SEC Adopts Rules Regarding Fund-of-Funds Arrangements
Yesterday, the SEC adopted three new rules under the Investment Company Act of 1940 (1940 Act) that provide exemptive relief for certain fund-of-funds arrangements. The rules codify and expand on a number of exemptive orders the SEC has issued that permit funds to invest in other funds. The SEC also mandated enhanced disclosure concerning the expenses associated with a fund-of-funds arrangement by requiring the expenses of acquired funds to be aggregated and shown as a separate line item in the acquiring fund’s prospectus fee table. The disclosure requirements have a compliance date of January 2, 2007.
Section 12(d)(1)(A) and (B) of the 1940 Act restrict the ability of a fund to invest in shares of other funds. Though these provisions have proven effective in curbing abuses that characterized previous fund-of-funds arrangements, they also had the effect of preventing legitimate fund-of-funds arrangements. To alleviate this, Congress created certain statutory exceptions from the restrictions of Section 12(d)(1), and the SEC has granted numerous exemptive orders permitting legitimate fund-of-funds arrangements. The new rules are designed to further the ability of a fund to invest in shares of other funds in a manner consistent with the public interest and the protection of investors.
Rule 12d1-1: Fund Investments in Money Market Funds
Rule 12d1-1 permits funds to invest in shares of affiliated and unaffiliated money market funds in excess of the limits of Section 12(d)(1) and is designed to permit "cash sweep" arrangements in which a fund invests all or a portion of its available cash in a money market fund rather than directly in short-term instruments. Under Rule 12d1-1, a fund may invest in shares of affiliated or unaffiliated registered money market funds as well as unregistered money market funds that: (i) limit their investments to those in which a registered money market fund may invest under Rule 2a-7, (ii) undertake to comply with the provisions of Rule 2a-7, and (iii) have investment advisers that are registered with the SEC. Rule 12d1-1 is available to unregistered funds. This would allow a hedge fund, for example, to sweep its cash into a registered money market fund pending investment or distribution of the cash to investors. The rule also provides relief from, among other provisions, certain affiliated transaction limitations of Section 17 of the 1940 Act.
The SEC has not included in the rule most of the conditions of exemptive relief it has granted over the past 20 years to permit these cash sweep arrangements. One condition that the SEC has retained, however, precludes the acquiring fund from paying a sales load, distribution fee, or service fee on acquired fund shares, or, if it does, the acquiring fund’s investment adviser must waive a sufficient amount of its advisory fee to offset the cost of the loads or distribution fees..
Rule 12d1-2: Affiliated Funds-of-Funds
Section 12(d)(1)(G) permits a fund-of-funds arrangement that goes beyond the limits of Section 12(d)(1)(A) and (B) provided that, among other limitations, the only securities owned by the acquiring fund are shares issued by funds that are "part of the same group of investment companies" as the acquiring fund, government securities, and short-term paper.
Rule 12d1-2 provides the following types of relief from some of the Section 12(d)(1)(G) limitations:
Investments in Unaffiliated Funds: Permits an affiliated fund-of-funds to acquire securities of funds that are not part of the same group of investment companies, subject to the limits of Section 12(d)(1)(A) or Section 12(d)(1)(F).
Investments in Other Types of Issuers: Permits an affiliated fund-of-funds to invest directly in stocks, bonds, and other types of securities (i.e., securities not issued by a fund) provided that the investments are consistent with the fund’s investment policies.
Investments in Money Market Funds: Permits an affiliated fund-of-funds to invest in affiliated or unaffiliated money market funds in reliance on Rule 12d1-1.
Rule 12d13: Unaffiliated Funds-of-Funds
Section 12(d)(1)(F) of the 1940 Act provides an exemption from Section 12(d)(1) that permits a registered fund to invest all of its assets in other registered funds if: (i) the acquiring fund (together with its affiliates) acquires no more than 3% of the outstanding stock of any acquired fund, and (ii) the sales load charged on the acquiring fund’s shares is no greater than 1½%. Rule 12d1-3 permits a fund relying on Section 12(d)(1)(F) to charge a sales load greater than 1½%, provided that the aggregate sales load any investor pays (i.e., the combined distribution expenses of both the acquiring and acquired funds) does not exceed the limits on sales loads established by the NASD for funds-of-funds (see NASD Conduct Rule 2830(d)(3)).
Prospectus Fee Table Disclosure: Funds-of-Funds Expenses
The SEC also amended Form N-1A and Form N-2 to require registered open-end funds and registered closed-end funds, respectively, investing in shares of another fund to include in the fee table section of the prospectus an additional line item, titled "Acquired Fund Fees and Expenses," under the section that discloses total annual fund operating expenses, setting forth the acquiring fund’s pro rata portion of the cumulative expenses charged by acquired funds. Those costs will be included in the acquiring fund’s total annual fund operating expenses, which will be reflected in the "Expense Example" portion of the fee table. The SEC has provided detailed instructions to assist acquiring funds in determining the amount of acquired funds’ fees and expenses that must be reflected in its fee table.
The new disclosure requirements apply with respect to investments in any unregistered fund that would be an investment company under Section 3(a) of the 1940 Act but for the exceptions provided in Sections 3(c)(1) and 3(c)(7) of the 1940 Act. Thus, a fund of hedge funds or a fund with a cash sweep arrangement will be required to report the expenses of the underlying unregistered funds in which it invests.
Investment Management FYI is a service of the Investment Management Practice Group of Morgan Lewis. If you have any questions concerning the important legal developments reflected herein, please contact any member of Morgan Lewis’ Investment Management Practice Group, including:
Washington, D.C.
Dianne M. Sulzbach
202.739.5470
dsulzbach@morganlewis.com