On October 7, 2020, the Securities and Exchange Commission (SEC) adopted a new fund of funds rule. New Rule 12d1-4 is designed to streamline and enhance the existing regulatory framework under which registered funds of funds have been offered. The new rule’s adoption is a recognition that fund of funds arrangements provide an efficient means of achieving portfolio diversity and asset allocation and, among other things, simplify recordkeeping and investment monitoring. In the words of the SEC, the new rule will “provide investors with the benefits of fund of funds arrangements, and . . . provide funds with investment flexibility to meet their investment objectives efficiently.”
New Rule 12d1-4 will be effective 60 days after publication of the adopting release in the Federal Register.
Section 12(d)(1) of the Investment Company Act of 1940, as amended (the “1940 Act”), limits the ability of an investment company to invest substantially in securities issued by another investment company. Section 12(d)(1)(A) prohibits a registered fund from:
Private funds are also subject to these limits with respect to investments in registered funds.
Section 12(d)(1)(B) of the 1940 Act prohibits a registered mutual fund, and any principal underwriter to the fund or broker-dealer registered under the Securities Exchange Act of 1934, from knowingly selling securities to any other investment company if, after the sale, the acquiring investment company would:
These statutory provisions are intended to prevent fund of funds arrangements that permit an acquiring fund to control the assets of an acquired fund and use those assets to enrich the acquiring fund at the expense of acquired fund shareholders. Prohibiting such fund of funds arrangements also eliminates the potential for duplicative and excessive fees when one fund invests in another.
Notwithstanding these concerns, fund of funds structures can benefit retail investors. Thus, Congress adopted legislation that permits master-feeder fund arrangements and the SEC has issued numerous exemptive orders permitting fund of funds arrangements. As a result of this approach, however, substantially similar fund of funds arrangements may be subject to differing conditions (e.g., under different exemptive orders). Among other things, new Rule 12d1-4 seeks to resolve this inconsistency.
New Rule 12d1-4 will permit registered investment companies, including open-end funds, closed-end funds, exchange traded funds (ETFs) and unit investment trusts (UITS), and business development companies (BDCs) to acquire the securities of another registered investment company or BDC in excess of the limits in Section 12(d)(1). In order to rely on the new rule, an acquiring fund must generally comply with the following control and voting requirements:
New Rule 12d1-4 also requires the investment adviser to both the acquiring fund and the acquired fund to make the following findings:
In evaluating the complexity of the structure, the acquiring fund’s investment adviser should compare the proposed structure to directly investing in similar holdings as those in the acquired fund’s portfolio. The investment adviser should also consider whether the proposed structure will make it more difficult for the acquiring fund’s shareholders to evaluate the risks of investing and whether the acquired fund invests in other funds.
The investment adviser to an acquiring fund must also consider the fees of both the acquiring fund and the acquired fund and consider whether the acquired fund’s advisory fees are duplicative. The adviser should also evaluate any other fees and expenses within the structure, such as sales charges, recordkeeping fees, sub-transfer agency services, and fees for other administrative services.
Additionally, if the acquiring fund and the acquired fund do not have the same investment adviser, they must enter into an agreement prior to the purchase of acquired fund shares in excess of Section 12(d)(1)’s limits (a “fund of funds investment agreement”). The fund of funds investment agreement is similar to the participation agreements required under most existing fund of funds exemptive orders and must be filed with each fund’s registration statement. A fund of funds investment agreement must include:
Rule 12d1-4 generally prohibits three-tier structures with certain enumerated exceptions. For example, investments in funds that are wholly -owned and controlled subsidiaries, investments in money market funds and certain interfund lending arrangements are not precluded. In addition to these exceptions, the new rule will allow an acquired fund to invest up to 10% of its total assets in any one fund (including a private fund), without regard to the purpose of the investment or types of underlying funds.
One year after the new rule’s effective date, the SEC will rescind Rule 12d1-2 and previously granted exemptive relief with respect to fund of funds arrangements. Currently, Rule 12d1-2 permits funds that primarily invest in other funds to invest in unaffiliated funds and non-fund assets. After Rule 12d1-2 is rescinded, 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. Alternatively, advisers to affiliated fund of funds structures must make the necessary determinations and report to their boards if they choose to rely on Rule 12d1-4.
New Rule 12d1-4 creates a consistent fund of funds framework regardless of the type of registered fund that is acquiring interests in another fund and eliminates the need to obtain exemptive relief from the SEC. As such, the new rule may support innovative fund of funds structures. However, funds and advisers that intend to rely on Rule 12d1-4 should carefully review the conditions of the rule, which may add to the compliance burdens of operating a fund of funds structure. Among other things, funds and advisers should carefully evaluate the advisory group aggregation requirements of the rule, which may be challenging for fund advisers with multiple independently operated affiliates that do not currently have integrated reporting capabilities.
 The voting and control requirements in Rule 12d1-4 do not apply if either: (a) an acquiring fund is in the same group of investment companies as the acquired fund; or (b) the acquiring fund’s sub-adviser or any person controlling, controlled by, or under common control with such sub-adviser acts as an acquired fund’s investment adviser or depositor.
 For purposes of Rule 12d1-4, an “advisory group” means either: (1) an acquiring fund’s investment adviser or depositor, and any person controlling, controlled by, or under common control with such investment adviser or depositor; or (2) an acquiring fund’s investment sub-adviser and any person controlling, controlled by, or under common control with such investment sub-adviser.
 Under the 1940 Act, “control” generally means the power to exercise a controlling influence over the management and policies of a company. Section 2(a)(9) of the 1940 Act also includes a rebuttable presumption that any person who, directly or indirectly, beneficially owns more than 25% of a company’s voting securities “controls” the company.
 The new rule will also require similar findings with respect to UITs and separate accounts funding variable insurance contracts, taking into account the unique structural characteristics of such entities.