On October 7, 2020, the SEC adopted new Rule 12d1-4 under the Investment Company Act of 1940 and related rule and form amendments that implement a new comprehensive rules-based framework for fund of funds arrangements involving investments by registered funds in other registered funds that exceed the limitations set forth in Section 12(d)(1) of the 1940 Act. In connection with the adoption of the final rule, the SEC also rescinded existing Rule 12d1-2 under the 1940 Act and existing fund of funds exemptive orders that fall within the scope of the new rule.

Background

Section 12(d)(1) of the 1940 Act generally prohibits any registered fund (acquiring fund) from (1) acquiring more than 3% of another fund’s (underlying fund’s) outstanding voting securities; (2) investing more than 5% of its assets in any one fund; and (3) investing more than 10% of its total assets in funds generally. These limits apply to both registered and unregistered funds with respect to their investments in a registered fund, and to registered funds with respect to their investments in unregistered funds. Over the years, statutory and rules-based exemptions and no-action relief, in addition to exemptive relief granted to many fund complexes, have relaxed these requirements but resulted in substantially similar fund of funds arrangements being subject to different requirements.

New Fund of Funds Framework

The new fund of funds framework is intended to continue to address the SEC’s concerns regarding fund pyramiding (e.g., layering of fees) and undue control or influence over underlying funds while providing relief similar to that granted under current exemptive orders, but in a consistent manner, and will be available to registered open- and closed-end funds, including exchange-traded funds, as well as business development companies. The new framework steers board responsibility for such arrangements away from ongoing involvement to one of oversight. The responsibility to review fund of funds arrangements and make certain findings that address the SEC’s concerns regarding pyramiding and undue control or influence is shifted to investment advisers.

New Rule 12d1-4 under the 1940 Act will permit an acquiring fund to purchase shares of an underlying fund in excess of the limits set forth in Section 12(d)(1) of the 1940 Act, subject to the following conditions:

• Control and Voting. An acquiring fund and its advisory group (i.e., the fund’s investment adviser or sub-adviser and any person controlling, controlled by or under common control with the adviser or sub-adviser) generally may not “control” (as defined in Section 2(a)(9) of the 1940 Act) an underlying fund. In addition, an acquiring fund that holds more than 25% (in the case of an open-end fund or unit investment trust) or 10% (in the case of a closed-end fund) of an underlying fund’s shares must use either mirror voting or pass-through voting with respect to the underlying fund shares, subject to exceptions for certain affiliated funds. This voting requirement represents a change from the rule as initially proposed in 2018, which would have required mirror voting or pass-through voting when an acquiring fund and its advisory group exceed the 3% limit of Section 12(d)(1) regardless of the type of underlying fund.

• Investment Adviser Findings. Before an acquiring fund invests in an underlying fund in excess of the 3% limit in Section 12(d)(1), the investment adviser of the acquiring fund must evaluate the complexity of the fund of funds structure and the underlying fund’s fees and expenses, and must find that the acquiring fund’s fees and expenses do not duplicate the fees and expenses of the underlying fund. (This replaces the “best interest” finding set forth in the rule as initially proposed in 2018.) In addition, the investment adviser of the underlying fund must find that concerns of undue influence are reasonably addressed based on prescribed considerations. The investment adviser to each fund must report its findings, and the basis therefor, to the applicable fund’s board no later than the next regularly scheduled board meeting. In a change from the rule as proposed in 2018, subsequent annual reporting to the board is not required. Different requirements apply where the fund is a unit investment trust or separate account funding variable insurance contracts.

• Fund of Funds Investment Agreements. Before relying on Rule 12d1-4 to invest in excess of limits of Section 12(d)(1), the acquiring fund and the underlying fund must enter into a fund of funds investment agreement that includes certain specified terms, including any material terms necessary to enable the funds’ investment advisers to make the necessary findings described above, a provision that permits either fund to terminate the agreement on 60 days’ notice and a requirement that the underlying fund provide the acquiring fund with information on fees and expenses. This requirement does not apply if the acquiring fund and the underlying fund have the same investment adviser. The requirement for a fund of funds investment agreement replaces a provision in the proposed rule that would have prohibited an acquiring fund from redeeming shares of an underlying fund in an amount greater than 3% of the underlying fund’s outstanding shares during any 30-day period.

• Complex Structures. Under Rule 12d1-4, fund of fund arrangements generally will be limited to two-tiered structures (i.e., a fund cannot acquire an underlying fund that itself invests in an additional third-tier underlying fund), except that a second-tier underlying fund may itself invest up to 10% of its total assets in a third-tier underlying fund. Certain additional limited exceptions to the 10% limit on third-tier funds also will available. The final rule eliminated a provision of the rule as proposed that would have required acquiring funds to disclose in their registration statements actual or intended reliance on Rule 12d1-4.

Related Amendments and Rescissions

As part of the revised fund of funds framework, the SEC is rescinding Rule 12d1-2 and fund of funds exemptive orders and no-action letters that fall within the scope of Rule 12d1-4. As a result, Rule 12d1-1 is being amended to enable funds relying on Section 12(d)(1)(G) to continue to invest in an unlimited amount of unaffiliated money market funds (e.g., cash sweep arrangements). Amendments to Form N-CEN will require that acquiring funds disclose if they relied upon Rule 12d1-4 or Section 12(d)(1)(G) during the reporting period.

Compliance Date and Transition Period

The final rule is effective 60 days after publication in the Federal Register, at which point funds may rely on Rule 12d1-4. In order to provide a transition period for compliance with the new framework, fund of funds exemptive orders and no-action letters and Rule 12d1-2 will be rescinded, and compliance with the amendments to Form N-CEN will be required, one year after the effective date of the rule.

The SEC’s adopting release for Rule 12d1-4 is available here.