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On October 7, the Securities and Exchange Commission (SEC) adopted Rule 12d1-4 (Rule), which establishes a comprehensive regulatory framework for fund of funds arrangements. Prior to its adoption, fund managers navigated a complex and sometimes inconsistent regime of rules and exemptions to engage in fund of funds arrangements. In adopting the Rule, the SEC acknowledged the growing trend of funds investing in other funds and the desirability of fund of funds arrangements to achieve asset allocation, diversification or other investment objectives.

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The Rule permits a registered investment company or business development company (acquiring fund) to acquire securities of another registered investment company or business development company (acquired fund) in excess of the usual “3-5-10%” limits set forth in Section 12(d)(1) of the Investment Company Act of 1940, as amended (1940 Act), subject to the following conditions:

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The Rule does not include, as was initially proposed, any limits on the redemption of acquired fund shares held by the acquiring fund.

Under the Rule, registered investment companies (including open-end mutual funds, exchange-traded funds (ETFs), unit investment trusts (UITs) and closed-end funds) and business development companies (BDCs) can operate as both acquired and acquiring funds. The Rule broadens what was previously permitted by the SEC’s prior fund of funds exemptive relief and offers a more consistent framework for registered funds and BDCs. For example, open-end mutual funds, UITs and ETFs can now invest in unlisted closed-end funds and unlisted BDCs in excess of Section 12(d)(1) limits, where previously, exemptive orders limited investments in closed-end funds and BDCs to those that were listed. Private funds and unregistered investment companies cannot rely on the Rule as acquiring funds and thus, private and unregistered funds continue to be limited in their ability to acquire shares of registered funds.

The Rule prohibits an acquiring fund and its “advisory group” from controlling an acquired fund. An advisory group is either the fund’s investment adviser and any person controlling, controlled by or under common control with the adviser, or the fund’s investment sub-adviser and any person controlling, controlled by or under common control with the sub-adviser.

If the acquiring fund and its advisory group hold more than 25% of the outstanding voting securities of an open-end fund or UIT as a result of a decrease in the outstanding voting securities of the acquired fund or hold more than 10% of the outstanding voting securities of a closed-end fund or BDC, the acquiring fund and its advisory group must “mirror vote” – i.e., vote the securities of the acquired fund in the same proportion as the vote of other holders of the acquired fund’s securities.

The prohibitions on control do not apply if the acquiring fund and acquired fund are in the same group of investment companies.

To address concerns that an acquiring fund could exert undue influence over an acquired fund or charge excessive fees, the Rule requires certain evaluations and findings before an acquiring fund invests in an acquired fund. These differ depending upon whether a fund is the acquiring or acquired fund and whether it is a management company, UIT or a separate account funding variable insurance contracts.

If an acquired fund is a registered investment company, its investment adviser must find that any undue influence concerns associated with the acquiring fund’s investment in the acquired fund are reasonably addressed after considering the following non-exhaustive factors:

Because concerns regarding undue influence are more prominent for acquired funds, the Rule only requires the acquired fund’s adviser to make this determination.

The Rule requires the acquiring fund’s adviser to evaluate the complexity of the structure associated with the acquiring fund’s investment in the acquired fund. The acquiring fund’s adviser must evaluate the relevant fees and expenses and find that the acquiring fund’s fees and expenses are not duplicative of the acquired fund’s fees and expenses. Only the acquiring fund’s adviser needs conduct this evaluation.

The acquiring fund’s adviser must report its evaluations and findings to the acquiring fund’s board of directors prior to the initial investment. The Rule does not require the adviser to make subsequent reports to the board, but the board is required to review these fund of funds arrangements and conclude that they continue to be reasonable and appropriate no less than annually as part of its Rule 38a-1 compliance review.

The Rule requires that funds with different investment advisers must enter a fund of funds investment agreement, which is similar to, yet substantially different from, current participation agreements required under most fund of funds exemptive relief orders granted by the SEC. This new agreement must include:

As the SEC staff considers these agreements to be material contracts not made in the ordinary course of business, they must be filed as an exhibit to each applicable fund’s registration statement.

The Rule restricts the ability to establish three-tier fund of funds structures to protect shareholders from undue influence and excessive fees. Certain exceptions exist for investments in funds that are wholly owned and controlled subsidiaries, investments in money market funds, and certain interfund lending or borrowing transactions where the threat of undue influence or investor confusion is minimal. The Rule also permits an acquired fund to invest up to 10% of its total assets in any one fund, regardless of the size of the investment, to give funds flexibility to gain exposure to any asset class or sector through investments in underlying funds.

One year after the Rule’s effective date, the SEC will rescind Rule 12d1-2, which permits funds that primarily invest in other funds to invest in unaffiliated funds and non-fund assets, and the exemptive relief it had previously granted with respect to fund of fund arrangements. As a result, advisers to affiliated fund of fund structures must make the necessary determinations and report to their boards if they choose to rely on the Rule. Advisers may continue operating an affiliated fund of funds structure under Section 12(d)(1)(G) but will no longer be able to invest in other investments, stocks, bonds or other securities due to Rule 12d1-2’s rescission.

Funds relying on the Rule must maintain the proper records for five years and make the necessary disclosures on Form N-CEN. All funds must comply with the amended Form N-CEN requirements within one year of the amendment’s effective date.

Andrew J. Davalla 614.469.3353 <a href="mailto:Andrew.Davalla@ThompsonHine.com">Andrew.Davalla@ThompsonHine.com</a>

Joshua J. Hinderliter <a href="mailto:Joshua.Hinderliter@ThompsonHine.com">Joshua.Hinderliter@ThompsonHine.com</a> 614.469.3345

Krisztina Nadasdy <a href="mailto:Krisztina.Nadasdy@ThompsonHine.com">Krisztina.Nadasdy@ThompsonHine.com</a> 614.469.3243

Philip B. Sineneng <a href="mailto:Philip.Sineneng@ThompsonHine.com">Philip.Sineneng@ThompsonHine.com</a> 614.469.3217

This advisory bulletin may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgment of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel.

This document may be considered attorney advertising in some jurisdictions.

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SEC Adopts New Rule for Fund of Funds Arrangements

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