(Article from Registered Funds Alert, January 2019)
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The SEC recently proposed new Rule 12d1-4 under the 1940 Act that, if adopted, would provide an exemption for fund of funds arrangements where registered funds and business development companies (collectively, “regulated funds”) acquire shares of other regulated funds in excess of the statutory 1940 Act limits. This article provides background on the fund of funds restrictions in the 1940 Act, current exemptions to these general prohibitions and an overview of the requirements of the proposed rule. The article then examines potential adverse or unintended consequences of the proposed rule and suggests potential revisions for the SEC staff to consider prior to adopting a final rule.
Background
Section 12(d)(1) of the 1940 Act restricts the ability of a regulated fund (an “acquiring fund”) to invest in other funds (“acquired funds”). There are three key restrictions that apply each time an acquiring fund purchases shares of an acquired fund, commonly referred to as the 3%/5%/10% restrictions (together, the “12(d)(1) Limits”):
- an acquiring fund cannot own more than 3% of the total outstanding voting stock of a single acquired fund (note: the 3% limit also applies when private funds relying on the exceptions in Sections 3(c)(1) and 3(c)(7) of the 1940 Act acquire shares of regulated funds);
- an acquiring fund cannot invest more than 5% of the value of its total assets in a single acquired fund; and
- an acquiring fund cannot, in the aggregate, invest more than 10% of its total assets in acquired funds.
The 1940 Act and the rules thereunder include certain exemptions from the 12(d)(1) Limits for master-feeder arrangements, affiliated fund of funds arrangements, investments in money market funds, and acquisitions of less than 3% of an acquired fund’s securities in the aggregate by a regulated fund and all affiliated persons of such regulated fund. The SEC has also issued numerous exemptive orders (the “Existing Orders”) that allow certain regulated funds to invest in shares of other regulated funds in excess of the 12(d)(1) Limits, subject to certain conditions and the execution of a participation agreement between the acquiring fund and the acquired fund. Under these participation agreements, an acquired fund agrees to allow the acquiring fund to acquire more than 3% of its shares in reliance on the order and each fund agrees to comply with the applicable conditions of the order. As is often the case with exemptive orders, the conditions contained in the various Existing Orders are generally similar, but not identical.
Overview of the Proposed Rule
The proposed rule would allow a regulated fund to acquire shares of another regulated fund in excess of the 12(d)(1) Limits, subject to the following conditions:
- No private funds may rely on the proposed rule. The rule would only be available for investments by regulated funds. Private funds could not rely on the rule as proposed, and thus would still be restricted to the 3% limit described above.
- No controlling stake. An acquiring fund and its advisory group will not control (individually or in the aggregate) an acquired fund. Under the 1940 Act, control is presumed when a person (or in this case, a group) beneficially owns, directly or through one of more controlled companies, more than 25% of another person’s voting securities. “Advisory group” refers to an acquiring fund’s investment adviser, sub-adviser or depositor (i.e., sponsor), and any person controlling, controlled by, or under common control with such investment adviser, sub-adviser or depositor (including other funds managed by the sponsor).
- Acquiring funds must either mirror vote or pass-through vote. If an acquiring fund and its advisory group hold more than 3% of an acquired fund’s outstanding voting securities in the aggregate, each holder will either mirror vote its acquired fund shares in the same proportion as the vote of all other shareholders or seek voting instructions from its shareholders. The mechanics of this proposal are identical to the 1940 Act voting provisions for master-feeder funds.
- Redemptions limited to 3% per any 30-day period. When an acquiring fund holds more than 3% of an acquired fund’s outstanding voting securities, such acquiring fund may not redeem more than 3% of the acquired fund’s outstanding voting securities during any 30-day period.
- Adviser must undertake a periodic evaluation. Before investing in an acquired fund in reliance on the rule, and no less frequently than annually thereafter, the acquiring fund’s investment adviser must evaluate the complexity of the structure and the aggregate fees associated with the acquiring fund’s investment in the acquired fund, and find that it is in the best interest of the acquiring fund to invest in the acquired fund. The investment adviser of the acquiring fund must report its findings to the fund’s board.
- Restrictions on complex fund of fund structures. If a regulated fund intends to be (or at times may be) an acquiring fund for purposes of the rule, it must disclose that intent in its registration statement. No acquiring fund may acquire shares of another regulated fund in excess of the 12(d)(1) Limits if the prospective acquired fund has disclosed that it may be an acquiring fund under the rule. Under the proposed rule, an acquired fund is also prohibited from acquiring shares of other funds (including private funds even though there is otherwise no statutory basis for limiting investments in private funds) in excess of the 12(d)(1) Limits except for certain limited circumstances, including master-feeder arrangements, investments in money market funds for cash management purposes, investments in wholly owned subsidiaries and interfund borrowing and lending transactions pursuant to a SEC exemptive order.
- Additional recordkeeping requirements. The acquiring fund must maintain and preserve for not less than five years a written record of the investment adviser’s finding that the investment is in the best interest of the acquiring fund.
Key Issues the SEC Should Reconsider
There are a number of aspects of the proposed rule that should be reconsidered before the SEC adopts a final rule. Certain of these considerations are discussed below.
Private funds should be allowed to qualify as acquiring funds under the rule when investing in ETFs and other open-end funds
Private funds cannot rely on the proposed rule to invest in ETFs and other open-end funds. The SEC should reconsider whether to allow private funds to acquire interests in ETFs and other open-end funds in excess of the 12(d)(1) Limits under the final rule.
While there are some key additional factors to be considered in permitting private funds to rely on the rule, as discussed in further detail below it would not appear to be impractical to address those key considerations in a revised final rule. If the changes proposed below are implemented, it would appear that allowing private funds to invest in regulated funds in excess of the 12(d)(1) Limits in accordance with the conditions of the rule would not present any additional meaningful risks than those associated with a regulated fund engaging in the same activity. Certain concerns, such as large-scale redemption requests by acquiring funds, are less relevant when a private fund is an acquiring fund since most private funds do not offer daily liquidity to their investors. Like regulated funds, private funds also invest in ETFs and other regulated funds to gain market exposures. So long as a private fund complies with the conditions of the rule, there is no apparent reason to treat investments by private funds in ETFs and other open-end funds differently under the rule.
The proposing release explains that private funds were omitted from the types of funds that can rely on the rule because private funds (i) do not make annual reports on Form N-CEN, (ii) do not report acquired fund holdings on Form N-PORT and (iii) are not subject to the recordkeeping requirements of the 1940 Act. These concerns should not preclude private funds from relying on the rule as acquiring funds because the rule could be revised to require substantially similar reporting and recordkeeping for private funds. For example:
- (i) the investment adviser to the private fund could be required to make the same disclosures by adding questions to Form ADV Part 1 that correspond to the questions in Form NCEN,
- (ii) private funds that rely on the rule could be required to submit a confidential monthly report of acquired fund holdings to the SEC that aligns with the information on Form N-PORT or similar reporting could be added to Form PF and
- (iii) the Advisers Act recordkeeping rule could be amended to require investment advisers to private funds that rely on the rule to maintain the records that will be required of regulated funds under the 1940 Act.
Although private fund managers may object to this increased level of required reporting, it is not unreasonable that the ability to rely on an exemptive rule would require a certain amount of concomitant burden on any party that avails itself of the benefits of the rule.
The rule should be revised to include appropriate protections for closed-end funds and BDCs
The rule poses serious concerns for closed-end funds and BDCs in light of the trend for certain activists to form multiple funds to invest in listed closed-end funds and BDCs to seek short-term actions that may not be consistent with the best interests of long-term investors. In particular, the option to pass-through the vote to acquiring fund investors could be abused by acquiring funds managed by activist investors. For example, an activist investor could form a closely held regulated fund to make activist investments in closed-end funds or BDCs. Investors in such funds would be likely to vote in a manner that is consistent with the activist’s interest—but may be inconsistent with the best interests of the acquired fund’s long-term investors. To protect closed-end funds and BDCs, the rule should be revised to require mirror voting if an acquiring fund managed by a different advisory group holds more than 3% of an acquired fund’s shares. Acquiring funds managed by the same advisory group could have the option of mirror voting or pass-through voting.
Allowing private funds to invest in closed-end funds and BDCs in reliance on the rule as proposed would not be in the best interests of long-term investors. If the voting provisions of the rule are revised to require mirror voting when investing in a closed-end fund or BDC, however, then a private fund should not be precluded from relying on the rule to invest in closed-end funds and BDCs. This approach would prevent activist private fund managers from abusing the rule while allowing private funds to gain desired investment exposures through investments in closed-end funds and BDCs.
Acquired funds should be allowed to screen certain acquiring funds
Existing Orders require an acquiring fund and an acquired fund to enter into a participation agreement prior to an acquisition of acquired fund shares that exceeds the 12(d)(1) Limits. While this requirement ensures that each party is contractually obligated to comply with the conditions of the applicable Existing Order, it also allows an acquired fund to screen prospective acquiring funds—i.e., if the acquired fund declines to enter into the participation agreement, the acquiring fund cannot invest in excess of the 12(d)(1) Limits. We anticipate that the removal of the participation agreement requirement will be a welcome development, but the elimination of a mechanism to screen prospective acquiring funds may have adverse consequences for certain acquired funds. For example, if the acquired fund is listed on a stock exchange, or if the acquiring fund invests through an omnibus account, then under the proposed rule the acquired fund may not have the opportunity to reject an investment by an acquiring fund before such investment exceeds the Section 12(d)(1) Limits. Closed-end funds and BDCs may wish to screen prospective acquiring funds to prevent activists from investing in reliance on the rule. Open-end funds may wish to screen investors to manage capacity constraints and redemption risk. The SEC should consider these potential adverse consequences before finalizing the rule.
A key issue to reconsider is the 3% redemption limit in any 30-day period, which would impose severe limitations on the utility of the rule
The rule condition limiting redemptions to not more than 3% of the acquired fund’s total outstanding shares during any 30-day period is not a condition of Existing Orders. The SEC has indicated that the proposed redemption limit is designed to provide a check against the influence that an acquiring fund can have on an acquired fund through the threat of large-scale redemptions. The SEC proposed a mandatory limit that prohibits redemptions above a threshold percentage, rather than a permissive limit that would be at the acquired fund’s discretion similar to section 12(d)(1)(F) of the 1940 Act, because the SEC believes an acquiring fund could influence an acquired fund to eliminate (or never establish) a permissive limit on redemptions.
The proposed redemption limit has the potential to adversely affect acquiring fund liquidity and may inhibit current portfolio management techniques—for example, this condition may prevent an acquiring fund from optimally rebalancing its portfolio. We question the need for the redemption limit, especially since it is not a condition of the Existing Orders. We anticipate that the SEC will be presented with alternatives to the 3% redemption limit. For example, some commenters may suggest a higher threshold percentage, relief that would permit the acquired fund to delay redemption payments beyond seven days under certain circumstances (rather than simply prohibiting such redemption), and/or longer notice periods for acquiring funds to redeem a certain percentage of an acquired fund’s shares.
If the final rule includes a redemption limit, the rule should specify that such investments by acquiring funds will not be deemed illiquid for purposes of the liquidity rule
The SEC states in the release that an open-end acquiring fund that relies on the rule should take the 3% redemption limitation into account when classifying its investment in the acquired fund as part of its liquidity risk management program pursuant to Rule 22e-4. In effect, the redemption limit would prevent an acquiring fund from disposing of more than 3% of the acquired fund’s shares in seven calendar days or less. If a redemption limit is included in the final rule, the rule should specify that (i) an investment made in reliance on the rule is liquid for purposes of the liquidity rule’s 15% illiquid investments limit and (ii) the rule’s redemption limit should only be considered for purposes of the liquidity rule’s classification requirement .
The rule should not unduly limit the use of efficient portfolio management techniques by acquired funds, such as investments in ETFs
The rule prohibits investments by an acquired fund in other funds, subject to certain limited exceptions that are generally consistent with Existing Orders. As proposed, however, the rule would prohibit portfolio management techniques where an acquired fund seeks to invest in ETFs or other funds to efficiently invest large subscriptions into the fund or to gain investment exposures to certain asset classes. To ensure portfolio management decisions are made in the best interests of acquired fund investors, the final rule should allow acquired funds to invest a portion of their assets in ETFs or other funds for these purposes.
Next Steps
The proposed rule is a necessary step to seek to harmonize the 1940 Act regime for fund of funds investments and to free up SEC staff resources that are otherwise spent reviewing exemptive applications for similar relief. It is likely, however, that the proposal draws significant and wide-ranging comments from the industry. The end of the rule’s comment period is not yet known because the proposing release has not been published in the Federal Register due to the partial shutdown of the federal government. The comment period will end 90 days after the proposing release is published. Simpson Thacher will be monitoring developments regarding the proposed rule, which will be addressed in future Alerts.