SEC Final Funds Rule 12d1-4 Adopted

Thursday, October 15, 2020

The Securities and Trade Fee (SEC) adopted on October 7, 2020 Rule 12d1-4 (last rule) and different amendments underneath the Funding Firm Act of 1940, as amended (1940 Act), which streamline and improve the regulatory necessities for registered funding corporations and enterprise growth corporations (collectively, funds) to amass shares of different funds in extra of the bounds in Part 12(d)(1) of the 1940 Act (fund of funds preparations).1,2 Fund of funds preparations have traditionally been permitted by means of statutory exemptions within the 1940 Act, SEC guidelines underneath the 1940 Act and SEC exemptive orders. The ultimate rule usually codifies current circumstances within the SEC exemptive orders, eradicating the necessity for SEC exemptive reduction for a lot of fund of funds preparations. The SEC adopted necessities underneath the ultimate rule, usually as proposed by the SEC (proposed rule)3, aside from sure variations which can be mentioned under.

The SEC accredited the next as a part of the October 7, 2020 rule-making:

Adoption of latest Rule 12d1-Four underneath the 1940 Act (with sure variations from the proposed rule);

Rescission of Rule 12d1-2 underneath the 1940 Act;

Rescission of most SEC orders granting exemptions from 12(d)(1)(A), (B), (C) and (G) of the 1940 Act;

Amendments to Rule 12d1-1 underneath the 1940 Act; and

Amendments to Type N-CEN

These are described under.

New Rule 12d1-4

Rule 12d1-Four permits funds (buying funds) topic to sure circumstances to amass shares of different funds4 (acquired funds) with out acquiring a fund of funds exemptive order from the SEC. The ultimate rule builds upon the fund of funds exemptive orders which have traditionally been issued by the SEC and permits extra varieties of fund of funds preparations. Along with mutual funds and exchange-traded funds (ETFs), exchange-traded managed funds (ETMFs), listed and unlisted closed-end funds, unit funding trusts (UITs), and listed and unlisted enterprise growth corporations could be buying and bought funds underneath the ultimate rule. Personal funds and unregistered funding corporations, resembling international funding corporations, are excluded from the ultimate rule.

Situations.The ultimate rule topics fund of funds preparations to a tailor-made set of circumstances designed to deal with the historic abuses related to fund of funds preparations. The proposed rule would have imposed redemption limits if an buying fund held greater than 3% of an acquired fund and required disclosure if a fund was or might be an buying fund. The SEC decided to not undertake the redemption restrict or the disclosure requirement. As an alternative, the ultimate rule features a mixture of circumstances relating to: (i) required evaluations and findings by funding advisers, and (ii) fund of funds funding agreements. These circumstances are primarily based on the circumstances contained in SEC exemptive orders with some variations as proven within the chart under. The next chart summarizes sure of the circumstances underneath the ultimate rule, and reveals the variations from present regulatory necessities and the proposed rule.

Situations

Current Fund of Funds Exemptive Reduction

Proposed Rule

Remaining Rule

Management and Voting

Differing voting circumstances and procedures to stop undue affect.

If an buying fund and its advisory group within the mixture maintain greater than 3% of an acquired fund’s excellent voting securities should use pass-through or mirror voting to attenuate the affect that an buying fund could train over an acquired fund.

Voting circumstances differ primarily based on the kind of acquired fund. Voting circumstances require an buying fund and its advisory group to make use of mirror voting after they maintain greater than: (i) 25% of the excellent voting securities of an open-end fund attributable to a lower within the excellent securities of the acquired fund, or in any other case management the acquired fund (throughout the that means of the 1940 Act); or (ii) 10% of the excellent voting securities of a closed-end fund. In circumstances the place an buying fund is the one shareholder of an acquired fund, nevertheless, pass-through voting could also be used.

The ultimate rule doesn’t impose a restrict on redemptions.

Required Findings: Layering of Charges

Requires the funding adviser to an buying fund to waive advisory charges in sure circumstances or the board of the buying fund to make sure findings relating to the advisory charges (e.g., that they aren’t duplicative).

Units limits on gross sales expenses and repair charges.

Advisers to administration corporations could be required to guage the complexity of the fund of funds association and the related mixture charges related to funding within the acquired fund and decide that it’s in the very best curiosity of the buying fund to spend money on the acquired fund. The adviser could be required to report such dedication and the premise for the dedication to the board of the buying fund earlier than investing and no less than yearly. This analysis wouldn’t be required for every particular person funding.

Part 15 of the 1940 Act requires the board of the buying fund to guage any data moderately needed to guage the phrases of the buying fund’s advisory contract (together with charges for providers supplied by the buying fund’s adviser).

The proposed rule didn’t require that the board of the buying fund discover that the advisory charges are primarily based on providers supplied which can be along with, moderately than duplicative of, providers supplied by the acquired fund’s adviser and did require an buying fund’s adviser to waive charges acquired from an acquired fund.

No gross sales cost or service charges limits as a result of sure fund of funds preparations are in any other case topic to limits by the Monetary Business Regulatory Authority (FINRA) Rule 2341.

Usually, the identical as proposed. As well as, an buying fund’s funding adviser should discover that the buying fund’s charges and bills will not be duplicative of the charges and bills of the acquired fund.

Funding advisers to acquired funds which can be administration corporations should make a discovering that any undue affect issues associated to an buying fund’s investments within the acquired fund are moderately addressed, together with the consideration of the (i) scale of funding, (ii) anticipated timing of redemption requests, (iii) advance notification of investments or redemptions and (iv) insurance policies associated to in-kind redemptions.

A fund’s funding adviser should additionally report its findings to its board of administrators on the board’s subsequent scheduled board assembly.

Fund of Funds Funding Settlement

Fund of funds participation agreements/board procedures and findings to stop undue affect.

Proposed redemption restrictions to exchange the necessities for sure board procedures and findings and fund of funds participation agreements.

The ultimate rule requires funds that don’t have the identical funding adviser to enter right into a fund of funds funding settlement. Though the agreements can usually be negotiated between the events, the ultimate rule requires that every such settlement additionally embrace three particular circumstances, together with (i) any materials phrases essential to make fund findings specified above, (ii) a termination provision permitting both get together to terminate with advance discover not than 60 days, and (iii) a provision requiring an acquired fund to supply the buying fund with any moderately requested payment and expense data.

Complicated Buildings

Limits the power of acquired fund to spend money on underlying funds (three-tier fund of funds preparations), topic to sure exceptions.

Prohibits a fund counting on Part 12(d)(1)(G) or proposed rule 12d1-Four from investing in an buying fund and limits acquired funds from investing in underlying funds (three-tier buildings), topic to sure exceptions.

Requires an analysis of the complexity of the fund of funds construction. (e.g., comparability to direct funding in comparable belongings held by an acquired fund). (see above)

An buying fund could be required to reveal that it’s or could at instances be an buying fund in its registration assertion.

Prohibits a fund counting on Part 12(d)(1)(G) or the ultimate rule from investing in an buying fund and limits acquired funds from investing in underlying funds (three-tier buildings), topic to sure exceptions.

Permits an acquired fund to take a position as much as an extra 10% of its belongings in different funds and personal funds.

Limits on Management and Voting

As proposed, the ultimate rule prohibits an buying fund and its advisory group from controlling an acquired fund (as management is outlined within the 1940 Act) and establishes voting limitations famous above with the intention to scale back the quantity of affect that an buying fund and its advisory group could have over an acquired fund. The constraints on management and voting circumstances don’t apply to fund of funds preparations involving solely funds throughout the similar group of funding companies5.

Required Findings

Pursuant to the ultimate rule, advisers of acquired funds and buying funds should make sure evaluations and findings described above associated to the potential exertion of undue affect over an acquired fund or the potential charging of duplicative charges and bills. These findings differ relying upon the kind of entity and whether or not a fund is the buying fund or the acquired fund.

Required Fund of Funds Funding Settlement

The ultimate rule establishes a brand new requirement that was not included within the proposed rule. A fund of funds funding settlement, just like participation agreements underneath present exemptive orders, should be entered into by buying and bought funds that don’t share the identical funding adviser. Though the SEC expects such agreements to be individually negotiated, three particular circumstances should be included as summarized within the chart above. The fund of funds funding settlement gives acquired funds with extra safety from potential undue affect from buying funds by offering acquired funds higher management over the timing and sort of redemptions and the timing and scale of investments.

Complicated Construction Limitations

The SEC addressed its concern over the potential to create overly advanced fund of funds preparations buildings by additionally usually prohibiting an buying fund from investing in an acquired fund that in flip invests in one other fund (three-tier buildings), besides in sure circumstances. Allowing acquired funds to take a position as much as 10% of their whole belongings in different funds and personal funds with out restriction permits for flexibility in such acquired funds’ funding methods. Nevertheless, many nontraded closed-end funds, which are actually permitted acquired funds underneath the ultimate rule, themselves spend money on non-public funds. This provision within the last rule will restrict the power of buying funds to spend money on such funds.

Exemptions from Part 17(a) of the Act. As proposed, the ultimate rule gives an exemption from Part 17(a) of the 1940 Act with respect to fund of fund preparations. Part 17(a) of the 1940 Act usually prohibits an affiliated individual of a fund, or any affiliated individual of such individual, from promoting any safety or different property to, or buying any safety or different property from the fund. The 1940 Act usually defines an “affiliated individual” as somebody proudly owning, controlling or having the facility to vote, 5% or extra of a fund’s excellent securities. Absent an exemption, Part 17(a) would prohibit an buying fund that holds 5% or extra of an acquired fund’s securities from making any extra investments within the acquired fund, thereby limiting the scope of the ultimate rule. As well as, the SEC adopted a modified exemption from Part 17(a) to supply reduction for the in-kind buy and redemption of shares in creation items straight by an buying fund that’s an affiliated individual of an acquired fund ETF solely by cause of the acquired fund holding with the facility to vote 5% or extra of the acquired fund ETF’s shares.

Rescission of Rule 12d1-2 and Modification to Rule 12d1-1 and Type N-CEN; Disclosures

In reference to the ultimate rule, the SEC is rescinding Rule 12d1-2 underneath the 1940 Act, which allows a fund counting on Part 12(d)(1)(G) of the 1940 Act to (i) purchase securities of different funds that aren’t a part of the identical group of funding corporations, (ii) make investments straight in shares, bonds and different varieties of securities and (iii) purchase the securities of cash market funds. The SEC famous within the last rule launch that because of the rescission, funds counting on Part 12(d)(1)(G) wouldn’t have the ability to purchase belongings apart from funds which can be throughout the similar group of funding corporations, authorities securities and short-term paper. Funds at the moment counting on Part 12(d)(1)(G) might be required to depend on the ultimate rule to make these different direct investments.

The SEC additionally adopted amendments to Rule 12d1-1 underneath the 1940 Act to permit funds counting on Part 12(d)(1)(G) to proceed to spend money on unaffiliated cash market funds (i.e., money sweep preparations).

Moreover, the SEC adopted amendments to Type N-CEN, which require {that a} fund report if it relied on the ultimate rule or the statutory exception from Part 12(d)(1)(G) to function as a fund of funds through the reporting interval.

An buying fund is at the moment required to reveal the charges and bills it incurs not directly from investing in an acquired fund. The SEC’s launch relating to the proposed rule requested touch upon the affect of this disclosure on sure acquired funds, resembling enterprise growth corporations. The SEC will not be addressing disclosure of acquired fund charges and bills (AFFE) as half of the present rule-making. Within the last rule launch, the SEC referred to its latest broader evaluation of fund disclosures and request for remark.6

Rescission of Exemptive Reduction and Withdrawal of Employees No-Motion Letters

The SEC is rescinding beforehand granted exemptive reduction allowing fund of funds preparations that fall throughout the scope of the ultimate rule. Fund of funds exemptive reduction or parts of reduction from provisions of the 1940 Act which can be outdoors the scope of the ultimate rule won’t be rescinded. For instance, the exemptive reduction from Part 17(a) and 17(d) of the 1940 Act and Rule 17d-1 underneath the 1940 Act included in orders to allow a registered fund to spend money on non-public funds would keep in place.

The fund of funds exemptive reduction that’s throughout the scope of the ultimate rule and might be rescinded embrace:

Normal fund of funds orders granting reduction from Part 12(a)(1)(A), (B) and (C) and Part 17(a)(1) and (2);

Reduction from Part 12(d)(1)(A) and (B) included within the ETF exemptive orders. In reference to adopting Rule 6c-11, the SEC rescinded most ETF orders however had not at the moment rescinded the reduction supplied to ETFs from part 12(d)(1) and sections 17(a)(1) and (a)(2) underneath the Act associated to fund of funds preparations involving ETFs.

ETFs counting on Rule 6c-11 underneath the 1940 Act that don’t have fund of funds orders could enter into fund of funds preparations by satisfying the representations and circumstances contained in latest ETF fund of funds orders. The SEC’s launch adopting Rule 6c-11 acknowledged that the SEC’s place was efficient till a last fund of funds rule was adopted; nevertheless, the SEC within the last rule launch has prolonged the termination date for its place to 1 12 months from the efficient date of the ultimate rule.

Fund of funds reduction supplied to nontransparent ETFs and ETMFs;

Fund of funds reduction granted to funds counting on Part 12(d)(1)(G) to make direct investments in belongings apart from funds throughout the similar group of funding corporations, authorities securities and short-term paper;

Fund of funds reduction supplied to open-end funds or UITs to spend money on affiliated open-end or closed-end funds; and

Reduction granted in reference to fund of funds preparations which can be captive to an affiliated managed account program.

The next exemptive reduction is taken into account by the SEC to be outdoors the scope of the ultimate rule and isn’t being rescinded:

Interfund lending;

Affiliated insurance coverage fund reduction;

Transaction-specific reduction;

Grantor trusts; and

Fund of funds preparations with managed threat provision and reduction associated to Part 12(d)(1)(E).

Over time, the SEC workers has additionally supplied no-action reduction with respect to sure fund of funds preparations. Sure no-action letters that fall throughout the scope of the ultimate rule might be withdrawn one 12 months from the efficient date of the ultimate rule. Info relating to the no-action letters which can be withdrawn is posted on the SEC’s web site.7

Compliance and Transition Dates

The ultimate rule will change into efficient 60 days after publication within the Federal Register.8

The rescission of Rule 12d1-2 will change into efficient one 12 months after the efficient date of the ultimate rule. The compliance date for the modification to Type N-CEN is 425 days after publication within the Federal Register. The SEC additionally adopted a one-year interval after the efficient date of the ultimate rule earlier than rescission of the SEC exemptive orders and no-action letters which can be throughout the scope of the ultimate rule.

Observe Factors and Ideas

The ultimate rule and associated rule-making try to create a harmonized fund of funds regulatory regime. It lessens lots of the monetary and time burdens on funding advisers who would have wanted exemptive reduction to enter into fund of funds preparations which can be throughout the scope of the ultimate rule, however would require these advisers with current fund of funds preparations to evaluation these preparations and make procedural and operational modifications as wanted. In some circumstances, the permitted scope of acquired funds could have expanded. Advisers with current fund of funds orders and people at the moment counting on Part 12(d)(1)(G) and/or Rule 12d1-2 might want to decide whether or not they are going to have the ability to proceed to depend on their fund of funds orders and/or whether or not they are going to wish to depend on the ultimate rule or Part 12(d)(1)(G) to proceed their fund of funds operations. This can require a cautious evaluation of their current fund of funds operations, scope of present fund of funds reduction and the circumstances underneath the ultimate rule. Funding advisers of each acquired funds and buying funds should evaluation their insurance policies, procedures and controls, and make modifications essential to implement the circumstances required underneath the ultimate rule to the extent they are going to be counting on the ultimate rule. These with current fund of funds participation agreements ought to amend these agreements as essential to adjust to the circumstances. Pursuant to Rule 38a-1 underneath the 1940 Act, buying and bought funds could be required to undertake insurance policies and procedures moderately designed to stop a violation of rule 12d1-4. Fund boards and chief compliance officers must also evaluation the funds’ present compliance insurance policies and procedures, in addition to develop acceptable board reporting and oversight.

Footnotes:

Part 12(d)(1)(A) usually gives that it’s illegal for any registered fund (the buying firm) and any firm or corporations managed by such buying firm to buy or in any other case purchase any safety issued by another funding firm (the acquired firm), and for any funding firm (the buying firm) and any firm or corporations managed by such buying firm to buy or in any other case purchase any safety issued by any registered funding firm (the acquired firm), if the buying firm and any firm or corporations managed by it instantly after such buy or acquisition personal within the mixture: (i) greater than 3% of the overall excellent voting inventory of the acquired firm, (ii) securities issued by the acquired firm having an mixture worth in extra of 5% per centum of the worth of the overall belongings of the buying firm, or (iii) securities issued by the acquired firm and all different funding corporations having an mixture worth in extra of 10% of the worth of the overall belongings of the buying firm.

Part 12(d)(1)(B) usually gives that it’s illegal for any registered open-end fund (the acquired firm), any principal underwriter therefor, or any dealer or supplier registered underneath the Trade Act, knowingly to promote or in any other case eliminate any safety issued by the acquired firm to another funding firm (the buying firm) or any firm or corporations managed by the buying firm, if instantly after such sale or disposition: (i) greater than 3% of the overall excellent voting inventory of the acquired firm is owned by the buying firm and any firm or corporations managed by it, or (ii) greater than 10% of the overall excellent voting inventory of the acquired firm is owned by the buying firm and different funding corporations and corporations managed by them. Personal funds that depend on the Sections 3(c)(1) and three(c)(7) are topic to the three% limitation on investments in a registered fund in Part 12(d)(1)(A)(i) and Part 12(d)(1)(B)(i).

See 2018 Fund of Funds Proposing Launch, Funding Firm Act Launch No. 33329 (Dec. 19, 2018).

Issuers excepted from the definition of funding firm pursuant to Part 3(c)(1) or 3(c)(7) (non-public funds) will not be funding corporations for this goal. Personal funds are, nevertheless, funding corporations for functions of the three% limitation in Part 12(d)(1)(A) with respect to their funding in funds. The ultimate rule, as famous above, doesn’t exempt such a transaction from that restrict.

Group of funding corporations means any two or extra registered funding corporations or enterprise growth corporations that maintain themselves out to traders as associated corporations for functions of funding and investor providers.

See Tailor-made Shareholder Studies, Therapy of Annual Prospectus Updates for Current Traders, and Improved Charge and Danger Disclosure for Mutual Funds and Trade-Traded Funds; Charge Info in Funding Firm Commercials, Funding Firm Act Launch No. 33963 (Aug. 5, 2020) (“Investor Expertise Proposal”). The SEC, in proposing the AFFE disclosure modifications within the Investor Expertise Proposal, thought-about feedback acquired in reference to the 2018 Fund of Funds Proposing Launch.

https://www.sec.gov/divisions/funding/im-modified-withdrawn-staff-statements

As of the date of this alert, the ultimate rule has not been revealed within the Federal Register.