SEC staff expands upon prior no-action positions to permit funds that track a third-party index to invest in insurance companies and securities related businesses beyond the limitations set forth in Sections 12(d)(2) and 12(d)(3) of the 1940 Act, subject to certain conditions.

On March 28, the Securities and Exchange Commission’s (SEC’s) Division of Investment Management issued a no-action letter[1] to SPDR Series Trust (Trust). The no-action letter states that the Division would not recommend that the SEC take enforcement action under Sections 12(d)(2) and 12(d)(3) of the Investment Company Act of 1940 (1940 Act) against the SPDR S&P Dividend ETF (Fund), a series of the Trust, where the Fund invests such that it may (i) own more than 10% of the total outstanding voting stock of an insurance company and/or (ii) purchase more than 5% of an outstanding class of equity securities of an issuer that, in its most recent fiscal year, derived more than 15% of its gross revenues from securities related activities (Equity Issuer).

The no-action letter expands upon prior no-action letters by giving assurances in the context of Section 12(d)(2) of the 1940 Act and Rule 12d3-1(b)(1) thereunder, which are discussed below.[2]

The Fund and the Index

The investment objective of the Fund that obtained relief is to seek to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P High Yield Dividend Aristocrats Index (Index).[3] Companies in the Index include insurance companies and financial service firms that derive a substantial portion of their revenues from securities related activities. The Fund is not managed according to traditional methods of “active” investment management (i.e., the buying and selling of securities based upon economic, financial, and market analyses and investment judgment). Rather, using an indexing investment approach, the Fund attempts to track the performance of the Index by investing in a portfolio of stocks with generally the same risk and return characteristics of the Index. The most efficient and accurate way for the Fund to track the Index is to acquire securities in the same proportion as they are represented in the Index. However, as discussed in more detail below, such investments by the Fund may implicate Sections 12(d)(2) and/or 12(d)(3) of the 1940 Act.

Section 12(d)(2)

Section 12(d)(2) of the 1940 Act generally prohibits an investment company from purchasing or otherwise acquiring any security issued by an insurance company if, as a result of the purchase or acquisition, the investment company (and any company or companies controlled by it) will own more than 10% of the insurance company’s total outstanding voting stock. As a result of the limitations contained in Section 12(d)(2) and the increasing size of the Fund,[4] absent the no-action letter, the Fund may not have been able to invest in insurance companies to the extent necessary to track the Index, because doing so would result in the Fund owning more than 10% of an insurance company’s total outstanding voting stock.

The SEC has previously “interpreted Section 12(d)(2) as prohibiting control of an insurance company by an investment company but permitted acquisition of stock of an insurance company upon assurance that there would be no control.”[5] To address this concern, the Fund made the following representations:

• The Fund is an “index fund” and its investment objective is to seek to provide investment results that, before fees and expenses, correspond generally to the total return performance of the Index.

• The Fund will comply with its stated investment objectives and policies.

• The most efficient and accurate way to manage the Fund consistent with this objective would be to acquire the securities issued by insurance companies in the same proportion as such issuers represent in the Index.

• The Fund will not own the securities of an insurance company in an amount exceeding the approximate proportion that the insurance company’s stock represents in the Index.

• The Fund will purchase the outstanding voting stock of an insurance company and maintain position in the same approximate proportion that the insurance company’s stock is represented in the Index except insofar as may be necessary for the Fund to retain its status as a regulated investment company as defined in Subchapter M of the International Revenue Code.

• The Fund will not exercise a controlling influence over the management or policies of the insurance company and will either (a) vote its shares in the insurance company as directed by an independent third party, or (b) vote its shares in the insurance company in the same proportion as the vote of all other holders of the insurance company’s shares.

Section 12(d)(3) and Rule 12d3-1

Section 12(d)(3) of the 1940 Act, with limited exceptions, prohibits an investment company from acquiring any securities issued by a securities related business, such as a broker, dealer, underwriter, or investment adviser. Rule 12d3-1 under the 1940 Act, however, exempts some acquisitions from Section 12(d)(3). The Rule permits investment companies to acquire securities of an Equity Issuer, provided certain conditions are met. One condition in particular, Rule 12d3-1(b)(1), requires that the investment company not own more than 5% of the outstanding securities of a particular class of equity securities of the Equity Issuer. As the Fund increases in size, it may be unable to comply with this 5% limitation and therefore would not be able to rely on the Rule. As a result, absent the no-action letter, the Fund may not have been able to invest directly in Equity Issuers to the extent necessary to track the Index.

In releases proposing amendments to Rule 12d3-1, the SEC identified two apparent US Congressional purposes for prohibiting investment company investments in securities issued by persons engaged in securities related activities:

(i) “to limit, at least to some extent, the exposure of registered investment companies to entrepreneurial risks peculiar to securities related businesses”.

(ii) “to prevent potential conflicts of interest and reciprocal practices,” such as directed brokerage. 

With respect to the first concern, in 1940, most issuers that engaged in securities related activities were organized as general partnerships, and investments in these businesses exposed investment companies to potential losses that are not present in other types of investments. Rule 12d3-1(c), in its current form, effectively precludes an investment company from acquiring general partnership interests in a broker, dealer, registered investment adviser, or underwriter. Today, virtually all large securities firms are organized as corporations, not general partnerships, and as a result, the first concern is largely theoretical.

To address the second concern, the Fund made the following representations:

• The Fund is an “index fund” and its investment objective is to seek to provide investment results that, before fees and expenses, correspond generally to the total return performance of the Index.

• The Fund will comply with its stated investment objectives and policies.

• The Fund will comply with all of the provisions of Rule 12d3-1 except subparagraph (b)(1).

• The Fund will not acquire securities issued by an Equity Issuer in an amount exceeding the approximate proportion that the issuer represents in the Index.

• The Fund will purchase and maintain any position in an Equity Issuer only in the approximate proportion that the issuer’s stock is represented in the Index except insofar as may be necessary for the Fund to retain its status as a regulated investment company as defined in Subchapter M of the International Revenue Code.

• If the Fund owns more than 5% of the value of outstanding securities issued by persons that engage in securities related activities (with the exception of Equity Issuers), the Fund will comply with the provisions of Section 17(e) of the 1940 Act and Rule 17e-1 thereunder when using that issuer, or any affiliated person of that issuer, as a broker for the purchase or sale of any security in the Fund’s portfolio. The Fund will not use an Equity Issuer as the executing broker for any Fund transactions, and the Fund will comply with the provisions of Section 17(e) of the 1940 Act and Rule 17e-1 thereunder when using any affiliated personof such Equity Issuer.

^{[1] See SPDR S&P Dividend ETF (pub. avail. Mar. 28, 2016).}

^{[2] Prior no-action letters have given assurances in the context of Rule 12d3-1(c) prohibiting an investment company from acquiring a security issued by its investment adviser, promoter or principal underwriter, or one of their affiliated persons (see The Victory Stock Index Fund (pub. avail. Feb. 7, 1995); Kidder Peabody Investment Trust (pub. avail. May 14, 1993); Dreyfus Index Fund (pub. avail. Mar. 31, 1992); IBM Mutual Funds, Inc. (pub. avail. May 18, 1990)) and in the context of Rule 12d3-1(b)(3) prohibiting an investment company from investing more than 5% of the value of its total assets in the securities of an issuer that engages in securities related activities (see Select Sector SPDR Fund and Diamonds Trust (pub. avail. July 6, 2000)).}

^{[3] The Index is sponsored by Standard & Poor’s Financial Services LLC (Index Provider), which is not affiliated with the Fund or the Fund’s adviser. The Index Provider determines the composition of the Index, relative weightings of the securities in the Index, and publishes information regarding the market value of the Index.}

^{[4] As of February 29, 2016, the Fund had more than $12 billion in assets.}

^{[5] In the Matter of Investors Syndicate of America, Inc., Investment Company Act Rel. Nos. 1401 (Jan. 18, 1950) and 2722 (June 4, 1958).}

^{[6] The Fund has a non-fundamental investment restriction that prevents it from investing in the securities of companies.} 

^{[7] Exemption of Acquisitions of Securities by Persons Engaged in Securities Related Businesses. Investment Company Act Rel. No. 19204 (Jan. 4, 1993) (Proposing Amendments to Rule 12d3-1).}

^{[8] Section 17(e) and Rule 17e-1, taken together, permit an affiliate of an investment company to act as broker, subject to certain conditions including board approved procedures.}