The Securities and Exchange Commission (the SEC) has proposed rules that would modernize the “fund of funds” rules. The rules would replace a patchwork of exemptive rules and orders, with the goal of a “consistent and efficient regulatory framework for funds that seek to invest in other funds to achieve their investment objectives.
Proposed Rule 12d1-4 under the Investment Company Act of 1940 (the “1940 Act”) would allow a registered investment company or a business development company (BDC) to invest, subject to certain conditions, in shares of another registered fund or BDC without being subject to the three, five and ten rules described below. This rule would replace Rule 12d1-2.
With regard to a fund of funds, the drafters of the 1940 Act were concerned about four perceived abusive practices: pyramiding of voting control; undue influence over an acquired fund through the threat of large-scale redemptions; investor confusion caused by complex fund of funds structures; and layering of fees and costs.
To address these concerns, Section 12(d)(1)(A) of the 1940 Act limits the amount of shares that funds may acquire in other funds. Specifically, a fund may not (i) acquire more than 3% of another fund’s outstanding voting stock; (ii) invest more than 5% of its total assets in any single fund; or (iii) invest more than 10% of its total assets in funds. These are widely referred to as the “three, five and ten” rules.
Various exemptions are available, including for structures providing for (a) one fund to invest substantially all its assets in another fund (Section 12(d)(1)(E)—relatively widely relied upon to establish a dedicated “feeder” or “conduit” fund), (b) certain unaffiliated funds of funds (Section 12(d)(1)(F)—viewed as cumbersome in practice), and (c) affiliated “funds of funds” in which the various funds involved are within the same fund group (Section 12(d)(1)(G)—also relatively widely relied upon). Rule 12d1-2, which the SEC proposes to replace with new rule 12d1-4, permits hybrid arrangements that include both affiliated and unaffiliated funds.
Significantly, these various rules govern only funds registered under the 1940 Act (and BDCs). That is so with one important exception, namely that the limitation on owning more than 3% of the voting securities of a registered investment company (or registered BDC) applies equally to ownership of those securities by unregistered funds—with the effect that hedge funds, private equity funds and non-U.S. funds can be limited in their ability to hold large positions in individual registered funds.
If adopted as proposed, the rule would allow a registered fund (of any type, e.g., mutual fund, closed-end fund, BDC, unit investment trust, exchange traded fund, etc.) to invest in another registered fund (again of any type) without being subject to the three, five and ten rules, subject to these conditions:
Unlike the restrictions that apply to control and voting, the redemption limitations apply even when (1) the acquiring fund is within the same group of funds as an acquired fund, and (2) the acquiring fund’s sub-adviser (or any person controlling the subadviser) acts as the acquired fund’s adviser. Not exempting these acquiring funds from the redemption restrictions may translate into a significant brake on the ability to use the proposed rule in affiliated fund relationships. Redemption limits also presumably result in at least a portion of the securities held being deemed illiquid for purposes of the acquiring fund’s compliance with its liquidity requirements.
In its 2006 “fund of funds” rulemaking, the SEC generally required an acquiring fund—whether investing in other registered funds or private funds like hedge or private equity funds—to calculate its proportionate share of the operating fees and expenses of the underlying fund(s) and present them as a line item in the acquiring fund’s required prospectus fee and expense table. These so-called “acquired fund fees and expenses” (or AFFE) presentations are intended to allow fund investors to better understand the “all-in” expenses they bear when investing in an acquired fund, but also have been criticized as confusing and at times misleading. A fund investing in hedge funds, for example, paradoxically will show a higher AFFE when invested in better performing hedge funds than when invested in lower performing hedge funds—because the performance fees charged by the hedge funds increase as their investment returns increase.
The SEC asks in the course of the current rule proposal whether the AFFE requirements should be revisited and requests comment on a dozen variations on how the AFFE requirements might be narrowed or changed.
The SEC proposed to amend Rule 12d1-1 to allow funds that invest in affiliated funds (pursuant to Section 12(d)(1)(G)) to continue to invest in unaffiliated money market funds—a clarification that would be required as a result of the rescission of Rule 12d1-2.
Form N-CEN (an annual reporting of various data of interest to the SEC) would be amended to require funds to report whether they relied on Rule 12d1-4 or Section 12(d)(1)(G) during the reporting period.
The SEC’s proposal is consistent with current rulemaking priorities. It seeks to balance the need to streamline confusing and outdated rules and exemptive orders with its oft-stated priority of protecting investors. But funds of funds arrangements tend to be bespoke to the particular commercial purpose, and one-size-fits-all treatment inevitably will put some pressure on that reality. We expect the proposal will generate detailed and thoughtful industry comments.
 Somewhat confusingly, there is no reverse limitation; registered funds can invest in hedge funds, private equity funds and non-U.S. funds without restriction by Section 12(d)(1). The application of Section 12(d)(1) to hedge funds, private equity funds and non-U.S. funds would not change under proposed Rule 12d1-though the SEC invites comment on whether changes would be appropriate.
 Also proposed is a parallel exemption from Section 17(a) of the Investment Company Act, a provision that prohibits purchase and sale transactions between a registered investment company and its affiliated persons (or affiliated persons of affiliated persons). The SEC suggests that, without this proposed exemption, Section 17(a) would operate to prohibit certain purchases of shares by an acquiring fund of an underlying registered fund when the two are affiliated with each other.
 Over the years, and in various circumstances, the industry debated what constitutes a “voting security” and when they can overcome a presumption of control by limiting the right to vote shares. The SEC’s adopting release appears to subtly tiptoe around this issue. For example, the SEC suggests a 25% limit on an acquiring fund’s ownership of an underlying registered fund, but does so without directly acknowledging that this presumption of “control” derives from ownership of “voting securities” (rather than securities generally). Nor does the SEC address whether the proposed rule’s required pass-through or mirror voting terms effectively nullify or transfer the voting authority to third parties. Moreover, it is not necessarily intuitive why the proposed voting condition under Rule 12d1-4 requires all securities held by the acquiring fund (as opposed to just those representing the excess over the Section 12(d)(1) 3% limit) be voted under pass-through or mirror voting terms. The rationale, while not fully set out here, appears to be that Congress required the same “all-or-nothing” application to voting limitations under Section 12(d)(1)(F).
 The SEC’s discussion includes guidance as to the nature of the analysis that the SEC expects, including that:
“In evaluating the fees associated with the fund’s investment in acquired funds, an adviser should consider the fees of all tiers in the fund of funds arrangement with an eye towards duplication. As part of this analysis, an adviser should consider whether the acquired fund’s advisory fees are for services that are in addition to, rather than duplicative of, the adviser’s services to the acquiring fund. The adviser should consider sales charges and other fees, including fees for recordkeeping, sub-transfer agency services, sub-accounting services, or other administrative services. In particular, the adviser should consider whether these fees could be duplicative or excessive when evaluating an investment in a particular acquired fund.”