Fund of Funds Arrangements

Federal RegisterFeb 1, 2019

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Securities and Exchange Commission

17 CFR Parts 270 and 274

[Release Nos. 33-10590; IC-33329; File No. S7-27-18]

RIN 3235-AM29

Fund of Funds Arrangements

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (the “Commission”) is proposing a new rule under the Investment Company Act of 1940 (“Investment Company Act” or “Act”) to streamline and enhance the regulatory framework applicable to funds that invest in other funds (“fund of funds” arrangements). In connection with the proposed rule, the Commission proposes to rescind rule 12d1-2 under the Act and most exemptive orders granting relief from sections 12(d)(1)(A), (B), (C), and (G) of the Act. Finally, the Commission is proposing related amendments to rule 12d1-1 under the Act and Form N-CEN.

DATES:

Comments should be received on or before May 2, 2019.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (

http://www.sec.gov/rules/proposed.shtml

); or

• Send an email to

rule-comments@sec.gov

. Please include File Number S7-27-18 on the subject line.

Paper Comments

• Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-27-18. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's internet website (

http://www.sec.gov/rules/proposed.shtml

). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly.

Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission's website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at

www.sec.gov

to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Joel Cavanaugh, John Foley, Senior Counsels; Jacob D. Krawitz, Branch Chief; Melissa S. Gainor, Senior Special Counsel; Brian McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation Office, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

The Commission is proposing for public comment 17 CFR 270.12d1-4 (new rule 12d1-4) under the Investment Company Act [15 U.S.C. 80a-1

et seq.

]; amendments to 17 CFR 270.12d1-1 (rule 12d1-1) under the Investment Company Act; amendments to Form N-CEN [referenced in 17 CFR 274.101] under the Investment Company Act; and rescission of 17 CFR 270.12d1-2 (rule 12d1-2) under the Investment Company Act.

Unless otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act are to title 17, part 270 of the Code of Federal Regulations [17 CFR part 270].

Table of Contents

I. Background

A. Funds' Investments in Other Funds

B. Overview of Section 12(d)(1) Limits

II. Proposed Rule 12d1-4

A. Scope of Proposed Rule 12d1-4 and Exemptions From Section 12(d)(1) of the Act

B. Exemptions From the Act's Prohibition on Certain Affiliated Transactions

C. Conditions

III. Proposed Rescission of Rule 12d1-2 and Proposed Amendments to Rule 12d1-1

IV. Amendments to Form N-CEN

V. Proposed Rescission of Exemptive Orders; Withdrawal of Staff Letters

VI. Economic Analysis

A. Introduction

B. Economic Baseline

C. Benefits and Costs and Effects on Efficiency, Competition, and Capital Formation of Rule Proposal

D. Reasonable Alternatives

VII. Paperwork Reduction Act

A. Introduction

B. Rule 12d1-4

C. Rule 0-2

D. Form N-CEN

E. Request for Comments

VIII. Initial Regulatory Flexibility Analysis

A. Reasons for and Objectives of the Proposed Actions

B. Legal Basis

C. Small Entities Subject to the Proposed Requirements

D. Projected Board Reporting, Recordkeeping, and Other Compliance Requirements

E. Duplicative, Overlapping, or Conflicting Federal Rules

F. Significant Alternatives

G. General Request for Comment

IX. Consideration of Impact on the Economy

X. Statutory Authority

I. Background

We are proposing new rule 12d1-4 under the Investment Company Act to streamline and enhance the regulatory framework applicable to fund of funds arrangements.

The proposed rule would, under specified circumstances, permit a fund to acquire shares of another fund in excess of the limits of section 12(d)(1) of the Act without obtaining an exemptive order from the Commission.

The proposed rule reflects decades of experience with fund of funds arrangements, and would subject funds relying on proposed rule 12d1-4 to a tailored set of conditions that we believe would help protect investors from the harms Congress sought to address by enacting section 12(d)(1) of the Act. As the proposed rule would provide a comprehensive exemption for funds of funds to operate, we also propose to rescind rule 12d1-2 under the Act and individual exemptive orders for certain fund of funds arrangements in order to create a consistent and efficient rules-based regime for the formation and oversight of funds of funds. Finally, in connection with the proposed rescission of rule 12d1-2, we are proposing amendments to rule 12d1-1 under the Act to allow funds that rely on section 12(d)(1)(G) of the Act to invest in money market funds

that are not part of the same group of investment companies.

For purposes of this release, we generally use the term “funds” to refer to registered investment companies and business development companies (“BDCs”) unless the context otherwise requires. A BDC is a closed-end fund that: (i) is organized under the laws of, and has its principal place of business in, any state or states; (ii) is operated for the purpose of investing in securities described in section 55(a)(1)-(3) of the Act and makes available “significant managerial assistance” to the issuers of those securities, subject to certain conditions; and (iii) has elected under section 54(a) of the Act to be subject to the sections addressing activities of BDCs under the Act.

See

15 U.S.C. 80a-2(a)(48). Section 6(f) of the Act exempts BDCs that have made the election under section 54 of the Act from registration provisions of the Act.

We also are proposing amendments to Form N-CEN, a structured form that requires registered funds to provide census-type information to the Commission on an annual basis.

See infra

section IV.

See infra

section III.

A. Funds' Investments in Other Funds

Funds increasingly invest in other funds as a way to achieve asset allocation, diversification, or other investment objectives. For example, a fund may invest in another fund to gain exposure to a particular market or asset class in an efficient manner.

A fund could, for instance, obtain exposure to a foreign market by investing in a country-specific fund rather than investing in the securities of companies listed on an exchange in that country. Funds also may invest in other funds to equitize cash, engage in hedging transactions, or manage risk.

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 utilizing this arrangement grew from 839 to 1,400.

See

Investment Company Institute, 2018 Investment Company Fact Book (2018) (“2018 ICI Fact Book”), at 256,

available at

https://www.ici.org/pdf/2018_factbook.pdf

According to staff estimates, almost one half of all registered funds hold investments in other funds.

Of those funds investing in other funds, one half invest at least 5% of their assets in other funds, and one quarter hold almost all of their assets (90%) in other funds. The acquired funds most often provide exposures to US equity, international equity, or fixed income asset classes.

This estimate is derived from an analysis of data obtained from Morningstar Direct for the period ending August 2018. For more data on fund of funds arrangements,

see infra

section VI.

Main Street investors similarly use fund of funds arrangements as a convenient way to allocate and diversify their investments through a single, professionally managed portfolio. For example, a fund of funds may provide an investor with the same benefits as separate direct investments in several underlying funds, without the increased monitoring and recordkeeping that could accompany investments in each underlying fund.

In addition, a fund of funds may provide an investor with exposure to an asset class or fund that may not otherwise be available to that investor.

Target-date funds are a common type of fund of funds arrangement that are designed to make it easier for investors to hold a diversified portfolio of assets that is rebalanced over time without the need for investors to rebalance their own portfolio.

See

Investment Company Advertising: Target Date Retirement Fund Names and Marketing, Investment Company Act Release No. 29301 (June 16, 2010) [75 FR 35920 (June 23, 2010)] (proposing disclosure requirements for target date retirement funds' marketing materials).

A fund of funds may invest, for example, in funds or share classes with minimum investment amounts that are higher than some retail investors could afford.

B. Overview of Section 12(d)(1) Limits

Section 12(d)(1) of the Investment Company Act limits the ability of a fund to invest substantially in shares of another fund.

Section 12(d)(1)(A) of the Act prohibits a registered fund (and companies, including funds, it controls) from:

As originally enacted, section 12(d)(1) prohibited a registered fund (and any companies it controlled) from purchasing more than 5% of the outstanding shares of any fund that concentrated its investments in a particular industry, or more than 3% of the shares of any other type of fund.

See

Public Law 76-768, 54 Stat. 789, 809-10 § 12(d)(1) (1940) (codified at 15 U.S.C. 80a-12(d)(1) (1940)). Congress amended section 12(d)(1) to include the current limits in section 12(d)(1)(A) and (B) in 1970.

• 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.

See

15 U.S.C. 80a-12(d)(1)(A). Both registered and unregistered investment companies are subject to these limits with respect to their investments in a registered investment company. Registered investment companies are also subject to these same limits with respect to their investment in an unregistered investment company. Pursuant to sections 3(c)(1) and 3(c)(7), private funds are subject to the 3% limitation on investments in registered funds as well. 15 U.S.C. 80a-3(c)(1) and 3(c)(7)(D). A “private fund” is an issuer that would be an investment company, as defined in section 3 of the Investment Company Act, but for section 3(c)(1) or 3(c)(7) of that Act. 15 U.S.C. 80b-2(a)(29). In addition, section 60 of the Act makes section 12(d) applicable to a BDC to the same extent as it if were a registered closed-end fund. 15 U.S.C. 80a-60.

Section 12(d)(1)(B) of the Act addresses the other side of the transaction by prohibiting a registered open-end fund

(and any principal underwriter thereof or broker-dealer registered under the Exchange Act) from knowingly selling securities to any other investment company if, after the sale, the acquiring fund would:

A registered open-end fund is a management company that is offering for sale or has outstanding any redeemable security of which it is the issuer. 15 U.S.C. 80a-5(a)(1) (defining “open-end company”). A registered closed-end fund is any management company other than an open-end fund. 15 U.S.C. 80a-5(a)(2) (defining “closed-end company”). Section 12(d)(1)(C) of the Act also includes specific limitations on investments in registered closed-end funds.

See

15 U.S.C. 80a-12(d)(1)(C).

• Together with companies it controls, own more than 3% of the acquired fund's outstanding voting securities; or

• together with other funds (and companies they control), own more than 10% of the acquired fund's outstanding voting securities.

See

15 U.S.C. 80a-12(d)(1)(B). This prohibition applies to the sale of securities issued by an open-end fund to registered funds and unregistered investment companies. Pursuant to sections 3(c)(1) and 3(c)(7), private funds are subject to the 3% limitation with respect to the sale of any security by any open-end fund to such private fund. 15 U.S.C. 80a-3(c)(1) and 3(c)(7)(D).

Congress enacted these restrictions because it was concerned about “pyramiding,” a practice under which investors in the acquiring fund could control the assets of the acquired fund and use those assets to enrich themselves at the expense of acquired fund shareholders.

Control could be exercised either directly (such as through the voting power of a controlling interest) or indirectly (such as coercion through the threat of large-scale redemptions). Congress also was concerned about the potential for excessive fees when one fund invested in another,

and the formation of overly complex structures that could be confusing to investors.

Congress imposed these limits, in part, based on our conclusions in 1966 that fund of funds structures served little or no economic purpose.

See

Hearing on H.R. 10065 before the Subcomm. of the House Comm. on Interstate and Foreign Commerce, 76th Cong., 3d Sess., 112-14 (1940) (statement of David Schenker); Investment Trusts and Investment Companies, Report of the Securities and Exchange Commission, pt. 3, ch. 4, H.R. Doc. No. 136, 77th Cong., 1st Sess., 1031-1041, nn. 58-59 (1941) (“Investment Trust Study”);

id.,

at ch. 7, 2742-50.

See also

Exchange-Traded Funds, Investment Company Act Release No. 28193 (Mar. 11, 2008) [73 FR 14618 (Mar. 18, 2008)] (“2008 Proposing Release”), at n.195 (discussing the legislative history of “pyramiding schemes”). In some cases, acquired funds directed underwriting and brokerage business to entities affiliated with acquiring fund investors on terms that were unfavorable to acquired fund shareholders.

Controlling persons profited when acquiring fund shareholders paid excessive fees due to duplicative charges at both the acquiring and acquired fund levels.

See

Investment Trust Study,

supra

footnote 13, at ch. 7, 2725-39, 2760-75, 2778-93.

Complicated corporate structures could allow acquiring funds to circumvent investment restrictions and limitations and make it difficult for shareholders of the acquiring fund to understand who controlled the fund or the true value of their investments.

See

Investment Trust Study,

supra

footnote 13, at 2776-77. Acquiring fund shareholders might believe that they owned shares in a fund that invested in equity securities of large companies without understanding that the acquiring fund actually held funds that provided substantial exposure to smaller issuers, foreign currencies, or interest rates.

See id.,

at 2721-95.

See

2008 Proposing Release,

supra

footnote 13 (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) (“PPI Report”)).

See also

Fund of Funds Investments, Investment Company Act Release No. 26198 (Oct. 1, 2003) [68 FR 58226 (Oct. 8, 2003)] (“Fund of Funds Proposing Release”) at n.8.

Our views and those of Congress regarding fund of funds arrangements have evolved over the years as fund of funds structures have developed to include investor protections and serve purposes that benefit investors.

As a

result, Congress created statutory exceptions that permit different types of fund of funds arrangements subject to certain conditions.

First, section 12(d)(1)(E) of the Act allows an acquiring fund to invest all of its assets in a single fund so that the acquiring fund is, in effect, a conduit through which investors may access the acquired fund.

Second, section 12(d)(1)(F) of the Investment Company Act permits a registered fund to take small positions (up to 3% of another fund's securities) in an unlimited number of other funds.

Finally, section 12(d)(1)(G) allows a registered open-end fund or unit investment trust (“UIT”) to invest in other open-end funds and UITs that are in the same “group of investment companies.”

See

Fund of Funds Investments, Investment Company Act Release No. 27399 (June 20, 2006) [71 FR 36640 (June 27, 2006)] (“Fund of Funds

Adopting Release”) at n.7 and accompanying text; 2008 Proposing Release,

supra

footnote 13.

See

Fund of Funds Proposing Release,

supra

footnote 16, at n.8 and accompanying text.

See

15 U.S.C. 80a-12(d)(1)(E). This section is relied upon by master-feeder fund arrangements, in which one or more funds pool their assets by investing in a single fund with the same investment objective.

See

15 U.S.C. 80a-12(d)(1)(F). A fund relying on section 12(d)(1)(F) is restricted in its ability to redeem shares of the acquired fund and is unable to use its voting power to influence the outcome of shareholder votes held by the acquired fund.

See

15 U.S.C. 80a-12(d)(1)(G). “Group of investment companies” is defined in section 12(d)(1)(G) as any two or more registered funds that hold themselves out to investors as related companies for purposes of investment and investor services. 15 U.S.C. 80a-12(d)(1)(G)(ii).

When Congress enacted section 12(d)(1)(G), it also gave the Commission specific authority to permit additional types of fund of funds arrangements as structures evolved. Section 12(d)(1)(J) of the Act allows the Commission to exempt any person, security, or transaction, or any class or classes of transactions, from section 12(d)(1) if the exemption is consistent with the public interest and the protection of investors.

A House of Representatives committee report on the amendments urged the Commission to use this exemptive authority “in a progressive way as the fund of funds concept continues to evolve over time.”

See

National Securities Markets Improvement Act of 1996 (“NSMIA”), Public Law 104-290, 110 Stat. 3416 (1996), at § 202(4) (codified at 15 U.S.C. 80a-12(d)(1)(J); Comm. On Commerce, Securities Amendments of 1996, H.R. Rep. No. 104-622 (1996), 104th Cong., 2nd Sess., at 43-44 (“H.R. Rep. No. 622”). Congress added section 12(d)(1)(J) to resolve questions regarding the scope of our authority under section 6(c) of the Act.

See

Vanguard Special Tax-Advanced Retirement Fund, Inc., Investment Company Act Release No. 14361 (Feb. 7, 1985) (order), dissenting opinion of Commissioners Treadway and Peters (concluding that applicants failed to establish an adequate record on which the Commission could find an exemption from section 12(d)(1)(A) to meet the standards of section 6(c) of the Act).

H.R. Rep. No. 622,

supra

footnote 22, at 44-45. The report specifically noted that many fund complexes might not have a sufficient number or variety of fund types to permit a workable fund of funds arrangement under section 12(d)(1)(G) and the Commission should use its exemptive authority so “the benefits of [funds of] funds are not limited only to investors in the largest fund complexes, but, in appropriate circumstances, are available to investors through a variety of different types and sizes of investment company complexes.” The report stated that, in exercising its authority, the Commission should consider factors that relate to the protection of investors, including the extent to which a proposed arrangement is subject to conditions that are designed to address conflicts of interest and overreaching by a participant in the arrangement, so as to avoid the abuses that gave rise to the initial adoption of the Investment Company Act's restrictions against funds investing in other funds.

We exercised this exemptive authority in 2006 when we adopted 17 CFR 270.12d1-1 (rule 12d1-1), 17 CFR 270.12d1-2 (rule 12d1-2), and 17 CFR 270.12d1-3 (rule 12d1-3), which were based on relief we previously provided in a number of exemptive orders.

We also have used our authority under section 12(d)(1)(J) to issue exemptive orders permitting fund of funds arrangements that the Act or our rules otherwise restrict when we found those arrangements to be consistent with the public interest and the protection of investors.

These exemptive orders permit fund investments in other funds, subject to specified conditions that are designed to prevent the abuses that led Congress to enact section 12(d)(1).

Relief from sections 12(d)(1)(A) and (B) also is included in our exemptive orders that allow exchange-traded funds (“ETFs”) and exchange traded managed funds (“ETMFs”) to operate.

See

Fund of Funds Adopting Release,

supra

footnote 17. Rule 12d1-1 allows funds to invest in shares of money market funds in excess of the limits of section 12(d)(1).

See infra

section III (discussing the proposed amendment of rule 12d1-1). Rule 12d1-2 provides funds relying on section 12(d)(1)(G) with greater flexibility to invest in other types of securities.

See infra

section III (discussing the proposed rescission of rule 12d1-2). Finally, rule 12d1-3 allows acquiring funds relying on section 12(d)(1)(F) to charge sales loads greater than 1.5%. We did not rescind the exemptive orders that funds had relied upon in connection with these arrangements before we adopted rules 12d1-1, 12d1-2 and 12d1-3.

As the orders are subject to terms and conditions set forth in the applications requesting exemptive relief, references in this release to “exemptive relief” or “exemptive orders” include the terms and conditions described in the related applications.

See, e.g.,

Schwab Capital Trust,

et al.,

Investment Company Act Release Nos. 24067 (Oct. 1, 1999) [64 FR 54939 (Oct. 8, 1999)] (notice) and 24113 (Oct. 27, 1999) (order) and related application (“Schwab”); Franklin Fund Allocator Series,

et al.,

Investment Company Act Release Nos. 32669 (June 5, 2017) [82 FR 26720 (June 8, 2017)] (notice) and 32722 (July 3, 2017) (order) and related application (“Franklin Fund”). In addition to our section 12(d)(1)(J) authority, we have issued these orders pursuant to our exemptive authority under sections 17(a) and 6(c) of the Act.

See, e.g.,

Schwab,

supra

footnote 25. The conditions include: (i) Limits on the control and influence an acquiring fund can exert on the acquired fund; (ii) limits on certain fees charged to the acquiring fund and its shareholders; and (iii) limits on the acquired fund's ability to invest in other funds.

ETFs are organized as either open-end funds or UITs and require exemptive relief from certain provisions of the Act to operate. ETFs issue shares that can be bought or sold throughout the day in the secondary market at a market-determined price.

See, e.g.,

IndexIQ ETF Trust,

et al.,

Investment Company Act Release Nos. 33163 (July 19, 2018) [83 FR 35289 (July 25, 2018)] (notice) and 33200 (Aug. 14, 2018) (order) and related application. ETMFs are hybrid structures between mutual funds and ETFs and similarly need relief from the Act to operate. Unlike ETFs, secondary market transactions in ETMFs occur at the next-determined net asset value (“NAV”) plus or minus a market-determined premium or discount that may vary during the trading day.

See, e.g.,

Eaton Vance Management,

et al.,

Investment Company Act Release Nos. 31333 (Nov. 6, 2014) [79 FR 67471 (Nov. 13, 2014)] (notice) and 31361 (Dec. 2, 2014) (order) and related application (“Eaton Vance”).

This combination of statutory exemptions, Commission rules, and exemptive orders, however, has created a regulatory regime where substantially similar fund of funds arrangements are subject to different conditions. For example, an acquiring fund could rely on section 12(d)(1)(G) and rule 12d1-2 when investing in an acquired fund within the same group of investment companies.

Alternatively, it could rely on relief provided by an exemptive order, which would allow it to invest in substantially the same investments, but would require the fund to comply with different conditions.

Such a fund would rely on section 12(d)(1)(G) to invest in acquired funds within the same group of investment companies, government securities, and short term paper. In addition, the fund could rely on rule 12d1-2 to invest in: (i) Securities of funds that are not in the same group of investment companies up to the limits in section 12(d)(1)(A) or (F); (ii) securities of money market funds in reliance on rule 12d1-1; and (iii) stocks, bonds, and other securities.

In order to create a more consistent and efficient regulatory framework for fund of funds arrangements, we are proposing to rescind rule 12d1-2 and many of the exemptive orders we have granted giving relief from sections 12(d)(1)(A), (B), (C), and (G) of the Act.

We propose to replace that relief with a comprehensive fund of funds framework under new rule 12d1-4. A comprehensive, streamlined framework would reduce confusion and subject fund of funds arrangements to a tailored set of conditions that would enhance investor protection, while also providing funds with investment flexibility to meet their investment

objectives in an efficient manner. We believe that the proposed rule would provide investors with the benefits of fund of funds arrangements, while protecting them from the historical abuses described above. We also propose to amend rule 12d1-1 under the Act to allow funds that rely on section 12(d)(1)(G) to invest in money market funds that are not part of the same group of investment companies in reliance on that rule.

We do not propose to rescind exemptive orders providing relief from section 12(d)(1)(A) and (B) of the Act with respect to certain interfund lending arrangements.

See infra

footnote 201 and accompanying text.

Under the proposal, a fund relying on section 12(d)(1)(G) would no longer have the flexibility to: (i) Acquire the securities of other funds that are not part of the same group of investment companies; or (ii) invest directly in stocks, bonds, and other securities. In order to make these investments, the fund would need to comply with proposed rule 12d1-4 (including its conditions).

See infra

section III.

In developing this proposal, the Commission considered comments we received in response to a package of new rules and rule amendments focused largely on ETFs proposed in 2008.

This proposal also takes into account Commission staff observations of developments in the industry since that time.

See

2008 Proposing Release,

supra

footnote 13. The 2008 Proposing Release, among other things, would have allowed funds to invest in ETFs beyond the section 12(d)(1) statutory limits. Proposed rule 12d1-4 also would allow funds to invest in ETFs, and would allow ETFs to act as acquiring funds, in excess of the limits in section 12(d)(1). As discussed in section V, we propose to rescind the exemptive relief relating to investments in ETFs that has been included in our ETF exemptive orders.

II. Proposed Rule 12d1-4

A. Scope of Proposed Rule 12d1-4 and Exemptions From Section 12(d)(1) of the Act

Registered funds and BDCs.

Proposed rule 12d1-4 would permit a registered investment company or BDC (collectively, “acquiring funds”) to acquire the securities of any other registered investment company or BDC (collectively, “acquired funds”) in excess of the limits in section 12(d)(1), subject to conditions that are designed to address historical abuses associated with fund of funds arrangements. Accordingly, open-end funds, UITs, closed-end funds (including BDCs), ETFs, and ETMFs could rely on proposed rule 12d1-4 as both acquiring and acquired funds.

The proposed rule would not be available to face-amount certificate companies. Face-amount certificate companies are registered investment companies which are engaged or propose to engage in the business of issuing face-amount certificates of the installment type, or which have been engaged in such businesses and have any such certificates outstanding.

See

section 4(1) of the Investment Company Act. There is only one face-amount certificate company currently operating as an investment company and making current filings pursuant to section 13 [15 U.S.C. 80a-13] or section 15(d) of the Exchange Act [15 U.S.C. 80a-15]. Given the very limited universe of face-amount certificate companies and the nature of their investments, we do not propose to include face-amount certificate companies within the scope of proposed rule 12d1-4 as acquiring funds or acquired funds.

Today, an acquiring fund's ability to invest in an acquired fund in excess of the limits in section 12(d)(1) varies significantly based on the type of acquiring fund. The following chart describes the types of fund of funds arrangements that have been permitted under our exemptive orders:

Acquiring fund under exemptive orders

Acquired fund under exemptive orders

Open-end funds

Open-end funds, UITs, ETFs, ETMFs, Listed closed-end funds,

Listed BDCs.

UITs

Open-end funds, UITs, ETFs, ETMFs, Listed closed-end funds.

Closed-end funds (listed and unlisted)

ETFs, ETMFs.

BDCs (listed and unlisted)

ETFs.

ETFs

Open-end funds, UITs, ETFs, Listed closed-end funds, Listed BDCs.

Proposed

rule 12d1-4 would

create a consistent framework for all registered funds and BDCs. The proposed rule would subject fund of funds arrangements to conditions that are tailored to different acquiring fund structures, rather than assessing the merit of a particular fund of funds arrangement on an individual basis. As described in more detail below, we believe that these tailored conditions would serve to protect fund investors at both tiers of a fund of funds arrangement.

We use the terms “listed closed-end funds” and “listed BDCs” to refer to closed-end funds and BDCs that are listed and traded on national securities exchanges. Our exemptive orders have included a representation that acquiring funds will not invest in reliance on the order in closed-end funds or BDCs that are not listed and traded on a national securities exchange.

See, e.g.,

Innovator ETFs Trust,

et al.,

Investment Company Act Release Nos. 33214 (Aug. 24, 2018) [83 FR 44374 (Aug. 30, 2018)] (notice) and 33238 (Sept. 19, 2018) (order) and related application (“Innovator ETFs”).

We have provided this relief to ETFs that are structured as open-end funds and UITs.

See

Exchange-Traded Funds, Investment Company Act Release No. 33140 (June 28, 2018) [83 FR 37332 (July 31, 2018)] (“2018 ETF Proposing Release”) at nn. 344-46 and accompanying text (describing relief from section 12(d)(1) for investments in ETFs).

The following chart describes the types of fund of funds arrangements that would be permitted under proposed rule 12d1-4:

Acquiring fund under proposed rule 12d1-4

Acquired funds under proposed rule 12d1-4

Open-end funds

Open-end funds.

UITs

UITs.

Closed-end funds (listed and unlisted)

Closed-end funds (listed and unlisted).

BDCs (listed and unlisted)

BDCs (listed and unlisted).

ETFs

ETFs.

ETMFs

ETMFs.

Thus, in

addition to the fund of funds arrangements currently allowed by our exemptive orders, the proposed rule would allow open-end funds, UITs, and ETFs to invest in unlisted closed-end funds and unlisted BDCs beyond the limits in section 12(d)(1). Proposed rule 12d1-4 would similarly increase permissible investments for closed-end funds beyond ETFs and ETMFs to allow them to invest in open-end funds, UITs, other closed-end funds, and BDCs, in

excess of the section 12(d)(1) limits. Under the proposed rule, BDCs, which currently may only invest in ETFs in excess of the section 12(d)(1) limits, would additionally be permitted to invest in open-end funds, UITs, closed-end funds, other BDCs, and ETMFs. Finally, the proposed rule would allow ETMFs to invest in all registered funds and BDCs.

Under proposed rule 12d1-4, an acquiring fund could invest in unlisted closed-end funds and BDCs. For example, an acquiring fund could invest in interval funds under the proposed rule, which are closed-end funds that offer to repurchase their shares at periodic intervals pursuant to 17 CFR 270.23c-3 (rule 23c-3 under the Investment Company Act), and are generally unlisted. Based on staff analysis, there were 39 interval funds, representing approximately $21 billion in assets, in 2017.

Expanding permissible fund of funds arrangements would provide funds covered by the rule with flexibility to meet their investment objectives. In addition, we believe that the proposed rule's scope would eliminate unnecessary and potentially confusing distinctions among permissible investments for different types of acquiring funds. The proposed rule also would level the playing field among these entities, allowing each to invest in the same universe of acquired funds in excess of the limits in section 12(d)(1) without obtaining individualized exemptive relief from the Commission. We believe that the universe of permissible fund of funds arrangements generally should not turn on the type of the funds in the arrangement. Instead, we believe that the proposed rule should address differences in fund structures with tailored conditions designed to protect against the abuses historically associated with funds of funds.

When conditioned appropriately, expanding the scope of permissible acquiring and acquired funds in the manner described above would create a consistent and streamlined regulatory framework, while addressing investor protection concerns.

In 2008, the proposed relief from section 12(d)(1) was considered within the context of a broader ETF rule proposal and thus was limited to sales of shares of ETFs beyond the limits in section 12(d)(1). That proposal, however, similarly would have permitted all registered funds and BDCs to act as acquiring funds under the rule.

See

2008 Proposing Release,

supra

footnote 13.

For example, we do not believe that expanding the scope of permissible acquiring funds to include BDCs would present investor protection concerns regarding undue influence, duplicative fees, or complex structures that the proposed rule's conditions would not address. A BDC relying on the proposed rule as an acquiring fund also is subject to other limitations on its ability to invest in acquired funds.

Similarly, we do not believe that including ETMFs within the scope of the proposed rule would present investor protection concerns that we have not already extensively considered with other investment products. We believe that the proposed rule's conditions appropriately address investor protection concerns underlying section 12(d)(1)(A) with respect to these products.

See

15 U.S.C. 80a-54(a) (prohibiting a BDC from making any investment unless, at the time of the investment, at least 70% of the BDC's total assets are invested in securities of certain specific types of companies, which do not include funds).

See supra

footnote 27.

Further, we believe that the proposed rule's scope of permissible arrangements is appropriately calibrated based on our understanding of these investment products and our experience with conditions similar to the proposed rule's conditions. As noted above, Congress specifically urged the Commission to monitor the evolution of legitimate fund of funds arrangements and permit such arrangements when investors are adequately protected against the abuses that led Congress to enact section 12(d)(1). We believe that the proposed rule's conditions appropriately guard against those abuses, serving to protect investors. More specifically, the proposed rule 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 funds structures.

Accordingly, we believe that the proposed exemptions from sections 12(d)(1)(A), (B), and (C) are consistent with the public interest and the protection of investors under section 12(d)(1)(J) of the Act.

Proposed rule 12d1-4(b)(1) would prohibit the acquiring fund and its advisory group from controlling (individually or in the aggregate) the acquired fund, with certain exceptions. Proposed rule 12d1-4(b)(2) would limit the amount of acquired fund shares that an acquiring fund may redeem directly from the acquired fund during any thirty-day period.

See infra

section II.C.1-2.

Proposed rule 12d1-4(b)(3).

See infra

section II.C.3.

Proposed rule 12d1-4(b)(4).

See also

Item 7.B and Section 7.B. of Schedule D of Form ADV.

• Should we allow unregistered investment companies, including foreign funds, to rely on the rule as acquiring funds? If we permit unregistered investment companies to rely on the rule, should we include additional conditions in rule 12d1-4 designed to address an unregistered investment company's investments? If so, what conditions?

• Should we continue to take the interpretive position that foreign funds that make private offerings in the U.S. in reliance on section 3(c)(1) or 3(c)(7) are private funds for purposes of section 12(d)(1)? Alternatively, should we only treat foreign funds that conduct their activities with respect to U.S. investors in compliance with section 3(c)(1) or 3(c)(7)

and

are privately offered outside the United States as private funds for purposes of section 12(d)(1)? For example, should we take the position that a fund that conducts a private U.S. offering in compliance with sections 3(c)(1) or 3(c)(7), but also conducts a public offering in a foreign jurisdiction (

e.g.,

certain UCITS funds),

is an investment company, rather than a private fund, solely for purposes of section 12(d)(1)? Should the treatment of foreign funds as private funds differ when the foreign fund is an acquiring fund versus when the foreign fund is an acquired fund? Are there different or greater concerns, particularly regarding duplicative fees and complex structures, if registered funds are permitted to invest in foreign funds in excess of the limits in section 12(d)(1)(A) than there are with domestic private funds or registered funds?

See supra

footnote 51.

• If we permit private funds or unregistered investment companies to rely on rule 12d1-4, should we require those acquiring funds to make certain filings with the Commission disclosing their reliance on the rule? If so, should we promulgate a new form for those filings, and what information should be required on this form? For example, should we consider requiring these funds to report information to the Commission regarding their amount of holdings in an acquired fund? How frequently should we require these funds to report such information? For example, should we require monthly filings? Should reports be filed more or less frequently? Should those reports be public or non-public? Would any special concerns arise with respect to such a condition? To the extent that a foreign fund is registered in a foreign jurisdiction, should we consider requests for substituted compliance when the foreign fund complies with comparable non-U.S. rules?

B. Exemptions From the Act's Prohibition on Certain Affiliated Transactions

Proposed rule 12d1-4 would provide exemptive relief from section 17(a) of the Act.

Section 17 of the Act generally prohibits an affiliated person of a fund, or any affiliated person of such person, from selling any security or other property to, or purchasing any security or other property from, the fund.

It is designed to prevent affiliated persons from managing the fund's assets for their own benefit, rather than for the benefit of the fund's shareholders.

Proposed rule 12d1-4(a).

An affiliated person of a fund includes: (i) Any person directly or indirectly owning, controlling, or holding with power to vote, 5% or more of the outstanding voting securities of the fund; and (ii) any person 5% or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote by the fund.

See

15 U.S.C. 80a-2(a)(3)(A), (B). Section 17 also restricts certain transactions involving funds that are affiliated because both funds have a common investment adviser or other person exercising a controlling influence over the management or policies of the funds.

See

15 U.S.C. 80a-2(a)(3)(C). The determination of whether a fund is under the control of its advisers, officers, or directors depends on all the relevant facts and circumstances.

See infra

section II.C.1.

See Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. On Banking and Currency,

76th Cong., 3rd Sess. 37 (1940) (Statement of Commissioner Healy).

Absent exemptive relief, section 17(a) would prohibit a fund that holds 5% or more of the acquired fund's securities from making any additional investments in the acquired fund.

Fund of funds arrangements involving funds that are part of the same group of investment companies or that have the same investment adviser (or affiliated investment advisers) also implicate the Act's protections against affiliated transactions, regardless of whether an acquiring fund exceeds the 5% threshold.

Furthermore, in instances where an ETF is an acquired fund, section 17(a) would prohibit the delivery or deposit of basket assets on an in-kind basis by an affiliated fund (that is, by exchanging certain assets from the ETF's portfolio, rather than in cash).

If an acquiring fund holds 5% percent or more of the outstanding voting shares of an acquired fund, the acquiring fund is an affiliated person of the acquired fund and the acquired fund is an affiliated person of the acquiring fund. In general, to the extent that purchases and sales of acquired fund shares occur on the secondary market and not through principal transactions directly between an acquiring fund and an acquired fund, relief from section 17(a) would not be necessary.

As discussed below, the proposed rule would allow fund of funds arrangements when: (i) The acquiring fund is in the same group of investment companies as the acquired fund; or (ii) 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 adviser.

See infra

section II.C.1. For purposes of this section, we assume that funds in the same group of investment companies are under common control because funds that are not affiliated persons would not require relief from section 17(a).

See

Fund of Funds Adopting Release,

supra

footnote 17.

An ETF would be prohibited under section 17(a)(2) from purchasing securities and other property (

i.e.,

securities and other property in the ETF's basket assets) from the affiliated acquiring fund in exchange for ETF shares. An acquiring fund would be prohibited under section 17(a)(1) from selling any securities and other property (

i.e.,

securities and other property in the ETF's basket assets) to an affiliated ETF in exchange for the ETF's shares. The orders we have granted permitting investments in ETFs provide relief from section 17(a) of the Act to permit these transactions.

See, e.g.,

Barclays Global Fund Advisors,

et al.,

Investment Company Act Release Nos. 24394 (Apr. 17, 2000) [65 FR 21215 (Apr. 20, 2000)] (notice) and 24451 (May 12, 2000) (order) and related application. In addition, our orders provide separate affiliated transaction relief for the acquisition or sale of an ETF's basket assets as part of the creation or redemption of ETF creation units. Such relief is subject to its own protections.

See

2018 ETF Proposing Release,

supra

footnote 34. The exemptive orders granted to ETMFs have included similar exemptions from section 17(a).

See

Eaton Vance,

supra

footnote 27.

Section 17(b) of the Act authorizes the Commission to exempt a proposed transaction from the provisions of section 17(a) if the terms of the transaction, including the consideration to be paid or received, are fair and reasonable and do not involve

overreaching on the part of any person concerned, and the transaction is consistent with the policy of the investment company as recited in the fund's registration statement and the general purposes of the Act. In addition, section 6(c) of the Act permits the Commission to exempt any person, security, or transaction or any class or classes of persons, securities or transactions from any provision of the Act if such exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act.

We believe that the exemptions from section 17(a) set forth in the proposed rule meet the standards set forth in sections 17(b) and 6(c). We believe that the proposed rule's conditions make unlikely the prospect of overreaching by an affiliated fund. For example, the proposed rule's redemption limit would prevent an acquiring fund (including an acquiring fund that is an affiliate of the acquired fund) from threatening to quickly redeem or tender a large volume of acquired fund shares as a means to exert undue influence over an acquired fund.

The Commission has interpreted its authority under section 17(b) as extending only to a single transaction and not a series of transactions.

See In re Keystone Custodian Funds, Inc.,

21 SEC. 295 (1945) (exempting, under section 6(c) of the Act, a series of transactions that otherwise would be prohibited by section 17(a)). The Commission's exemptive authority under section 6(c), however, is not constrained to a single transaction. The Commission looks to the standards set forth in section 17(b) when issuing exemptions by rule from section 17(a).

See infra

sections II.C.1 and 2.

An acquired fund that is an open-end fund or UIT is further protected from overreaching due to the requirement that all purchasers receive the same price.

In the case of a closed-end acquired fund, we similarly believe that the acquired fund's repurchase of its shares would provide little opportunity for the acquiring fund to overreach because all holders would receive the same share price.

The purchase of open-end fund or UIT shares must be at a price based on the current NAV of the shares which is next-computed after receipt of a tender of an offer to purchase or redeem the shares.

See

section 22(c) of the Act and 17 CFR 270.22c-1 (rule 22c-1). Primary market transactions with an ETF (or an ETMF) would also be done at a price based on NAV.

See

2018 ETF Proposing Release,

supra

footnote 34; Eaton Vance,

supra

footnote 27.

Closed-end fund shares typically are bought and sold on the secondary market. In cases where closed-end funds engage in repurchase transactions, such as with interval funds, the pricing of the closed-end fund's shares in those transactions are subject to certain rules.

See, e.g.,

rule 23c-3;

See also

2008 Proposing Release,

supra

footnote 13 (prohibiting an acquiring fund, any of its investment advisers or depositors, or any company in a control relationship with any of those entities from controlling an ETF, individually or in the aggregate).

The Act defines control to mean 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 Act 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 not control it.

A determination of control depends on the facts and circumstances of the particular situation.

15 U.S.C. 80a-2(a)(9).

Id.

These presumptions continue until the Commission makes a final determination to the contrary by order either on its own motion or on application by an interested person.

“[N]o person may rely on the presumption that less than 25% ownership is not control when, in fact, a control relationship exists under all the facts and circumstances.” Exemption of Transactions by Investment Companies with Certain Affiliated Persons, Investment Company Act Release No. 10698 (May 16, 1979) [44 FR 29908 (May 23, 1979)], at n.2.

Accordingly, an acquiring fund and its advisory group's beneficial ownership of up to 25% of the voting securities of an acquired fund would be presumed to not constitute control over the acquired fund. A fund relying on the proposed rule, therefore, generally could make a substantial investment in an acquired fund (

i.e.,

up to 25% of the acquired fund's shares). If, however, facts and circumstances existed that gave an acquiring fund and its advisory group the power to exercise a controlling influence over the acquired fund's management or policies other than as discussed below, that fund would not be able to rely on the proposed rule even if the fund and its advisory group owned 25% or less of the acquired fund's voting securities.

We have long held that “controlling influence” includes, in addition to voting power, a dominating persuasiveness of one or more persons, the act or process that is effective in checking or directing action or exercising restraint or preventing free action, and the latent existence of power to exert a controlling influence.

See, e.g.,

In re Investors Mutual, Inc.,

et al.,

Investment Company Act Release No. 4595 (May 11, 1966) (Commission opinion), at text accompanying nn.11-14 (

citing

The Chicago Corporation, Investment Company Act Release No. 1203 (Aug. 24, 1948); Transit Investment Corporation, Investment Company Act Release No. 927 (July 31, 1946); In the Matter of the M.A. Hanna Company, Investment Company Act Release No. 265 (Nov. 26, 1941)).

In assessing control, an acquiring fund's investment in an acquired fund would be aggregated with the investment of the acquiring fund's advisory group. Consistent with past exemptive orders, the proposed rule would not require an acquiring fund to aggregate the ownership of an acquiring fund advisory group with an acquiring fund sub-advisory group.

Instead, each of these groups would consider its ownership percentage separately and would be subject to the same voting provisions as discussed below.

Proposed rule 12d1-4(d) defines “advisory group,” to mean “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 proposed rule, an acquiring fund would not combine the entities listed in clause (1) with those listed in clause (2).

See

proposed rule 12d1-4(b)(1)(ii).

We believe requiring an acquiring fund to aggregate its holdings with its advisory group would prevent a fund or adviser from circumventing the control condition by investing in an acquired fund through multiple controlled entities,

e.g.,

other funds in the fund complex. Several commenters on our 2008 proposal, however, urged us to narrow the scope of entities that an acquiring fund would be required to aggregate when determining whether an acquiring fund controls an ETF.

These commenters noted that the scope of the 2008 Proposing Release's control prohibition was broader than that of section 12(d)(1)(A), which prohibits only an acquiring fund and companies it controls from acquiring in the aggregate more than 3% of an ETF's shares.

They also noted the difficulty of complying with the proposed aggregation requirement, particularly for those funds whose advisers are part of large financial organizations where information barriers may preclude the adviser from knowing positions held, for example, by advisers under common control.

See, e.g.,

BGFA Letter; Comment Letter of Stradley Ronon Stevens & Young LLP (May 19, 2008) (“Stradley Letter”); ICI Letter; Xshares Letter.

See, e.g.,

ICI Letter.

See, e.g.,

Xshares Letter. Section 12(d)(1)(B) prohibits an acquired fund from “knowingly” selling or otherwise disposing of a security issued by the acquired fund to any other investment company. Section 12(d)(1)(A) does not include a similar “knowing” element.

Because the control condition effectively allows an acquiring fund and its advisory group to obtain a significant ownership stake in an acquired fund, we do not believe it is appropriate to limit the affiliates that are subject to this condition as suggested by commenters in 2008. Our exemptive orders include a similar condition and funds relying on those orders likely already have established policies and procedures to monitor compliance with the aggregation requirement embedded in the proposed definition of the term “advisory group.” Other provisions of the Act and our rules also extend to affiliated persons of an investment adviser.

Funds (or the advisers) have experience developing compliance policies and procedures in those circumstances.

Finally, we also do not believe that the breadth of the entities that are included within an acquiring fund and its advisory group would limit the usefulness of proposed rule 12d1-4. Instead, the risk of undue influence over an acquired fund would be more effectively addressed by requiring the entities that fall within these definitions to aggregate their holdings in an acquired fund for purposes of the control condition.

See, e.g.,

section 17(a) of the Act (prohibiting first- and second-tier affiliates of a fund from borrowing money or other property, or selling or buying securities or other property to or from the fund, or any company that the fund controls).

See also

Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)] (“Compliance Rule Adopting Release”) (noting that funds or their advisers should have policies and procedures in place to identify affiliated persons and to prevent unlawful transactions with them).

In some circumstances, such as net redemptions, an acquiring fund's holdings may trigger the Act's control presumption through no action of its own. If the acquiring fund and its advisory group become a holder of more than 25% of the outstanding voting securities of an acquired fund as a result of a decrease in the outstanding voting securities of the acquired fund, the proposed rule would not require an acquiring fund to dispose of acquired fund shares. An acquiring fund, however, would not be able to rely on the proposed rule to acquire additional securities of the acquired fund when it (along with its advisory group) holds more than 25% of the acquired fund's voting securities.

a. Voting Provisions

The proposed rule would require an acquiring fund and its advisory group to vote their securities in the manner prescribed by section 12(d)(1)(E)(iii)(aa) of the Act if the acquiring fund and its advisory group (in the aggregate) hold more than 3% of the outstanding voting securities of an acquired fund.

In these circumstances, the acquiring fund would be required to either: (i) Seek voting instructions from its security holders and vote such proxies in accordance with their instructions (“pass-through voting”); or (ii) vote the shares held by it in the same proportion as the vote of all other holders of the acquired fund (“mirror voting”).

This proposed condition is designed to limit the acquiring fund and its advisory group's power to influence the outcome of shareholder votes of the acquired fund.

Proposed rule 12d-4(b)(1)(ii). The acquiring fund would be required to follow the prescribed voting procedures only so long as such holdings remain above the 3% holdings threshold. This threshold would be calculated as of the record date for a vote at an annual or special meeting of the holders of the acquired fund's shares.

See

proposed rule 12d1-4(b)(1)(ii).

See, e.g.,

Fund of Funds Adopting Release,

supra

footnote 17 (funds relying on section 12(d)(1)(F) of the Act are required to follow the section 12(d)(1)(E)(iii) voting procedures so that “the [acquiring] fund's adviser would not be able to influence the outcome of shareholder votes in the acquired fund.”).

Our exemptive orders have historically included conditions designed to limit an acquiring fund's ability to influence an acquired fund through voting power. The voting conditions in our exemptive orders, however, have differed based on the type of acquired fund. For example, our orders require an acquiring fund (and any other funds within the advisory group) to vote shares of acquired closed-end funds in the manner required by section 12(d)(1)(E), while non-fund entities within the advisory group are required to use mirror voting.

The voting condition in our orders applies whenever the acquiring fund invests in a closed-end fund beyond the limits in section 12(d)(1). For acquired open-end funds or UITs, our exemptive relief has required an acquiring fund (and its advisory group) to vote their shares using mirror voting only if the acquiring fund and its advisory group become holders of more than 25% of the acquired fund's outstanding voting securities due to a decrease in the outstanding securities of the acquired fund.

Our exemptive orders also include exceptions to the voting conditions when the fund of funds arrangement involves funds within the same group of investment companies as discussed below.

See

Innovator ETFs,

supra

footnote 33.

See, e.g.,

Janus Investment Fund,

et al.,

Investment Company Act Release Nos. 31753 (Aug. 13, 2015) (notice) and 31808 (Sept. 9, 2015) (order) and related application (“Janus Investment Fund”). Our 2008 proposal would have included a similar condition for investments in ETFs.

See

2008 Proposing Release,

supra

footnote 13.

We propose to subject all acquiring funds under proposed rule 12d1-4 that do not fall within the control exceptions discussed below to the same voting condition in order to simplify and streamline this requirement. We believe that this approach would facilitate compliance monitoring for fund groups that have multiple types of acquiring funds. We also believe that requiring acquiring funds to utilize mirror voting or pass-through voting whenever their holdings exceed the statutory limit in section 12(d)(1)(A)(i) is appropriate to protect the acquired fund (and ultimately its investors) from undue influence through shareholder votes. A 3% threshold for the voting condition is particularly important because our

proposal would allow funds to acquire shares of closed-end funds under proposed rule 12d1-4. Closed-end funds historically have been the target of proxy contests.

Since the mid-1990s, closed-end funds that have traded at a discount to NAV have been the target of proxy contests initiated by large investors in those funds, including other funds.

See, e.g.,

Tom Lauricella,

Proxy Fight at Closed-End Fund Opens Can of Worms for Industry,

The Wall Street Journal (Aug. 9, 2002).

Since 1999, our exemptive orders also have included specific voting provisions when an insurance product separate account is part of the acquiring fund advisory group or acquiring fund sub-advisory group.

These provisions are designed to comport with the conditions of exemptions the Commission has issued specific to certain insurance product structures.

Most insurance product separate accounts, however, are organized as UITs and rely on section 12(d)(1)(E) to invest proceeds from the sale of interests in variable annuity and variable life insurance contracts in shares of a mutual fund.

Accordingly, we believe most insurance product separate accounts already comply with the voting provisions set forth in section 12(d)(1)(E)(iii)(aa) of the Act, which we propose to incorporate into rule 12d1-4. We therefore do not believe separate voting conditions are necessary for these products.

See, e.g.,

The Ohio National Life Insurance Company,

et al.,

Investment Company Act Release Nos. 30895 (Jan. 28, 2014) [79 FR 6238 (Feb. 3, 2014)] (notice) and 30925 (Feb. 24, 2014) (order) and related application (“Ohio Life”). The exemptive relief granted by orders generally is conditioned on registered separate accounts seeking voting instructions from contract owners and then voting their shares in accordance with the instruction received (and voting shares for which no instruction were received in the same proportion as the shares for which instructions were received). Relief granted to unregistered separate accounts is conditioned on those accounts either mirror voting their shares or voting in the same manner as registered separate accounts.

See id.

The Commission has granted exemptions from certain rules under the Act to the extent necessary to permit certain insurance product structures—referred to as “mixed and shared funding.” These exemptions are subject to conditions, including voting conditions, designed to limit potential material conflicts of interest among the different contract owners.

See, e.g.,

The RBB Fund, Inc.,

et al.,

Investment Company Act Release Nos. 31648 (May 27, 2015) (notice) [80 FR 31420 (June 2, 2015)] and 31687 (Jun. 23, 2015) (order) and related application; SunAmerica Series Trust,

et al.,

Investment Company Act Release Nos. 31281 (Oct. 10, 2014) (notice) [79 FR 62473 (Oct. 17, 2014)] and 31331 (Nov. 15, 2014) (order) and related application.

See

Fund of Funds Proposing Release,

supra

footnote 16.

b. Exceptions From the Control and Voting Conditions

The proposed rule would include exceptions to the control and voting conditions when: (i) An acquiring fund is within the same group of investment companies as an acquired fund; or (ii) 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 adviser or depositor.

The proposed exceptions are designed to include arrangements that are permissible under section 12(d)(1)(G) and our exemptive orders within the regulatory framework of rule 12d1-4. Based on our experience overseeing fund of funds arrangements, we believe the proposed exceptions are appropriately tailored to except only those fund of funds arrangements that do not raise the concerns of undue influence that underlie section 12(d)(1) from the control and voting conditions.

Proposed rule 12d1-4(b)(1)(iii).

As noted above, open-end funds and UITs may rely on section 12(d)(1)(G) to invest in an open-end fund or UIT within the same group of investment companies. Our exemptive orders have expanded the relief in section 12(d)(1)(G) to allow open-end funds to invest in open-end funds, UITs, ETFs, listed closed-end funds, and listed BDCs within the same group of investment companies. Proposed rule 12d1-4 would allow registered funds and BDCs to invest in other registered funds and BDCs within the same group of investment companies.

For purposes of rule 12d1-4, we propose to define the term “group of investment companies” as “any two or more registered investment companies or business development companies that hold themselves out to investors as related companies for investment and investor services.”

100

This is similar to the definition used in many of our exemptive orders permitting investments in listed closed-end funds and listed BDCs. It is intended to clarify that closed-end funds and BDCs are within the scope of the exception.

100

Proposed rule 12d1-4(d).

We believe that it would be false or misleading for a group of investment companies to hold themselves out as related companies as that term is used in proposed rule 12d1-4 unless they are, in fact, related investment companies. We believe, for example, that funds that are advised by the same investment adviser, or by advisers that are control affiliates of each other, would be “related” companies for purposes of the proposed rule.

101

The determination of whether advisers are control affiliates, however, depends on the relevant facts and circumstances.

102

101

The definition of “affiliated person” includes any person directly or indirectly controlling, controlled by, or under common control with, such other person.

See

section 2(a)(3)(C) of the Act.

102

See

Investment Company Mergers, Investment Company Act Release No. 25259 (Nov. 8, 2001) [66 FR 57602 (Nov. 15, 2001)] (proposing rule amendments to permit mergers and other business combinations between certain affiliated investment companies), at n.11.

We believe that whether a group of funds sharing a common adviser or having advisers that are all control affiliates could satisfy the “holding out” prong of the definition would depend on the totality of communications with investors by or on behalf of the funds. For example, the acquiring fund's prospectus could identify the acquired funds in which the acquiring fund expects to invest, and disclose the control relationship among the advisers to the acquiring and acquired funds. In our view, it would not be necessary for the acquired funds to include comparable disclosure in their prospectuses or that the acquired funds and acquiring funds be marketed as related companies for all purposes and to all potential investors.

103

Rather, the requirement in the definition of “group of investment companies” that the funds must hold themselves out to “investors” as related companies for purposes of investment and investor services refers only to potential investors in the acquiring fund because the relevant inquiry is how the funds are holding themselves out to potential investors in the acquiring fund. Disclosure in the acquiring fund's prospectus of the identity of the acquired funds in which the acquiring fund expects to invest, and of the control relationship among the advisers to the acquired and acquiring funds, therefore, is one way to satisfy the “holding out” requirement of the definition.

103

If the acquired funds' marketing materials and/or prospectuses include any statements that are inconsistent with the representations made in the prospectuses for the acquiring funds regarding how the acquired fund and acquiring funds are related companies because of the affiliation of their investment advisers, such statements could call into question whether the investment companies are holding themselves out as related companies and potentially render the control exception unavailable to the fund of funds arrangement.

Our orders also allow an acquiring fund to invest in an acquired fund when an acquiring fund's sub-adviser (or a control affiliate of the sub-adviser) serves as the primary investment adviser or sponsor to the acquired fund.

104

Proposed rule 12d1-4 would

similarly except these arrangements from the control and voting conditions.

105

This proposed exception would cover arrangements that may not qualify for the proposed exclusion available to funds within the same group of investment companies under subparagraph (b)(1)(iii)(A) because the acquiring fund and acquired fund do not hold themselves out as related funds for purposes of investment and investor services.

106

We believe that these arrangements do not raise the same concerns regarding undue influence as other types of fund of funds arrangements because of the sub-adviser's duties as a fiduciary to both the acquiring fund and acquired fund.

104

See

Calamos Advisors LLC,

et al.,

Investment Company Act Release Nos. 30628 (July 24, 2013) [78 FR 46381 (July 31, 2013)] (notice) and 30653 (Aug. 20, 2013) (order) and related application.

See also

BGFA Letter (noting that asset allocation funds often retain the advisers of acquired ETFs as sub-advisers and that “[t]he Commission has previously

granted exemptive relief relating to this issue on many occasions”).

105

See

proposed rule 12d1-4(b)(1)(iii)(B). Proposed rule 12d1-4(b)(1)(iii)(B) would, however, use the term “depositor” instead of “sponsor” to be consistent with other rules.

106

Fund of funds arrangements where the acquiring fund's primary adviser served as adviser to the acquired fund typically would be able to qualify as funds within the “same group of investment companies” and would not require a separate exception under our orders.

The proposed rule would subject the fund of funds arrangements within these exclusions to a more limited set of conditions than other fund of funds arrangements relying on the rule. In circumstances where the acquiring fund and acquired fund share the same adviser, the adviser would owe a fiduciary duty to both funds, serving to protect the best interests of each fund.

107

In addition, in cases where the arrangement involves funds that are advised by advisers that are control affiliates, we do not believe that the acquiring fund adviser generally would seek to benefit the acquiring fund at the expense of the acquired fund (nor do we believe that the acquiring fund would seek to influence the acquired fund through its ownership interest in the acquired fund).

108

We believe that the proposed rule's other conditions, such as the redemption condition described below, would mitigate against the risks of undue influence when the arrangement involves funds that have advisers that are control affiliates.

107

An investment adviser has a fiduciary duty to act in the best interests of a fund it advises.

See

section 36(a) under the Investment Company Act.

See also infra

sections III and V (discussing the proposed rescission of rule 12d1-2 and exemptive orders).

We believe the proposed redemption condition, together with the proposed control and voting conditions, are more protective than certain conditions currently found in our orders and may be objectively tested as part of a fund's compliance program. The conditions in our orders generally require the acquired fund board to make certain findings and adopt procedures to prevent overreaching and undue influence by the acquiring fund and its affiliates once the investment in an unaffiliated acquired fund exceeds the section 12(d)(1) limits.

117

For example, our orders require an unaffiliated acquired fund board to adopt procedures reasonably designed to monitor purchases by the unaffiliated acquired fund in an underwriting in which an affiliate of the acquiring fund is the principal underwriter.

118

Our orders also require the acquiring fund to take measures to prevent the acquiring fund from influencing the terms of any services or transactions between the acquiring fund and an unaffiliated acquired fund or causing an unaffiliated acquired fund to purchase a security in any affiliated underwriting. The acquiring fund's board of directors, including a majority of its independent directors, is required by our orders to adopt procedures reasonably designed to assure that the acquiring fund's investment adviser does not take into account consideration received from an unaffiliated acquired fund (or certain of the unaffiliated acquired fund's affiliates).

119

In addition, our exemptive orders require the acquired fund and each unaffiliated acquiring fund to execute a participation agreement.

120

117

Our orders generally use the term “unaffiliated funds” to refer to acquired funds that are not part of the same group of investment companies as the acquiring fund. For purposes of this discussion of the conditions in our orders that differentiate based on whether the acquired fund is part of the same group of investment companies, we will use the term “unaffiliated acquired fund”.

See, e.g.,

USCF Advisers, LLC,

et al.,

Investment Company Act Release Nos. 32851 (Oct. 4, 2017) [82 FR 47262 (Oct. 11, 2017) (notice) and 32889 (Oct. 31, 2017) (order) and related application (“USCF Advisers”); Franklin Fund,

supra

footnote 25.

118

This condition also requires the board to review these transactions on at least an annual basis and to maintain certain records associated with the procedures and affiliated underwritings.

119

See, e.g.,

USCF Advisers,

supra

footnote 117.

120

See, e.g.,

Schwab,

supra

footnote 25.

We believe that the proposed redemption, control, and voting conditions address the same concerns regarding overreaching and undue influence that these exemptive order conditions sought to address, without requiring procedures and related board findings covering particular instances where undue influence and overreaching could exist. Therefore, replacing these conditions with the proposed redemption, control, and voting conditions would lower compliance costs and burdens and enhance investor protection for acquired funds.

121

We anticipate that fund of funds involving separate accounts will continue to enter into participation agreements as a result of the requirements in their “mixed and shared funding” orders.

See supra

footnote 97.

We believe the proposed limit is appropriately tailored to reduce the threat of large-scale redemptions. Along with the other conditions we are proposing today, it is designed to prevent an acquiring fund from unduly influencing the acquired fund without the board oversight and monitoring conditions imposed by our orders. At the same time, the redemption limit leaves an acquiring fund the ability to redeem a portion of its investment.

122

Because the threat of large-scale redemptions only exists when an acquiring fund holds a significant amount of an acquired fund, the redemption condition does not apply unless the acquiring fund holds shares of the acquired fund in excess of the 3% limit on the acquisition of an acquired fund's outstanding voting securities under section 12(d)(1)(A)(i) of the Act.

123

It does not apply as a result of the fund exceeding the 5% limit on the total assets of an acquiring fund that may be invested in a single acquired fund under section 12(d)(1)(A)(ii) of the Act or the 10% limit on the total assets of an acquiring fund that may be invested in all acquired funds under section 12(d)(1)(A)(iii) of the Act. In addition, acquiring funds that rely on the proposed rule to invest in funds that are listed on an exchange would be permitted to continue to sell shares in the secondary market without regard to the volume limit.

124

Based on the staff's analysis of redemptions of acquired fund shares, we do not believe that our proposed redemption limit would have a large effect on funds.

125

However, we acknowledge that this condition could have a larger impact during periods of market stress or high volatility.

122

The acquiring fund could redeem shares in multiple transactions within a 30-day period, provided that, taken together, they represent less than 3% of the acquired fund's outstanding shares.

123

If the section 12(d)(1)(A)(i) limits are exceeded, the acquiring fund could not redeem any shares from the acquired fund beyond the rule's limits until the acquiring fund disposes of shares it acquired in excess of the 3% statutory limit. Once the acquiring fund does not hold any shares in excess of 3%, the acquiring fund could redeem any remaining acquired fund shares it held.

124

We understand that most acquiring funds purchase ETFs, ETMFs, listed closed-end funds, and listed BDCs in secondary market transactions. In some cases, UITs also may have secondary market trading. Secondary market transactions would not involve redemptions from the acquired fund. However, an acquiring fund might seek to redeem ETF or ETMF shares from an ETF or ETMF in a primary market transaction through one or more authorized participants. When transacting with an ETF or ETMF in the primary market, an acquiring fund would be subject to, among other things, the redemption restrictions discussed herein, which could result in acquiring funds being treated differently than other market participants seeking to engage in primary market transactions with an ETF or ETMF.

125

See infra

section VI. From January 2017 to June 2018, 0.16% of the monthly redemptions of unlisted acquired funds exceeded the proposed 3% redemption limit. During that same period, 0.76% of the monthly redemptions of listed acquired funds exceeded the proposed 3% redemption limit. For these purposes, open-end funds and UITs are included in the figures for unlisted acquired funds and ETFs, ETMFs, listed closed-end funds, and listed BDCs are included in the figures for listed acquired funds. We estimate the percentage of fund redemptions that are above the 3% limit in any 30-day period using the quarterly fund holding information in Morningstar Investment Company Holdings database between January 2017 and June 2018, and assuming that the changes in quarterly portfolio holdings occur evenly across the three months in each quarter. Our analysis does not distinguish between changes in holdings as a result of primary and secondary market transactions.

Section 12(d)(1)(F) of the Act includes a redemption provision, but limits redemptions to only 1% of the acquired fund's total outstanding securities during a 30-day period.

126

However, a fund relying on section 12(d)(1)(F) of the Act only may acquire up to 3% of an acquired fund, whereas proposed rule 12d1-4 would permit an acquiring fund to acquire up to 25% of an acquired fund.

127

We believe a 3% redemption limit, rather than a 1% limit, would have a less significant impact on an acquiring fund's liquidity, particularly if the acquiring fund is not able to trade the acquired fund's shares on the secondary market.

128

The

proposed 3% redemption limit would provide funds and their advisers with greater flexibility to manage a fund's investments, while continuing to protect acquired funds from undue influence. In addition, we believe a 3% redemption limit is appropriate for proposed rule 12d1-4 because an acquiring fund that does not seek an exemption from section 12(d)(1)(A) would be able to redeem up to 3% of an acquired fund's total outstanding shares.

129

126

See

section 12(d)(1)(F)(ii) (providing that no issuer of a security purchased or acquired by a registered investment company pursuant to that section is obligated to redeem such security in an amount exceeding 1% of the issuer's total outstanding securities during any period of less than thirty days).

127

Acquiring funds could rely on proposed rule 12d1-4 to hold more than 25% of an acquired fund's outstanding voting securities when they are part of the same group of investment companies or when the acquiring fund's sub-adviser (or a control affiliate) acts as the acquired fund's adviser or depositor. Because acquiring funds that fall within the exceptions in rule 12d1-4(b)(1)(iii) are not constrained in their ability to control a fund and could acquire more than 25% of an acquiring fund's outstanding voting securities, we propose to subject these types of acquiring funds to the redemption limitation in proposed rule 12d1-4(b)(2).

128

An acquiring fund that holds more than 3% of an acquired fund's total outstanding shares should take this limitation into account when classifying this portfolio investment as part of its liquidity risk management program under 17 CFR 270.22e-4 (rule 22e-4 under the Act).

See

Investment Company Liquidity Risk Management Programs, Investment Company Act Release No.

32315 (Oct. 13, 2016) [81 FR 82142 (Nov. 18, 2016)] (“Liquidity Release”).

129

An acquiring fund that relies on the statutory exemption to section 12(d)(1)(A) in section 12(d)(1)(G) of the Act, however, may acquire more than 3% of an acquired fund's shares without being subject to any redemption limits if that acquired fund is in the same group of investment companies and structured as an open-end fund or UIT.

We acknowledge that the provision in section 12(d)(1)(F)(ii) is permissive (

i.e.,

acquired funds have the option to limit redemptions in this manner), while the proposed condition in rule 12d1-4 is mandatory. An acquiring fund, however, could influence an acquired fund to eliminate (or never establish) a limit on redemptions if the redemption condition were merely permissive. We therefore propose a mandatory limit on submitting redemptions as a more effective means to mitigate the threat of undue influence than an optional limit.

The Commission proposed stricter redemption limits in 2008, in part because that proposal related to investments in ETFs and we anticipated that most acquiring funds would transact in ETF shares on the secondary market.

130

Under that proposal, an acquiring fund that acquired more than 3% of an ETF's outstanding shares in reliance on rule 12d1-4 would have been prohibited from redeeming any of those shares. Commenters on the 2008 proposal generally supported the proposed condition.

131

One commenter, however, recommended that we modify the redemption condition to provide for volume and time limitations on redemption, rather than rendering particular shares ineligible for redemption.

132

130

See

2008 Proposing Release,

supra

footnote 13.

131

See, e.g.,

Comment Letter of Independent Directors Council (May 19, 2008) (“IDC Letter”) (“The proposed conditions, particularly the condition limiting the ability of an acquiring fund to redeem ETF shares, offer an efficient means to address the same policy concerns relating to undue influence by an acquiring fund of an ETF that the director-related conditions of the exemptive orders were designed to address.”); Comment Letter of Mutual Fund Directors Forum (May 21, 2008) (“MFDF Letter”); SSgA Letter.

132

The commenter asserted that it would be difficult to implement a tracking method for particular shares to abide by the redemption prohibition in the 2008 proposal.

See

MFA Letter (suggesting a redemption limit of 1% of an ETF's shares per month during any month the acquiring fund holds more than 3% of the ETF's outstanding shares).

Under the 2008 proposal, an ETF, its principal underwriter, and a broker or a dealer that relied on the rule to sell the ETF's shares in excess of section 12(d)(1)(B) limits also would have been prohibited from redeeming those shares acquired by another fund that exceeded the 3% limit in section 12(d)(1)(A)(i).

133

In proposing this limit, the Commission acknowledged that it may be difficult for these entities to know whether a redemption order is submitted by such an entity and included a safe harbor for each of those entities if certain conditions were met.

134

Commenters agreed such identification would be difficult and objected to this condition.

135

133

See

2008 Proposing Release,

supra

footnote 13, at n.221 and accompanying text. Section 12(d)(1)(B) applies to a registered open-end investment company (and any principal underwriter thereof or broker-dealer).

134

See id.

The proposed safe harbor was available for each of those entities if it had: (i) Received a representation from the acquiring fund that none of the ETF's shares the acquiring fund is redeeming includes any shares that it acquired in excess of 3% of the ETF's shares in reliance on the proposed rule; and (ii) no reason to believe that the acquiring fund is redeeming ETF shares that the acquiring fund acquired in excess of 3% of the ETF's shares in reliance on the proposed rule.

See id.

135

See, e.g.,

ICI Letter; Comment Letter of Morgan, Lewis & Bockius LLP (July 28, 2008) (“Morgan Lewis Letter”); BGFA Letter (noting that section 12(d)(1)(B) of the Act (from which this provision would provide an exemption) only prohibits acquired funds from

knowingly

selling shares in excess of the 3% limit in section 12(d)(1)(A)(i)).

Our proposal would not prohibit an acquired fund from redeeming, or its principal underwriter or a broker or dealer from submitting for redemption, shares held by an acquiring fund that exceed the 3% limit in section 12(d)(1)(A)(i). The proposed 30-day limit on redemptions for acquiring funds would reduce the risk of undue influence through the threat of large-scale redemptions, without requiring an acquired fund to track whether a redemption order was submitted by an acquiring fund that holds more than 3% of the acquired fund's shares. Instead, the acquiring fund would need to track its redemptions of acquired fund shares.

We request comment on the proposed redemption condition.

• Should we prohibit, as proposed, an acquiring fund that acquires more than 3% of an acquired fund's outstanding shares (

i.e.,

the statutory limit) from redeeming or submitting for redemption, or tendering for repurchase, more than 3% of an acquired fund's total outstanding shares in any 30-day period? Should either of these proposed limits be higher (

e.g.,

5% or 10%) or lower (

e.g.,

1%)? Should the period be longer or shorter than 30 days? Should the same limit apply for all types of acquired funds under the rule? How should the rule handle a situation where an acquiring fund initially holds less than 3% of an acquired fund, but comes to hold more than 3% as a result of a decline in assets of the acquired fund? Should this provision of the proposed rule apply to an acquiring fund that “holds” more than 3% of an acquired fund's outstanding shares, instead of an acquiring fund that “acquires” that amount?

• Should the redemption limit apply to funds that are not traded on the secondary market? Alternatively, should the redemption limit be higher for acquired funds that are not traded on the secondary market? Would eliminating this condition increase the risk that acquiring funds could exert undue influence over acquired funds through the threat of large-scale redemptions? Should there be an exception to the redemption limit for redemptions in kind?

• Should the redemption limit apply to an acquiring fund that is part of the same group of investment companies as the acquired fund? Should the redemption limit apply to an acquiring fund when 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 adviser or depositor? Alternatively, should we except these entities from the redemption condition for the same reasons we propose to except them from the control and voting conditions?

• Are we correct that acquiring funds typically buy and sell ETF shares on the secondary market? Are there instances where acquiring funds transact with an ETF in the primary market through an authorized participant? Would the proposed redemption condition affect the efficiency of the arbitrage mechanism for ETFs? If so, how? For example, would the proposed limitation contribute to premiums or discounts to NAV? How would the proposed redemption limitation affect ETMFs?

• How would the proposed redemption limitation affect acquiring fund's portfolio management? Where an acquiring fund holds more than 3% of the shares of an acquired fund, would the proposed redemption condition unduly impede the ability of acquiring funds to dispose of acquired fund shares, including during periods of market stress or high volatility? Do acquiring funds realize significant

benefits from the ability to redeem acquired fund shares in these circumstances? Would the proposed limitation disrupt acquiring funds' ability to change underlying funds from time to time? Would the proposed limitation contribute to changes in how acquiring funds allocate their assets to acquired funds? For example, would acquiring funds be more likely to invest in larger funds, or in ETFs rather than mutual funds, in order to avoid the redemption limit? Would the proposed redemption condition create a competitive disadvantage for smaller acquired funds or acquired funds that are not traded on the secondary market?

• How would the proposed redemption limitation affect an acquiring fund's liquidity risk management?

• Would acquiring funds incur significant costs from a mandatory prohibition on redemption of acquired fund shares once the 3% statutory limit has been exceeded? Should the proposed redemption limitation, like the one in section 12(d)(1)(F) of the Act, be voluntary at the election of an acquired fund? If so, what other safeguards could be added to protect against undue influence?

• If an acquiring fund redeems shares in multiple transactions, should the acquiring fund calculate the total percentage redeemed by adding the percentage total of each redemption or should we provide alternative guidance regarding this calculation? For example, should a fund calculate the percentages as of the time of the latest redemption?

• Should the proposed redemption limit apply to an acquiring fund's advisory group, rather than each acquiring fund individually, in order to address the potential for large-scale redemptions that could originate from a fund group? Alternatively, should the proposed redemption limit apply, on an aggregate basis, to affiliated acquiring funds, or acquiring funds with the same exact portfolio managers, or that have in common at least one portfolio manager, as listed in the registration statement? If so, should the redemption limit be higher (

e.g.,

no more than 5% of the acquired fund's total outstanding shares during any 30-day period)? What are the benefits and drawbacks of such an approach? How would this condition affect fund operations? How would funds design compliance policies and procedures to comply with this condition? Would it be difficult to track this type of redemption limit? If so, why? Would this better protect against undue influence in acquired funds? If so, how?

• Notwithstanding that the proposed condition limits the ability of an acquiring fund to redeem, rather than limiting the ability of an acquired fund to honor redemption requests, should we provide exemptions from section 22(e) of the Act in connection with this condition?

• Does the proposed condition appropriately limit the threat of redemption that an acquiring fund could otherwise use to unduly influence or control an acquired fund? If not, are there other conditions that would better address the risks associated with undue influence or control? For example, do the conditions in our existing orders more effectively limit the ability of an acquiring fund to unduly influence or control an acquired fund? Should we codify those conditions (including the procedural requirements, board findings, and participation agreements) instead of or in addition to including a redemption condition in the rule?

• As discussed above, we believe that participation agreements would not be necessary in light of the proposed conditions of rule 12d1-4. Are there benefits to participation agreements, however, that suggest we should include this requirement? For example, do participation agreements help funds determine who is investing in the funds above the statutory limits? Do participation agreements require the parties to a fund of funds arrangement to provide information necessary for compliance with other provisions of the Act? For example, do participation agreements require acquiring funds and acquired funds to provide lists of affiliates to aid in monitoring compliance with section 17(a)? How would funds use this information in complying with the conditions in proposed rule 12d1-4? Without participation agreements, would an acquired fund have sufficient information about the acquiring funds that hold its shares? Would funds continue to enter into participation agreements even if not required under the rule?

• Should an acquired fund, its principal underwriter, and a broker or a dealer that relies on the rule be prohibited from redeeming (or from submitting an order to redeem) acquiring fund shares that exceed the 3% limit in section 12(d)(1)(A)(i)? Should this prohibition apply only to an acquired fund that is a registered open-end fund, along with its principal underwriter and broker or dealer since section 12(d)(1)(B) applies to only those entities? Would an acquired fund (along with its principal underwriter, and a broker or a dealer that relies on the rule) have difficulty identifying acquiring funds investing in the acquired fund in reliance on rule 12d1-4? If we included this prohibition, should we also include the related safe harbors for an acquired fund, its principal underwriter, and a broker or dealer that we proposed in 2008?

136

Alternatively, should we consider including a knowledge qualifier in the prohibition, similar to the one included in section 12(d)(1)(B) itself? For example, should we prohibit an acquired fund (or its principal underwriter, or a broker or a dealer) only from

knowingly

redeeming shares acquired by the acquiring fund in excess of the 3% limit in section 12(d)(1)(A)(i)?

136

See supra

footnote 134.

• Are there alternative approaches to a redemption limitation that we should consider? For example, should we consider requiring acquired funds relying on the rule to set a redemption limit based on their evaluation of the effect of large redemptions on the acquired fund? If so, what parameters should we establish for such an evaluation? Would this approach raise investor protection concerns? For example, should we require the acquired fund to evaluate historical redemptions to determine what limit on redemptions is appropriate? Should we require acquired funds to disclose the redemption limit on Form N-CEN?

• Alternatively, should we consider requiring the acquiring fund to provide advance notice to an acquired fund prior to a large redemption? If so, what threshold should trigger this notice requirement (

e.g.,

3% or higher), and how far in advance should the acquiring fund provide notice? Similarly, should we require an acquiring fund to provide notice to an acquired fund before investing in the fund in reliance on rule 12d1-4? Should we consider permitting an acquired fund to impose redemption fees on acquiring funds that make redemptions over a certain limit?

137

If so, what should that limit be?

137

Funds are currently permitted to impose redemption fees in certain circumstances.

See

Mutual Fund Redemption Fees, Investment Company Act Release No. 26782 (Mar. 11, 2005) [70 FR 13328 (Mar. 18, 2005)] (adopting rule 22c-2 under the Act).

3. Duplicative and Excessive Fees

We are proposing conditions in rule 12d1-4 that are designed to prevent duplicative and excessive fees in fund of funds arrangements, a key concern underlying the enactment of section 12(d)(1).

138

The conditions vary based

on the structural characteristics of the acquiring fund, but generally hinge on a determination that the arrangement's aggregate fees do not implicate the historical abuses that section 12(d)(1) was intended to prevent. We believe that the proposed condition would help serve to protect acquiring fund investors from duplicative fees.

138

See

Investment Trust Study,

supra

footnote 13 at ch. 7, 2725-39, 2760-75, 2778-93. The Investment Trust Study observed that controlling persons profited from duplicative fees at the

acquiring and acquired fund levels. Additionally, complex multi-tier fund structures made it difficult for shareholders to understand who controlled their fund, to assess the true value of their investments, or to assess the nature of a fund's investment risks.

a. Management Companies

In cases where the acquiring fund is a management company, proposed rule 12d1-4 would require the acquiring fund's adviser to determine that it is in the best interest of the acquiring fund to invest in the acquired fund.

139

The proposed rule would require the adviser to make this determination before investing in acquired funds in reliance on the rule, and thereafter with such frequency as the board of directors of the acquiring fund, by resolution, deems reasonable and appropriate, but in any case, no less frequently than annually. The proposed rule also would require the adviser to report its finding and the basis for the finding to the board.

139

Proposed rule 12d1-4(b)(3)(i). This condition would apply to open-end funds, ETFs structured as open-end funds, ETMFs, closed-end funds, and BDCs.

Investment Adviser Review and Reporting.

In finding that it is in the best interest of the acquiring fund to invest in an acquired fund, the proposed rule would require the acquiring fund's investment adviser to evaluate: (i) The complexity of the fund of funds structure; and (ii) the aggregate fees associated with the fund's investment in an acquired fund. We believe it is appropriate to require the acquiring fund's investment adviser to make these evaluations because whether to invest in an acquired fund to achieve a fund's investment objective, rather than other types of assets, is a question of portfolio management. The acquiring fund's board of directors would be required to review these arrangements, and any conflicts they may present, as part of its oversight responsibilities. The proposed evaluations are designed both to help guard against the construction of a complex structure that could be confusing to the acquiring fund's shareholders and to prevent excessive layering of fund costs.

140

In addition, acquiring funds (other than those structured as UITs, discussed below) would be subject to our disclosure requirements for fund investments in other funds, which require all registered funds and BDCs to disclose in their prospectus fee tables expenses paid by both the acquiring and acquired funds so that shareholders can evaluate the costs of investing in a fund that invests in other funds.

See

Instruction 3(f) to Item 3 of Form N-1A; Instruction 10.a to Item 3 of Form N-2. The Commission adopted these disclosure requirements when it adopted rules 12d1-1, 12d1-2 and 12d1-3.

See

Fund of Funds Adopting Release,

supra

footnote 17, at n.67 and accompanying text. We request comment on these disclosure requirements at the end of this section.

In evaluating the complexity of a fund of funds structure, an adviser should consider the complexity of an acquiring fund's investment in an acquired fund versus direct investment in assets similar to the acquired fund's holdings. The adviser should consider whether the resulting structure would make it difficult for shareholders to appreciate the fund's exposures and risks. The adviser should consider whether an investment in an acquired fund would circumvent the acquiring fund's investment restrictions and limitations. The adviser also should consider whether an acquired fund invests in other funds.

141

See infra

section II.C.4.

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. While not required under proposed rule 12d1-4, fee waivers would be one way to mitigate the duplicative fee concerns.

142

Additionally, the adviser should consider reviewing acquired fund share classes to ensure that the acquiring fund is not holding a more expensive share class if a less expensive one is available to the acquiring fund.

142

See, e.g.,

Allianz Funds Multi-Strategy Trust,

et al.,

Investment Company Act Release Nos. 32533 (Mar. 15, 2017) [82 FR 14580 (Mar. 21, 2017)] (notice) and 32598 (Apr. 11, 2017) (order) and related application (providing that the acquiring fund adviser (or sub-adviser) will waive fees otherwise payable to it by an acquiring fund in an amount at least equal to any compensation (including fees received pursuant to any plan adopted by an acquired fund pursuant to rule 12b-1 under the Act) received from certain acquired funds by the adviser or sub-adviser, or an affiliated person of the adviser or sub-adviser, other than any advisory fees paid to the adviser, sub-adviser, or an affiliated person by the acquired fund, in connection with the investment by the acquiring fund in the acquired fund).

Rule 12b-1 under the Act permits a fund to use fund assets to pay broker-dealers and others for providing services that are primarily intended to result in the sale of the fund's shares. Among other things, rule 12b-1 requires that, before using fund assets to pay for distribution expenses, a fund must adopt a written plan describing all material aspects of the proposed financing of distribution. 17 CFR 270.12b-1.

The proposed rule does not require an acquiring fund's adviser to make these evaluations in connection with every investment in an acquired fund. For example, in developing policies and procedures reasonably designed to prevent violations of the federal securities laws by the fund, an adviser to a fund that invests regularly in acquired funds as part of its strategy could consider establishing parameters for routine investments in acquired funds, and review individual transactions that are outside of those parameters.

143

Any such policies and procedures should be tailored to the investment objectives and strategies of an individual fund. For example, an adviser to a fund that typically invests in fixed income securities of non-U.S. issuers, but periodically invests in an acquired fund to equitize cash before it can invest a large purchase of fund shares, may decide to make the evaluations in connection with each investment in an acquired fund.

143

See

rule 38a-1;

See also

FINRA Notice to Members 92-41: SEC Approval of Amendments to Article III, Section 26 of the NASD Rules of Fair Practice Regarding Limitations on Mutual Fund Asset-Based Sales Charges (Aug. 1992) (definitions of “sales charges” and “service fees” under FINRA Rule 2341 do not include fees for recordkeeping, transfer agency services, accounting services, or other administrative services),

available at

http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=1684

Recordkeeping Requirements.

The proposed rule would require the acquiring fund to maintain and preserve a written record of the adviser's finding, the basis for the finding, and the adviser's reports to the board.

156

These records must be maintained and preserved for at least five years, the first two in an easily accessible place.

157

Funds currently have compliance program-related recordkeeping procedures in place that incorporate this type of retention period, and consistency with that period would minimize any compliance burden to funds related to the preservation of the records.

158

We believe that these recordkeeping requirements would allow for external examinations of advisers' determinations without placing an undue burden on fund advisers or boards of directors.

156

Proposed rule 12d1-4(c)(1).

157

See id.

158

The retention period is consistent with the period provided in rules 22e-4 and 38a-1(d) under the Act.

b. UITs

Proposed rule 12d1-4 sets forth an alternative fee condition when the acquiring fund in a fund of funds arrangement is a UIT. Specifically, on or before the date of initial deposit of portfolio securities into a registered UIT, the UIT's principal underwriter or depositor must evaluate the complexity of the structure and the aggregate fees associated with the UIT's investment in acquired funds, and find that the fees of the UIT do not duplicate the fees of the acquired funds that the UIT holds or will hold at the date of deposit.

159

Proposed rule 12d1-4(b)(3)(ii).

The proposed condition for acquiring UITs under rule 12d1-4 differs from the condition applicable to acquiring management companies for several reasons. First, by statute, a UIT is unmanaged and its portfolio fixed.

160

Unlike a management company, a UIT does not have a board of directors, officers, or an investment adviser to render advice during the life of the trust. Accordingly, we do not propose to apply the best interest determination requirement to UITs. Second, acquiring UITs typically raise different fee concerns than management companies. A UIT, for example, does not bear investment advisory fees and the payments UITs make are limited by section 26 of the Act.

161

160

See

15 U.S.C. 80a-4(2) (defining a UIT, in part, to mean an investment company organized under a trust indenture or similar instrument that issues

redeemable securities, each of which represents an undivided interest in a unit of specified securities).

161

Section 26(a)(2)(C) of the Act requires that the trust indenture for a UIT prohibit payments to the depositor or to any affiliated person thereof, except payments for performing bookkeeping and other administrative services of a character normally performed by the trustee or custodian itself. 80 U.S.C. 80a-26(a)(2)(C). UIT ETFs have exemptive relief that allow the ETF to pay certain enumerated expenses that would be prohibited under section 26(a)(2)(C).

See

2018 ETF Proposing Release,

supra

footnote 34, at n.52 and accompanying text.

Due to the unmanaged nature of UITs and the fixed nature of their portfolios, we believe it would be inconsistent with their structure and portfolios to require UITs to re-evaluate their acquired fund finding over time. The requirement only applies, therefore, at the time of the UIT's creation. Nevertheless, this determination generally should consider taking into account the planned structure of the UIT's holdings. In particular, if the UIT tracks an index, the determination should consider the index design and whether the index design is likely to lead to the UIT holding acquired funds with duplicative fees or overly complex structures. We believe that requiring a UIT's principal underwriter or depositor to evaluate the complexity of the structure and aggregate fees associated with the UIT's investment in acquired funds, and to make a finding that the UIT's fees do not duplicate the fees of the acquired funds that the UIT holds or will hold at the date of deposit, is an appropriately calibrated means to protect investors, given a UIT's unmanaged structure.

162

See supra

section II.C.3.a. (discussing examples of factors that could be considered as part of such an evaluation).

In making this evaluation, the depositor could decide to waive fees payable to it by the UIT on account of any compensation (including any distribution fees) received by the UIT's depositor or any affiliated person from the acquired fund. Our exemptive orders have required UIT depositors to deposit only acquired funds that do not assess a sales load or that waive any sales loads.

163

We believe that fee waivers would be one way to mitigate the duplicative fee concerns, and would allow UIT depositors and affiliates to rely on processes that they may already have in place as a result of the exemptive order conditions.

163

See, e.g.,

Elkhorn Securities, LLC,

et al.,

Investment Company Act Release Nos. 31022 (Apr. 17, 2014) [79 FR 22720 (Apr. 17, 2014)] (notice) and 31043 (May 13, 2014) (order) and related application. UITs also have agreed as a condition to their exemptive orders to voluntarily comply with the FINRA sales charge rule, even though that rule does not apply to UITs.

See, e.g.,

Ausdal UIT,

et al.,

Investment Company Act Release Nos. 32922 (Dec. 14, 2017) [82 FR 60426 (Dec. 20, 2017)] (notice) and 32953 (Dec. 26, 2017) (order) and related application. As discussed above, we believe the conditions in proposed rule 12d1-4 more effectively capture concerns regarding complex structures and duplicative or excessive fees.

The proposed condition would apply only at the time of initial deposit for UITs that are formed after the proposed rule's effective date.

164

We do not believe it is necessary to exclude UITs that are already in existence from relying on proposed rule 12d1-4 as acquiring funds. UITs that serve as separate account vehicles funding variable annuity and variable life insurance contracts would be subject to additional fee conditions, as discussed below.

165

The majority of UITs fall into this category.

166

In addition, we believe that existing UIT ETFs are unlikely to rely on proposed rule 12d1-4 as acquiring funds because they replicate the components of broad-based securities indexes that do not currently include funds.

167

Even if funds were to become significant components of these indexes in the future, we believe that acquiring funds that invest in broad-based securities indexes are unlikely to raise complex structure concerns because the funds replicate the relevant index.

168

If an index were to include funds, the UIT ETF would simply acquire those funds as part of replicating the broader index. Such an arrangement also is unlikely to raise duplicative fee concerns because existing UIT ETFs do not bear advisory fees, sales loads, or other types of service fees at the UIT ETF level. Finally, UITs that do not serve as variable insurance contract separate account vehicles or that are not ETFs typically have a limited term of 12-18 months.

169

Given this short term, the number of UITs that have not made the finding required by proposed rule 12d1-4 would quickly decrease over time.

164

See

proposed rule 12d1-4(b)(3)(ii).

165

See

proposed rule 12d1-4(b)(3)(iii).

166

According to UIT annual Form N-SAR filings, as of December 2017, insurance UITs made up 673 of the total 719 registered UITs.

167

There are eight existing UIT ETFs that had total assets of approximately $374 billion as of December 31, 2017, representing 80% of UIT assets. All existing UIT ETFs seek to track the performance of a broad-based securities index by investing in the component securities of the index in the same approximate portions as the index.

168

The exemptive relief that has been granted to UIT ETFs provides that the trustee will make adjustments to the ETF's portfolio only pursuant to the specifications set forth in the trust formation documents in order to track changes in the ETF's underlying index. The trustee does not have discretion when making these portfolio adjustments.

See

2018 ETF Proposing Release,

supra

footnote 34, at nn. 46-47 and accompanying text.

169

This estimate is based on staff sampling of equity UIT prospectuses.

Recordkeeping Requirements.

The proposed rule would require an acquiring fund that is a UIT to maintain and preserve a written record of its principal underwriter's or depositor's finding under proposed rule 12d1-4(b)(3)(ii) and the basis for the finding.

170

UITs currently have compliance program-related recordkeeping procedures in place that incorporate this type of retention period, and consistency with that period would minimize any compliance burden to funds related to the preservation of the records.

171

Although the proposed retention period would differ from the period required for certain UIT findings under rule 22e-4 and the general recordkeeping requirements in rule 31a-2, we believe it is appropriate have consistent recordkeeping requirements under rule 12d1-4.

172

We also believe that these recordkeeping requirements would allow for external examinations of the principal underwriter's or depositor's determinations without placing an undue burden on those entities.

170

Proposed rule 12d1-4(c)(2). These records must be maintained and preserved for at least five years, the first two in an easily accessible place.

Id.

171

The retention period is consistent with the period provided in rule 38a-1(d) under the Act.

172

See

rule 22e-4(c) (requiring a UIT to maintain a record of the determination that the portion of the illiquid investments that the UIT holds or will hold a

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