On October 7, 2020, the US Securities and Exchange Commission (SEC) adopted Rule 12d1-4 (Rule) under the Investment Company Act of 1940 (Act) and related amendments (Amendments) that are collectively designed to provide a more consistent and efficient regulatory framework for funds that invest in other funds (“fund of funds” arrangements). The SEC is also rescinding Rule 12d1-2 under the Act, rescinding most exemptive orders granting relief from Sections 12(d)(1)(A), (B), (C), and (G) of the Act, and withdrawing its no-action letters related to Section 12(d)(1) that fall within the scope of the Rule. In addition, the SEC adopted related amendments to Rule 12d1-1 and Form N-CEN.
The changes were first proposed in December 2018 (Proposal), and the Rule, as adopted, includes several modifications to the Proposal that the SEC made in response to the more than 100 comment letters that it received on the Proposal.
The Rule and the Amendments will be effective 60 days after publication in the Federal Register, and the compliance date for the amendments to Form N-CEN will be 425 days after publication in the Federal Register. The rescission of Rule 12d1-2 and the applicable existing exemptive orders, and the withdrawal of the applicable no-action letters, will be effective one year after the effective date of the Rule and the Amendments. Funds of funds that are currently relying on affected exemptive orders or Rule 12d1-2 will have that one year to amend their compliance programs and transition to the Rule.
The Rule is available to registered funds and business development companies (BDCs) seeking to invest in other registered funds and BDCs beyond the limits currently imposed by Section 12(d)(1) of the Act. Unregistered funds, such as private funds and foreign investment companies, are not permitted to rely on the Rule.
Section 12(d)(1) of the Act places limits on the investments that funds may make in other funds. Specifically, Section 12(d)(1)(A) prohibits a registered fund from: (i) acquiring more than 3% of another fund’s outstanding voting securities; (ii) investing more than 5% of its total assets in any single fund; or (iii) investing more than 10% of its total assets in funds generally. The SEC has, however, adopted rules and issued various exemptive orders permitting fund of funds arrangements in excess of these limits. As a result, the SEC believes that the current mix of exemptive rules and exemptive relief, as well as two statutory exceptions to the Section 12(d)(1)(A) limits, has led to a regulatory regime with a variety of different fund of funds arrangements that are subject to a wide variety of conditions.
In adopting the Rule and related Amendments, the SEC sought to “eliminate the existing overlapping and potentially inconsistent conditions for funds of funds and to harmonize conditions across different fund arrangements.” To this end, the Rule has the effect of limiting fund of funds arrangements to three types:
The Rule will permit a fund (acquiring fund) to acquire the shares of another fund (acquired fund) in excess of the Section 12(d)(1)(A) limits described above. To rely on the Rule, a fund will have to satisfy, among others, the following conditions:
Control and Voting
Evaluations and Fund Findings
Before an acquiring fund initially acquires more than 3% of an acquired fund’s voting shares, the investment advisers of both the acquiring fund and the acquired fund must evaluate and make certain findings, subject to each adviser’s fiduciary duty to act in the best interest of each fund it advises, regarding the fund of funds arrangement. This condition, coupled with the “investment agreement” discussed below, replaces the proposed limitation on redemptions by an acquiring fund, which was perhaps the most widely opposed part of the Proposal.
Fund of Funds Investment Agreements
Complex Fund Structures
In connection with the adoption of the Rule and Amendments, the SEC is rescinding the exemptive relief previously granted to permit fund of funds arrangements that fall within the scope of the Rule. The exemptive orders covered by the rescission include all orders granting relief from Sections 12(d)(1)(A), (B), (C), and (G) of the Act with one exception – the exemptive orders permitting certain interfund lending arrangements are not being rescinded. In addition, the SEC is withdrawing its no-action letters related to Section 12(d)(1) that fall within the scope of the Rule.
The SEC is also rescinding Rule 12d1-2, which permits a fund of funds relying on Section 12(d)(1)(G) of the Act to (i) invest in securities of funds that are not part of the same group of funds; (ii) invest directly in stocks, bonds, and other securities, and (iii) acquire shares of money market funds in reliance on 12d1-1. By rescinding Rule 12d1-2 and the existing 12(d)(1) exemptive orders, all fund of funds arrangements that currently rely on Section 12(d)(1)(G) and Rule 12d1-2 and/or exemptive relief, will now have to comply with the Rule or discontinue certain investments.
Because of the rescission of Rule 12d1-2, the SEC is amending Rule 12d1-1 to specifically permit fund of funds arrangements that rely on Section 12(d)(1)(G) to invest in shares of money market funds that are not part of the same group of investment companies as the acquiring fund.
The Rule provides relief from Section 17(a) of the Act necessary to effectuate a fund of funds arrangement. Absent an exemption, Section 17(a) would prohibit a fund that holds 5% or more of the acquired fund’s securities from making any additional investments in the acquired fund, limiting the efficacy of Rule 12d1-4. In addition, the Rule provides relief from Section 17(a) for exchange-traded funds (ETFs) with regard to the deposit and receipt of baskets by an acquiring fund that is an affiliated person of an ETF (or who is an affiliated person of such a person) solely by reason of holding with the power to vote 5% or more of the ETF’s shares or holding with the power to vote 5% or more of any investment company that is an affiliated person of the ETF. The relief granted by the Rule from Section 17(a) is consistent with the relief previously granted by the SEC in fund of funds exemptive orders.
Form N-CEN is a structured form that requires registered funds to provide census-type data to the SEC on an annual basis. The SEC is also amending Form N-CEN to require a fund to report whether it relied on the Rule or on the statutory exemption in Section 12(d)(1)(G) of the Act during the relevant reporting period.
The Rule requires the acquiring and acquired funds that participate in fund of funds arrangements in accordance with the rule to maintain and preserve certain written records for a period of not less than five years, the first two years in an easily accessible place. These records include: (1) a copy of each fund of funds investment agreement that is in effect, or was in effect in the past five years, and any amendments thereto; and (2) a written record of the relevant findings (discussed in the “Evaluations and Fund Findings” section above) made under the Rule and the basis therefor within the past five years.
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Laurie A. Dee
 The SEC noted that it would be more appropriate for it to consider designing protective conditions through the exemptive application process before permitting private funds to be acquiring funds.
 Similarly, Section 60 of the Act makes these limits applicable to a BDC to the same extent as if it were a registered closed-end fund.
 See Sections 12(d)(1)(F) and (G) of the Act.
 Any fund that seeks to invest in money market funds beyond the Section 12(d)(1) limits would also still be able to rely on Rule 12d1-1.
 Subsection (d) of the Rule defines “advisory group” to mean “either: (1) an acquiring fund’s investment adviser or depositor, and any person controlling, controlled by, or under common control with such investment adviser or depositor; or (2) an acquiring fund’s investment sub-adviser and any person controlling, controlled by, or under common control with such investment sub-adviser.” Under the Rule, an acquiring fund would not combine the entities listed in clause (1) with those in clause (2).
 Section 2(a)(9) of the Act defines “control” to mean the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company. The Act also creates a rebuttable presumption that any person who, directly or indirectly, beneficially owns more than 25% of the voting securities of a company controls the company and that any person who does not own that amount does not control it. A determination of control is not based solely on ownership of voting securities of a company and depends on the facts and circumstances of the particular situation. Further, a “controlling influence” includes, in addition to voting power, a dominating persuasiveness of one or more persons, the act or process that is effective in checking or directing action or exercising restraint or preventing free action, and the latent existence of power to exert a controlling influence.
 Mirror voting requires the acquiring fund and its advisory group to vote shares of an acquired fund in the same proportion as the vote of all other holders of the acquired fund.
 Subsection (d) of the Rule defines “group of investment companies” as “any two or more registered investment companies or business development companies that hold themselves out to investors as related companies for investment and investor services.”
 Pass-through voting means that the acquiring fund will obtain instructions from its shareholders on how to vote an acquired fund’s proxies.
 As proposed, the Rule would have prohibited an acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares (i.e., the statutory limit) from redeeming or submitting for redemption, or tendering for repurchase, more than 3% of an acquired fund’s total outstanding shares in any 30-day period. Many commenters opposed the proposed redemption limit and they raised a number of concerns, including: (1) operational or administrative challenges; (2) the redemption limit’s potential effects on the acquiring fund’s investment objectives and its ability to respond timely to changing economic or market conditions; (3) the impact on competition and innovation; (4) whether funds in the same group of investment companies should be subject to the requirements; (5) concerns relating to liquidity; and (6) the cost of the proposed limits.
 However, the Rule would not limit the ability of a fund of funds relying on Section 12(d)(1)(F) of the Act from investing in other funds of funds.
 However, if an acquired fund were to invest in a single underlying fund in excess of the Section 12(d)(1) 3% or 5% limits, the acquired fund and underlying fund must comply with the conditions of the Rule as acquiring and acquired fund, respectively, or operate pursuant to another exemption from the Section 12(d)(1) limits.
 The list of no-action letters to be withdrawn will be available on the SEC’s website.
 The SEC noted that there are 954 acquiring funds, or 20% of all funds of funds, that rely on Section 12(d)(1)(G) and Rule 12d1-2 and will now be required to modify their operations to come into compliance with the Rule.