Investment funds, and in particular funds of funds, are powerful tools for investors to efficiently achieve asset allocation and diversification goals. According to the Investment Company Institute, total net assets in mutual funds that invest primarily in other mutual funds have grown from $469 billion in 2008 to $2.22 trillion in 2017. During this period, the number of mutual funds using this arrangement has increased from 839 to 1,400.
Funds of funds had a very different reputation in the 1940s through the early 1970s. Indeed, an SEC study in 1966 concluded fund of funds structures “served little or no economic purpose.” Funds of funds were susceptible to a practice known as “pyramiding,” in which an acquiring fund would exert control over an acquired fund in a way detrimental to the acquired fund’s shareholders. Funds of funds also were seen as leading to excessive fees and overly complex structures. Due, in part, to these concerns, Congress imposed limits on fund of funds structures, including ownership limitations.
Section 12(d)(1)(A) of the Investment Company Act of 1940 (the ICA) prohibits any registered investment company (the “acquiring company”) (and companies, including funds, it controls) 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
These limits apply to both registered and unregistered investment companies with respect to their investments in a registered investment company, and to a registered investment company with respect to its investment in an unregistered investment company.
Similarly, section 12(d)(1)(B) prohibits any registered investment company (the “acquired company”) and any principal underwriter therefor, or any registered broker-dealer, to knowingly sell securities to an acquiring company if, after the sale, the acquiring company would:
- Together with companies it controls, own more than 3% of the acquired fund’s outstanding voting securities, or
- Together with other funds (and companies under their control) own more than 10% of the acquired fund’s outstanding voting securities
As the SEC’s views on funds of funds have evolved, influenced by market developments and innovations, the SEC has loosened these restrictions through a series of rules and exemptive orders.
The SEC’s current proposal is intended to create a more consistent and efficient regulatory framework, replacing the patchwork of rules and exemptive orders. In its proposing release, the SEC purports to level the playing field among registered fund structures by enabling each to invest in the same universe of acquired funds. However, private funds and unregistered foreign funds are excluded from the rule’s exemption.
At the core of the proposal is new rule 12d1-4, which would allow a registered fund to exceed the purchase and sale limitations in sections 12(d)(1)(A) and (B) subject to certain conditions designed to address the concerns underpinning the restrictions. The SEC believes these conditions would “limit an acquiring fund’s ability to exert undue influence over an acquired fund directly through ownership or indirectly through the threat of large scale redemptions, would require evaluation of the fees associated with a fund of funds arrangement, and would guard against unduly complex fund of fund structures.”
The key elements of the proposed rule are summarized below:
Control: The first condition of the proposed rule is that an acquiring fund must not control the acquired fund. The ICA defines control as “the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company.” The ICA also creates a rebuttable presumption that any person who directly or indirectly beneficially owns more than 25% of the voting securities of a company controls the company, and that one who does not own that amount does have control. Thus, under the proposal, an acquiring fund and its advisory group generally could own up to 25% of an acquired fund’s shares. It is important to note, however, this is not an absolute threshold because the legal standard of control is ultimately dependent on the particular facts and circumstances.
Voting: The second condition is that if the acquiring fund and its advisory group hold more than 3% of the outstanding voting securities of an acquired fund, it must vote in accordance with ICA requirements. This requires the fund to either (i) seek voting instructions from the security holders and vote in accordance with such instructions (pass-through voting), or (ii) vote in the same proportion as all other holders of the acquired fund (mirror voting).
Redemption Limits: The third condition imposes redemption limits. To protect against improper influence by an acquiring fund over an acquired fund through, for example, coercion through the threat of large scale redemptions, the proposed rule would impose redemption limits of 3% of the acquired fund’s total outstanding shares during any 30-day period. 
Excessive Fees: The fourth condition addresses concerns over excessive fees from fund of fund arrangements. In particular, the proposed rule would require the acquiring fund’s investment adviser to evaluate the complexity of the structure and the aggregate fees and find that it is in the best interest of the acquiring fund to invest in the acquired fund. This finding and its rationale must be provided to the acquiring fund’s board of directors. In the Proposing Release, the SEC directs attention to fees that may be duplicative as well as the expense of the available share classes. Fee waivers could be utilized to mitigate duplicative fees. The SEC notes that fund advisers already have a fiduciary duty relating to their receipt of compensation for services or other payments.
Complex Structures: The final condition addresses the potential for overly complex fund structures by preventing an acquiring fund from using the higher ownership limits of the proposed rule (e.g., 25%) to acquire shares in another fund that is itself an acquiring fund in reliance on the proposed rule. Thus, the proposed rule would prevent funds of funds of funds with the higher ownership tiers. An acquiring fund could hold up to 3% of a fund that is itself an acquiring fund or of a fund that is a private fund. This provision would be implemented in part though fund disclosures. In particular, a registered investment fund that relies on rule 12d1-4 (or that wants to maintain the flexibility to do so in the future) must disclose this fact in its registration statement, thereby putting other, would-be acquiring funds, on notice. These funds of funds of funds provisions would not restrict arrangements where an acquired fund invests all of its assets in a master fund (i.e., a feeder fund) or invests in a wholly owned subsidiary, various short-term cash management activities, inter-fund lending or borrowing transactions, or receipt of securities as a dividend or as a result of a plan of reorganization. 
As noted above, private funds and unregistered investment companies would not be entitled to the exemption available through the proposed rule. The SEC acknowledges the interest from some segments of the investment community to allow private funds and unregistered investment companies to be acquiring funds. However, the Commission notes that private funds (i) are not registered with the SEC and thus would not be subject to the requirement to report whether or not they are an acquiring fund, as discussed above; (ii) do not report information on their acquired fund holdings; and (iii) are not subject to recordkeeping requirements under the ICA.
It is notable that the discussion of private funds and unregistered investment companies is featured frequently and extensively in the release. This suggests application of the proposed rule to private funds and unregistered investment companies is on the minds of at least some SEC Commissioners.
If you any questions about this proposal or its potential impact to your business, please reach out to your firm contact or any of the authors of this alert.
 Investment Company Institute, 2018 Investment Company Fact Book (2018) (cited in Securities and Exchange Commission, Release 33-10590 (Dec. 19, 2018) (the “Proposing Release”) at note 5).
 Proposing Release at 10; (citing legislative history and Report of the Securities and Exchange Commission on the Public Policy Implications of Investment Company Growth, H.Rep. No. 2337, 89th Cong., 2d Sess. (1966).
 Investments by a private fund in another private fund or other unregistered investment company are not restricted. See Proposing Release at note 42.
 Proposing Release at 17.
 Proposing Release at 18 (citations omitted).
 ICA section 2(a)(9).
 Proposing Release at 35; ICA section 12(d)(1)(E)(iii)(aa).
 Consistent with other provisions of the ICA and SEC exemptive orders, these control and voting conditions would not apply if the acquiring fund is in the same group of investment companies as the acquired fund, or the acquiring fund’s investment sub-adviser or any person controlling, controlled by, or under common control with such investment sub-adviser acts as the acquired fund’s investment advisers or depositor. The rationale for this exclusion is that investors are adequately protected when the same adviser has a fiduciary duty to both the acquiring and acquired fund. Similarly, if the funds are advised by advisers that are control affiliates, the Commission does not believe that the acquiring fund adviser would seek to benefit the acquiring fund at the expense of the acquired fund.
 Proposing Release at 47.
 Proposing Release at 60; This condition would be limited by its terms to acquiring funds that are management companies, but similar provisions are proposed for unit investment trusts and separate accounts funding variable investment contracts.
 Proposing Release at 61.
 Proposing Release at 64; ICA section 36(b).
 Proposing Release at 81-82.
 Proposing Release at 18.
 Proposing Release at 19-20.