On December 19, 2018, the Securities and Exchange Commission (the “SEC”) proposed a new rule (Rule 12d1-4) intended to modernize and improve the regulatory framework for fund of funds arrangements (fund investing in shares of another fund). Currently, funds are required to rely on existing statutory exemptions or exemptive rules or seek exemptive relief prior to creating a fund of funds arrangement, resulting in unnecessary and avoidable costs and delays and an inconsistent regulatory framework. The proposed rule would permit registered investment companies (“RICs”) and business development companies (“BDCs”) to acquire the securities of any RIC or BDC in excess of the limits in Section 12(d)(1) of the Investment Company Act of 1940, as amended. RICs and BDCs relying on the proposed rule would need to comply with the following conditions:

  • RICs/BDCs holding more than 3% of a fund’s outstanding voting securities would be required to vote those securities in a prescribed manner and would be prohibited from redeeming more than 3% of the fund’s outstanding shares during any 30-day period.
  • RICs/BDCs would be required to evaluate the layering of duplicative or excessive fees associated with its investment in a fund and the complexity of the fund of funds arrangement (specific considerations would vary given the particular structure).
  • RICs/BDCs would be prohibited from creating three-tier fund of funds arrangements, except in certain limited circumstances.

Unfortunately, the proposed rule does not address industry concerns relating to “Acquired Fund Fees and Expenses” (“AFFE”) disclosure requirements, which require acquiring funds to aggregate and disclose in their prospectuses the amount of total annual acquired fund operating expenses and express the total amount as a percentage of an acquiring fund’s net assets. As a consequence, some index providers removed acquired funds from their indices, causing a significant reduction in institutional ownership of such funds.

The SEC has requested public comment on the proposed rule and industry suggestions to improve AFFE disclosure (see pages 74-77 of the proposed rule).

Given that the proposed rule would provide a holistic exemption for fund of funds to operate, the SEC also proposes to rescind Rule 12d1-2 and individual exemptive orders for certain fund of funds arrangements, with the idea of creating a consistent rules-based regime for fund of funds arrangements. In addition, in connection with the proposed rescission of Rule 12d1-2, the SEC also proposed amendments to Rule 12d1-1 to allow funds that rely on Section 12(d)(1)(G) to invest in money market funds that are not part of the same group of investment companies.

The proposed rule and related rule amendments can be found using the following link: https://www.sec.gov/rules/proposed/2018/33-10590.pdf.