Q3 2019 - New Regulations for Fund of Funds Arrangements
September 18, 2019
The SEC recently voted to propose a new rule and related amendments of the Investment Company Act of 1940 which is designed to streamline and enhance the regulatory framework on fund of funds arrangements (“the Proposal”).
Funds of funds are created when a mutual fund or other type of fund invests in shares of another fund. “These funds invest in other funds for a variety of reasons, including to achieve asset allocation or diversification in an efficient manner, as well as to hedge and otherwise manage risk. However, depending on the size of the investments, funds may be required to seek an exemptive order, causing costs and delays, and resulting in a regulative regime where substantially similar fund of funds arrangements may be subject to different conditions. This proposal would create a consistent, rules-based framework for fund of funds arrangements while providing robust protections for investors,” said SEC Chairman Jay Clayton.
The Investment Company Act currently prohibits a registered fund from:
- Acquiring more than 3% of another fund’s outstanding voting securities,
- Investing more than 5% of its total assets in any one fund, or
Investing more than 10% of its total assets in funds generally. Statutory exceptions may be requested to adjust the limitations if certain criteria are met by the acquiring fund. The SEC also has the authority to permit additional types of fund of funds arrangements as structures evolve by allowing exceptions to any person, security, or transaction, or any class of classes of transactions, if the exception is consistent with the public interest and the protection of investors.
The combination of the existing SEC rules, statutory exemptions, and exemptive orders has created a regulatory regime where substantially similar fund of funds arrangements are subject to different conditions.
The SEC’s proposed rule 12d1-4, and rescission of rule 12d1-2 and many of the exemptive orders, are intended to create a consistent and efficient rules-based framework for the formation and oversight of funds of funds to replace the mix of regulation currently relied on. The proposed rule includes various conditions intended to enhance investor protections that fund of funds arrangements would be required to satisfy.
The proposed rules include the following for the acquiring fund:
|Ownership Control||Prohibit controlling interest in an acquired fund.|
|Voting||Vote their securities in a prescribed manner if the acquiring fund and its advisory group holds (in the aggregate) more than 3% of the outstanding voting securities.
Seek voting instructions and vote such proxies in accordance with their instructions (“pass-through voting”) or vote the shares held by it in the same proportion as the vote of all other holders of the acquired fund (“mirror voting”).
|Redemptions||Limit the redemption or tendering for repurchase of an acquired fund’s total outstanding shares to 3% within any 30-day period. (However, funds that rely on the proposed rule to invest in funds that are listed on an exchange would be permitted to continue to sell shares in the secondary market without the volume limit.)|
|Duplicate and Excessive Fees||Prevent duplicative and excessive fees by requiring an evaluation of aggregate fees associated with the investment in the acquired fund and the complexity of the fund of funds arrangement to determine that it is in the best interest of the acquiring fund to invest in the acquired fund.|
|Complex Structures||Stipulate conditions designed to restrict fund of funds arrangements to two tiers, other than in specific limited circumstances.|
The rescission of rule 12d1-2 would eliminate the flexibility of funds relying on section 12(d)(1)(G) to invest in (i) unaffiliated funds and (ii) stocks, bonds and other securities. Instead, acquiring funds would have flexibility to invest in different types of funds and other asset classes under proposed rule 12d1-4, under a single set of conditions. In addition, the proposal includes an amendment to provide funds relying on section 12(d)(1)(G) with continued flexibility to invest in money market funds outside of the same group of investment companies.
The financial service industry has generally supported the SEC’s efforts and recognizes the proposal as a step forward for fund of funds arrangements. They acknowledge that the currently governing structure has resulting in an inconsistent and inefficient regulatory framework where the relief on which a fund of funds arrangement is relying is not always clear to other funds, investors or regulators. However, not all aspects of the proposal have been embraced. The condition with the most opposition is the proposed limitation on redemptions, with the following noted comments:
- Redemptions in excess of 3% of the acquired fund’s shares are common for some acquiring funds, often in connection with reallocations among asset classes.
- The redemption limit may hold the acquiring fund hostage in certain circumstances. Depending on the size of the ownership percentage, it could potentially take months to fully redeem while other non-acquiring fund investors, such as high net worth individuals, employee benefit plans, collective investment trusts, and institutional managed account platforms, would not have such limitations. This could result in a spiral effect where the acquiring fund is limited in its redemptions, yet the redemptions of other investors continue to keep the acquiring fund’s ownership above 3%, dramatically extending its time to liquidate.
- The redemption limit may also result in acquiring funds to only invest in larger acquired funds and limit their investments in small funds that may be preferable because the ownership level would exceed 3%.
Road to Compliance
In preparation for the final rules, SEC registered investment companies should consider reviewing the impact to the existing compliance framework, including but not limited to asset acquisition and allocation controls; allocation of fees and expenses and redemptions.
Engaging Alternatives – Q3 2019