SEC Adopts Fund of Funds Arrangements Rule
By Toppan Merrill
1 min read | Industry Insights Insights Home

SEC Fund of Funds Blog_2

According to the SEC, at least 40% of registered Funds hold investments in at least one other Fund. Currently, Funds must obtain an SEC exemptive order to acquire shares of another Fund in excess of SEC limits. The new rule will eliminate this requirement and allow Funds to purchase and hold shares in other Funds providing they meet specific procedures and disclosure requirements.

EDGAR and Disclosure Impact: N-CEN changes related to Rule 12d1-4 and 12(d)(1)(G). Likely new checkbox(es). N-CEN compliance will not be required until 425 days after the rule becomes effective.

Existing Regulatory Framework

Section 12(d)(1) of the Investment Company Act of 1940 (the “1940 Act”) prohibits registered funds (and the companies, including funds, such registered funds control) from

(a) acquiring more than 3% of another fund’s outstanding voting securities,

(b) investing more than 5% of its total assets in any one fund, or

(c) investing more than 10% of its total assets in funds generally.

In connection with this provision, Section 12(d)(1)(B) of the 1940 Act prohibits a registered open-end fund and any principal underwriter thereof or registered broker-dealer from knowingly selling securities to any other investment company if the acquiring fund would: (x) together with the companies it controls, own more than 3% of the acquired fund’s outstanding voting securities, or (y) together with other funds (and companies they control), own more than 10% of the acquired fund’s outstanding voting securities. The restrictions aim to alleviate congressional concerns over the potential for an acquiring fund to exercise effective control over the acquired funds, and of duplicative or excessive fees or overly complex fund structures that could result from such arrangements.

Rescission of Existing Rules, Exemptive Orders and Staff Guidance

The SEC is adopting a new rule and amendments under the Investment Company Act of 1940 designed to streamline and enhance the regulatory framework for funds that invest in other funds (“fund of funds” arrangements).  The SEC is also rescinding rule 12d1-2 under the Act and most exemptive orders granting relief from sections 12(d)(1)(A), (B), (C), and (G) of the Act.  Finally, the Commission is adopting related amendments to rule 12d1-1 under the Act and Form N-CEN.  These modifications reflect the Commission’s decades of experience with fund of funds arrangements and will create a consistent and efficient rules-based regime for the formation and oversight of funds of funds.

Rule 12d1-4

Rule 12d1-4 will permit a registered investment company or business development company or “BDC” (referred to as “acquiring funds”) to acquire the securities of any other registered investment company or BDC (referred to as “acquired funds”) in excess of the limits in section 12(d)(1) of the Investment Company Act of 1940.  The rule will create a consistent framework for fund of funds arrangements to replace the existing approach, which depends on the Commission’s exemptive orders and varies based on an acquiring fund’s type. Open-end funds, unit investment trusts, closed-end funds (including BDCs), exchange-traded funds and exchange-traded managed funds will all be able to rely on rule 12d1-4 as both acquiring and acquired funds.

While the rule contains elements from the SEC’s current exemptive orders permitting fund of funds arrangements, it is tailored to enhance investor protections while providing funds with flexibility to meet their investment objectives in an efficient manner.  The rule’s conditions include the following:

  • Limits on Control and Voting. Rule 12d1-4 will prohibit an acquiring fund from controlling an acquired fund and will require an acquiring fund that holds more than a certain percentage of an acquired fund’s outstanding voting securities to vote those securities in a prescribed manner in order to minimize the influence that an acquiring fund may exercise over an acquired fund.  An acquiring fund that is part of the same fund group as the acquired fund and an acquiring fund that has a sub-adviser that acts as adviser to the acquired fund will not be subject to the control and voting conditions.
  • Required Evaluations and Findings. To address concerns that an acquiring fund could exert undue influence over an acquired fund or charge duplicative fees and expenses, the rule will require certain evaluations and findings be made before the 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, unit investment trust, or a separate account funding variable insurance contracts.
  • Required Fund of Funds Investment Agreements. In addition, the rule will require funds that do not share the same investment adviser to enter into a fund of funds investment agreement memorializing the terms of the arrangement.  This and the evaluation and finding requirements replace a proposed requirement that would have prohibited an acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares from redeeming more than 3% of the acquired fund’s total outstanding shares in any 30-day period.
  • Limits on Complex Structures. To limit funds’ ability to use fund of funds arrangements to create overly complex structures, rule 12d1-4 generally will prohibit funds from creating three-tier fund of funds structures, except in certain circumstances, including an exception that will permit an acquired fund to invest up to 10% of its total assets in other funds (including private funds) without restriction (the “10% bucket”).  The 10% bucket will provide flexibility for fund of funds arrangements to evolve, while permitting certain structures that could benefit investors through greater efficiency. 

Rescission of Rule 12d1-2 and Certain Exemptive Relief, and Amendments to Rule 12d1-1

To help create a consistent and streamlined regulatory framework for fund of funds arrangements, the SEC is also taking several related actions:

  • Rescission of Rule 12d1-2 and Certain Exemptive Relief. Rescinding rule 12d1-2, which permits funds that primarily invest in funds within the same fund group to invest in unaffiliated funds and non-fund assets.  The SEC is also rescinding the Commission’ exemptive orders permitting fund of funds arrangements, with limited exceptions.  As a result, funds wishing to create certain types of fund of funds arrangements that exceed the statutory limitations will be required to rely on rule 12d1-4 and comply with its associated conditions.
  • Amendments to Rule 12d1-1.Amending rule 12d1-1 to allow funds that primarily invest in funds within the same fund group to continue to invest in unaffiliated money market funds.

Amendments to Form N-CEN Amending Form N-CEN to require funds to report whether they relied on rule 12d1-4 or the statutory exception in section 12(d)(1)(G) of the Investment Company Act during the applicable reporting period.

Initial Takeaways and Effective Date

The adoption of Rule 12d1-4 may be welcome relief to funds that pursue fund of fund arrangements given the time and expense involved in pursuing and obtaining exemptive relief from the SEC. In addition, the final adopted version of Rule 12d1-4 resulted in a significant change from the original 2018 proposal, which initially included certain redemption limitations that were subject to critique from the industry during the proposed rule’s comment process. However, funds and advisers that intend to rely on the fund of funds relief under Rule 12d1-4 should carefully review and evaluate the more technical conditions of the rule, including the control determination requirements, required findings and fund of fund investment agreement requirements, which may prove to be more challenging in practice than on paper. In addition, the advisory group aggregation calculation requirements may present operational, organizational and monitoring challenges to certain fund advisers with multiple entities or affiliates that are run independently of each other and that may not already have processes in place to share necessary information among affiliates for compliance purposes.

The effective date for Rule 12d1-4 will be 60 days following publication of the rule in the Federal Register.


Release number:  33-1087

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Toppan Merrill


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