Client Alert

SEC Seeks to Level the Playing Field with New Fund of Funds Rule

27 Oct 2020

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:

  • acquiring more than 3% of the outstanding voting securities of any other investment company;
  • investing more than 5% of its total assets in any one investment company; or
  • investing more than 10% of its total assets in investment companies generally. 

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:

  • own more than 3% of the acquired fund’s outstanding voting securities; or
  • together with other funds, own more than 10% of the acquired fund’s outstanding voting securities.

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

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[1]:

  • An acquiring fund and its “advisory group” [2] are prohibited from controlling an acquired fund, except in certain limited circumstances. Consistent with the presumption of “control” in Section 2(a)(9) of the 1940 Act,[3] an acquiring fund and its advisory group’s beneficial ownership of up to 25% of the voting securities of an acquired fund will be presumed not to constitute control over the acquired fund. However, since the determination of control under the 1940 Act is not based solely on such beneficial ownership test, but rather depends on facts and circumstances, acquiring funds and their advisory groups should be aware that if they have the power to exercise a controlling influence over an acquired fund’s management or policies, they would be precluded from relying on Rule 12d1-4, even if they own 25% or less of the acquired fund’s voting securities.
  • An acquiring fund and its advisory group must use mirror voting if they hold more than (i) 25% of an acquired open-end fund or UIT due to a decrease in the outstanding securities of the acquired fund or (ii) 10% of a closed-end fund.
  •  If an acquiring fund is the only shareholder of an acquired fund, Rule 12d1-4 gives the acquiring fund the ability to use pass-through voting.  That is, the acquiring fund can solicit underlying shareholders and vote in accordance with the instructions of the underlying shareholders.

New Rule 12d1-4 also requires the investment adviser to both the acquiring fund and the acquired fund to make the following findings:

  • Investment advisers to an acquiring fund must make certain findings prior to acquiring more than 3% of another fund’s outstanding voting securities. The investment adviser to the acquiring fund must evaluate the complexity of the proposed structure, including related fees and expenses, and find that such fees and expenses are not duplicative. These findings must be reported to the fund’s board of trustees no later than the next regularly scheduled board meeting.

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.[4] 

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.

  • The investment adviser to the acquired fund must consider whether any potential undue influence by the acquiring fund exists and, if so, that it is adequately addressed.  A non-exclusive list of the factors that should be considered by the acquired fund’s board includes: (i) the scale of contemplated investments by the acquiring fund and any maximum investment limits; (ii) the anticipated timing of redemption requests by the acquiring fund; (iii) whether, and under what circumstances, the acquiring fund will provide advance notification of investments and redemptions; and (iv) the circumstances under which the acquired fund may elect to satisfy redemption requests in kind rather than in cash and the terms of any redemptions in kind. 

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:

  • material terms necessary for the investment advisers to both the acquiring fund and the acquired funds to make the determinations outlined above;
  • a termination provision such that either party may terminate on no longer than 60 days’ written notice; and
  • a representation that the acquired fund will provide the acquiring fund with fee and expense information as reasonably requested.

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.

[1] 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.

[2] 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.

[3] 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.

[4] 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.



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