SEC adopts new rule for fund of funds arrangements
- The new rule will provide a consistent framework for fund-of-fund arrangements.
- Recourse to the new rule will require that certain conditions be met.
- Exempt orders of existing funds of funds will be canceled.
On October 7, the Securities and Exchange Commission (SEC) adopted Rule 12d1-4 (rule), which establishes a comprehensive regulatory framework for fund-of-fund arrangements. Prior to its adoption, fund managers used a complex and sometimes inconsistent regime of rules and exemptions to engage in fund-of-fund arrangements. In adopting the Rule, the SEC recognized the growing trend for funds to invest in other funds and the desirability of fund-of-fund arrangements to achieve asset allocation, diversification or other investment objectives. investment.
The Rule allows a registered investment company or a business development company (acquiring fund) to acquire securities of another registered investment company or a business development company (acquired fund) beyond the usual limits of “3-5-10%” set out in Section 12 (d) (1) of the Investment Companies Act 1940, as amended (1940 Act), subject to the following conditions :
- Control and vote. Except in limited circumstances, or if the funds belong to the same group of investment companies, an acquiring fund (and certain affiliates) may not control an acquired fund.
- Assessments and results. Investment advisers, fund acquisition and acquired funds are required to make certain findings in order to enter into fund of fund arrangements.
- Investment agreement. An acquiring fund and an acquired fund that do not have the same investment advisor must enter into a fund of funds agreement.
- Limitations on complex structures. Three-tier structures are generally prohibited.
The Rule does not include, as was originally proposed, a limit on the redemption of acquired fund shares held by the acquiring fund.
Scope of the rule
Under the Rule, registered investment companies (including open-end mutual funds, exchange-traded funds (ETFs), unitary investment trusts (ITUs) and closed-end funds) and business development corporations (BDCs) can operate as both an acquired and an acquirer. . The rule expands what was previously allowed by the SEC’s previous fund-of-funds exemption and provides a more consistent framework for registered funds and PPAs. For example, open-end mutual funds, UITs and ETFs can now invest in unlisted closed-end funds and unlisted PPAs beyond the limits of Article 12 (d) (1), whereas previously, exemption orders limited investments in closed-end funds and BDCs to those that have been listed. Private funds and unregistered investment firms cannot rely on the Rule to acquire funds and, therefore, private and unregistered funds continue to be limited in their ability to acquire units of registered funds.
Control and vote
The rule prohibits an acquiring fund and its “advisory group” from controlling an acquired fund. An advisory group is either the investment adviser of the fund and any person controlling, controlled by or under common control with the adviser, or the investment sub-adviser of the fund and any person controlling, controlled by or under common control with the sub-adviser. advise.
If the acquiring fund and its advisory group hold more than 25% of the outstanding voting securities of an open-ended fund or UIT due to a decrease in the outstanding voting securities of the acquired fund or hold more than 10 % of outstanding voting securities of a closed-end fund or BDC, the acquiring fund and its advisory group must “mirror vote” – that is, vote the securities of the fund acquired in the same proportion as the vote of the other holders of the securities of the acquired fund.
The prohibitions on control do not apply if the acquiring fund and the acquired fund belong to the same group of investment companies.
Assessments and results
To address concerns that an acquiring fund may exercise undue influence over an acquired fund or charge excessive fees, the rule requires certain assessments and conclusions before an acquiring fund invests in an acquired fund. These differ depending on whether the fund is the acquiring or acquired fund and whether it is a management company, an ITU or a separate account financing variable insurance contracts.
If an acquired fund is a registered investment company, its investment advisor should find that any undue influence issues associated with the acquiring fund’s investment in the acquired fund are reasonably resolved after taking into account the following non-exhaustive factors: :
- The scale of the investments envisaged by the acquiring fund and any maximum investment limits.
- The expected timing of redemption requests by the acquiring fund.
- Whether and under what circumstances the acquiring fund will provide advance notification of the investment and redemptions.
- The circumstances under which the acquired fund may choose to satisfy requests for redemptions in kind rather than in cash and the terms of any redemption in kind.
Since concerns about undue influence are more important for acquired funds, the rule only requires that the acquired fund’s advisor make that decision.
The Rule requires the acquiring fund’s advisor to assess the complexity of the structure associated with the acquiring fund’s investment in the acquired fund. The acquiring fund’s advisor should assess the relevant fees and expenses and find that the acquiring fund’s fees and expenses do not duplicate the acquired fund’s fees and expenses. Only the advisor of the acquiring fund should perform this assessment.
The acquiring fund’s advisor should report its assessments and findings to the acquiring fund’s board of directors prior to the initial investment. The Rule does not require the advisor to make subsequent reports to the board, but the board is required to review these fund of funds provisions and conclude that they continue to be reasonable and appropriate at least once a year. year in connection with its compliance with rule 38a-1. see again.
The Rule requires that funds with different investment advisers must enter into a fund of fund investment agreement, which is similar to, but substantially different from, the current participation agreements required by most fund of fund exemption orders granted. by the SEC. This new agreement must include:
- All of the material conditions necessary to perform the appropriate valuations by the acquiring fund advisor and the acquired fund adviser as set out above.
- A termination clause allowing either party to terminate the contract by giving written notice within a period not exceeding 60 days.
- A provision requiring an acquired fund to provide the acquiring fund with information about fees and expenses to the extent reasonably requested.
Since SEC staff consider these agreements to be material contracts that are not made in the ordinary course of business, they should be filed as an attachment to each applicable fund’s registration statement.
Limitations on complex structures
The rule limits the ability to establish three-tier fund-of-fund structures to protect shareholders from undue influence and excessive fees. Certain exceptions exist for investments in funds that are wholly owned and controlled subsidiaries, investments in money market funds and certain interfund lending or borrowing transactions where the threat of undue influence or investor confusion is. minimal. The Rule also allows an acquired fund to invest up to 10% of its total assets in any fund, regardless of the size of the investment, in order to give funds the flexibility to gain exposure to any asset class or sector through investments in underlying funds.
Other modifications and considerations
One year after the effective date of the Rule, the SEC will repeal Rule 12d1-2, which allows funds that invest primarily in other funds to invest in unaffiliated funds and assets other than funds. , and the exemption it had previously granted with respect to the funds of fund arrangements. Accordingly, the advisers of the affiliated funds of fund structures must make the necessary decisions and report to their board of directors if they choose to rely on the rule. Advisors may continue to operate an affiliated fund of funds structure under section 12 (d) (1) (G) but may no longer invest in other investments, stocks, bonds or other securities due to the rule 12d1-2 canceled.
Funds that rely on the rule must keep proper records for five years and make the necessary disclosures on the N-CEN form. All funds must comply with the requirements of the amended N-CEN form within one year of the effective date of the amendment.