirements for assessments and findings. Rule 12d1-4 will require the investment adviser of an acquiring fund or an acquired fund to undertake certain evaluations and make certain conclusions prior to the initial acquisition by the acquiring fund of shares of the acquired fund under Rule 12d1 -4 (whether or not the two funds concerned belong to the same group of investment companies). The investment advisor of an acquiring fund should assess the complexity of the arrangement and the associated fees and expenses and find that the fees and expenses of the acquiring fund do not duplicate the fees and expenses of the acquired fund.8 In addition, the investment adviser of an acquired fund must conclude that any undue influence concerns associated with the acquiring fund’s investment in the acquired fund are reasonably addressed after considering certain specified factors. These findings will be subject to certain Board reporting requirements.
  • Investment agreements required. Rule 12d1-4 will require funds that do not share the same investment adviser to enter into a fund-of-funds investment agreement before relying on Rule 12d1 4. Such agreements must include certain provisions required by Rule 12d1 -4, such as the material conditions necessary to make the required findings and assessments summarized above. These investment agreements will be similar to the participation agreements currently used by many mutual funds and ETFs in connection with fund-of-funds arrangements used pursuant to exemption orders issued by the SEC.
  • Limits of complex structure. Rule 12d1-4 will restrict the ability to establish fund-of-funds structures at three levels, by limiting: (i) the ability of other funds to acquire shares of an acquiring fund that relies on Rule 12d1 -4; and (ii) the ability of an acquired fund to invest itself in other funds, except in certain circumstances (for example, investments in money market funds based on Rule 12d1-1, certain inter-fund lending or borrowing transactions, or investments in funds that are wholly owned and controlled subsidiaries). In addition to these exceptions, Rule 12d1-4 will allow an acquired fund to invest up to 10% of its total assets in other funds (including private funds), regardless of the purpose of the investment. investment or underlying fund types, and regardless of the size of the investment in any given fund.

Other changes to the existing regulatory regime

The SEC is also changing its current rules regarding fund-of-fund deals to facilitate a more consistent regulatory framework for such deals.

Specifically, the SEC repeals Rule 12d1-2, which allows funds that invest primarily in other funds within the same group of investment companies relying on Section 12(d)(1)(G) invest in: (i) non-affiliated funds (within the limits of Section 12(d)(1)(A) or (F)); and (ii) non-fund assets. The SEC is also revoking the Section 12(d)(1) exemption it granted with respect to fund-of-fund arrangements (other than the exemption relating to inter-fund loan arrangements).

In addition, the SEC amends Rule 12d1-1 to allow funds that invest primarily in affiliated funds based on Section 12(d)(1)(G) to continue to invest in unaffiliated money market funds .

Changes to Form N-CEN

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

An upcoming Dechert OnPoint will provide a more in-depth analysis of the 12d1-4 rule, as well as related issues for fund sponsors to consider with respect to fund-of-funds agreements.


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