United States: Investment Management Alert : SEC Adopts New Fund of Funds Rules

On June 20, 2006, the U.S. Securities and Exchange Commission (the "SEC") promulgated three rules that expand the ability of an investment company to acquire securities issued by other funds.¹ In general, new rules 12d1-1, 12d1-2 and 12d1-3 under the Investment Company Act of 1940 (the "1940 Act") codify and expand prior SEC orders exempting funds from certain prohibitions under Section 12(d)(1) of the 1940 Act, but the SEC also imposed specific disclosure requirements relating to fund of funds expenses. The new rules are effective as of July 31, 2006 but compliance with the new disclosure requirements is not required until after January 1, 2007.

Sections 12(d)(1)(A) and (B) of the 1940 Act limit the ability of an investment company to invest in other funds. Congress adopted these provisions in order to prevent abusive "pyramiding" schemes, common prior to the enactment of the 1940 Act, through which a small number of individuals could exercise control over the assets of an acquired fund and use those assets for personal enrichment.² The restrictions imposed by Section 12, however, had broad application and prohibited certain beneficial fund of funds arrangements. Accordingly, over the years, Congress has created exceptions to Sections 12(d)(1)(A) and (B) to permit certain kinds of fund of funds arrangements.³ The new rules adopted by the SEC continue the recent tradition of loosening the restrictions of Section 12 by further expanding the kinds of permissible fund of funds arrangements, without the need for prior staff approval.

Rule 12d1-1 allows a fund to invest its uninvested cash in money market funds without regard to the limitations imposed by Section 12(d)(1)(A).⁴ Under the new rule, a registered or unregistered, open-end or closed-end fund generally may purchase shares of affiliated or unaffiliated, registered or unregistered money market funds in excess of the Section 12 limitations. In addition to providing an exemption from Section 12(d)(1), the rule also provides exemptions from Section 17(e) and Rule 17d-1, which otherwise would restrict a fund’s ability to enter into transactions and joint arrangements with affiliates.

If a fund purchases shares of an unregistered money market fund, however, certain conditions must be satisfied. The acquiring fund must reasonably believe that the unregistered money market fund complies with the provisions of Rule 2a-7 under the 1940 Act, which imposes restrictions on the kinds of investments that a money market fund can make and imposes certain record-keeping and reporting requirements.⁵ Additionally, the money market fund’s adviser must be registered with the SEC as an investment adviser.

Under the rule, an acquired money market fund cannot charge an acquiring fund a sales load, distribution fee or service fee without a corresponding waiver of such amount by the acquired money market fund’s investment adviser. The rule does not, however, codify conditions of prior exemptive orders that imposed special duties on fund trustees to make findings that investors are not paying multiple advisory fees for the same service.

Rule 12d1-2 allows a registered fund to invest beyond the limitations imposed by Section 12(d)(1)(G) in (i) shares of unaffiliated funds, (ii) money market funds, when relying on Rule 12d1-1, and (iii) directly in securities.

Section 12(d)(1)(G) allows a fund to invest only in funds that are part of the same group of investment companies as the fund and in government securities and short-term paper. Rule 12d1-2 permits the same types of investments allowed under Section 12(d)(1)(G) but also permits certain other types. Under the new rule, a fund generally can also purchase shares of funds that are not part of the same group of investment companies as the fund (subject to the limits imposed by Section 12(d)(1)(A) and (B) or by Section 12(d)(1)(F)⁶ ) as well as stocks, bonds and other securities not issued by a fund.

A fund that relies on Rule 12d1-2 also may invest in money market funds pursuant to Rule 12d1-1. Moreover, a fund that relies on Rule 12d1-2 may invest in funds that in turn invest in money market funds pursuant to Rule 12d1-1.⁷

Rule 12d1-3 allows a fund to invest in shares of unaffiliated funds without complying with the sales load limitation of Section 12(d)(1)(F), which caps an acquiring fund’s sales load at 1.5%. Under the new rule, an acquiring fund (and its affiliates) may purchase up to 3% of an acquired fund as long as the acquiring fund does not charge a sales load exceeding the limits on sales loads established by NASD Sales Charge Rule 2830. The NASD has adopted a detailed set of rules applicable to sales charges relating to investment company securities.⁸

The SEC adopted amendments to its various disclosure forms (N-1A, N-2, etc.) to require each acquiring fund that invests in shares of any acquired funds to disclose in its prospectus fee table the expenses of the acquired funds in which it invests, even if the acquiring funds do not rely on the new rules. Under the new disclosure requirements, an acquiring fund will be required in most cases to include in its prospectus fee table an additional line item setting forth the fund’s pro rata portion of the cumulative net expenses charged by any acquired funds. The additional line item, called "Acquired Fund Fees and Expenses," should appear in the fee table directly above the line item "Total Annual Fund Operating Expenses." The costs associated with investing in other funds also will be reflected in the fee table example in which a fund discloses the cumulative amount of fund expenses for 1, 3, 5 and 10 years based on an initial investment of $10,000 at a 5% annual return.⁹

The form amendments contain a detailed formula on how to calculate the amount of acquired fund fees and expenses that must be reflected in the acquiring fund’s fee table. Generally speaking, the acquiring fund must aggregate the amount of total annual fund operating expenses of the acquired funds (which are paid by the acquiring fund) and transaction fees (which are paid by the acquiring fund over the past year) and express the total amount as a percentage of average daily assets of the acquiring fund.

The disclosure requirements also apply to investments in acquired funds exempt from registration pursuant to Sections 3(c)(1) or 3(c)(7) of the 1940 Act.

• The new rules should work to level the playing field within the mutual fund industry. Prior to their promulgation, various fund complexes had been operating under different exemptive orders with varying relief and conditions.

• Much in the way that Rule 17a-8 alleviated pressure on the SEC staff to review applications and issue exemptive orders in the fund merger context, we expect that the new rules should relieve some of the burden on the SEC staff and allow them to focus on less routine exemptive applications and no-action letter requests.

• The formulas and instructions relating to the disclosure of underlying fund fees are complex and should be reviewed carefully by a fund’s administrator or fund accountant, in concert with fund counsel, to ensure that the fees are accurately disclosed. Coordination at an early stage could benefit complexes that have large numbers of funds that are involved in fund of fund structures.

• In light of the new fee table line item and the related increased complexity, sponsors may wish to consider how fee waivers and expense reimbursements (committed and uncommitted) and related fee table, footnote and expense example disclosures will dovetail.

• The new fee table line item may drive changes in marketing strategies. For example, a closed-end fund of funds that invests in a hedge fund will be required to disclose in a line item all underlying hedge fund fees that are based on a share of income, capital gains or appreciation, e.g., a carried interest or performance fee. Such disclosure could drive closed-end funds away from those underlying funds that may now appear to be excessively expensive.

Rules 12d1-1, 12d1-2 and 12d1-3 add flexibility to Section 12 of the 1940 Act and provide exemptions that better fit with the practices of a continually evolving industry. The rules represent a balance between the interests of fund management and shareholders by increasing a fund’s structural options through expanded investment opportunities while protecting the interests of shareholders though enhanced disclosure.

1. See Fund of Funds Investments, Investment Company Act Release No. 27399 (June 20, 2006) (the "Release").

2. See Fund of Funds Investments, Investment Company Act Release No. 26198 (Oct. 1, 2003).

3. See 1940 Act Sections 12(d)(1)(E) (permitting certain master-feeder fund arrangements) 15 U.S.C. § 8a-12(d)(1)(E); 12(d)(1)(F) (permitting certain affiliated fund of funds arrangements) 15 U.S.C. § 8a-12(d)(1)(F); 12(d)(1)(G) (permitting certain unaffiliated fund of funds arrangements) 15 U.S.C. § 8a-12(d)(1)(G).

4. Section 12(d)(1)(A) would otherwise prohibit a fund from purchasing (i) more than 3% of the total outstanding voting stock of another fund, (ii) securities of another fund having an aggregate value in excess of 5% of the value of the acquiring fund, and (iii) securities of the other fund and all other funds having an aggregate value in excess of 10% of the value of the total assets of the acquiring fund. See 15 U.S.C. § 8a-12(d)(1)(A).

5. The new rule suggests that a fund may receive a representation from the acquired fund or its adviser to support its "reasonable belief." See 17 C.F.R. §§ 270.2a-7 and 270.12d1-1.

6. "A fund relying on Section 12(d)(1)(A) is subject to the limitations outlined in footnote 4. A fund relying on Section 12(d)(1)(F) (together with its affiliates) could not acquire more than 3 percent of the outstanding stock of any other fund in a different fund group. The acquiring fund also would be required either to seek instructions from its shareholders as to how to vote shares of those acquired funds, or to vote the shares in the same proportion as the vote of all other shareholders of the acquired fund. See 15 U.S.C. § 80a-12(d)(1)(F) (referencing 15 U.S.C. § 80a-12(d)(1)(E)). In addition, the acquiring fund would be limited to charging a sales load of 1½ percent on its shares and could be prevented from redeeming more than 1 percent of the shares of any acquired fund during any period of less than 30 days. Id." Release n.56.

7. See 15 U.S.C. § 80a-12(d)(1)(A) and Release n.62.

8. See NASD Sales Charge Rule 2830(d)(3).

9. See Item 3 of Form N-1A.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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