A new Securities and Exchange Commission rule will make it easier for funds to invest in other funds.

The commission voted unanimously on Wednesday to pass a rule that will regulate fund-of-funds arrangements. It also rescinded an existing rule, 12d1-2, which required mutual funds to obtain exemptive relief if they wanted to purchase more than 3% of the shares of another '40 product. The regulator also nullified existing fund-of-fund exemptive orders came out of that rule.

The SEC's new rule will allow funds to acquire more than 3% of another fund's shares, as long as they abide by certain conditions. For example, they would be prohibited from wielding "control" over the fund they invest in, and would be unable to use their ownership to exert influence on a fund's management or policies.

In addition, if a fund holds more than 25% of an open-end fund or unit investment trust's voting securities, or more than 10% of a closed-end fund's voting securities, it must use "mirror voting." This practice requires the fund to vote its shares proportionally to the results of the overall vote. For example, if 60% of all shares vote in favor of a proposal, then the fund with a large stake in another fund would have to vote yes on 60% of its shares.

The rule will be effective 60 days after it's published in the Federal Register.

The SEC initially proposed a version of this rule in December 2018.

At the time, there were concerns that it did not limit short-term activist investors from pushing their own interests within acquired registered funds, says Rajib Chanda, a partner at Simpson Thacher & Bartlett.

The draft rule's voting conditions remained the same for all types of acquired funds. It also required acquiring funds and their advisory groups to use mirror voting when they held more than 3% of the acquired fund's voting securities.

"The 10% rule is a welcome change, but not many activists own more than 10% of a closed-end fund," Chanda says. "It's helpful because it neuters their vote a little bit."

The new rule also doesn't impose a redemption limit on acquiring funds. The proposal would have forbidden funds that attain more than 3% of another fund's shares from redeeming more than 3% of the acquired fund's shares within a 30-day period. Commenters heavily criticized this limit, the SEC noted in its final rule. Plus, they argued, it would be burdensome and give vehicles listed on exchanges an "unfair advantage."

"We are pleased that the commission removed the proposed redemption restrictions that would prevent fund managers from acting in the best interest of investors," Susan Olson, the Investment Company Institute's general counsel, writes in an e-mail.

In lieu of the limit, the SEC asks both the acquiring and acquired fund to reach an agreement before one party buys more than the permitted share cap. The requirement for a bilateral agreement avoids a one-size-fits-all, "prescriptive" rule that the proposal pushed with its suggested redemption limit, Chanda says.

The rule also asks acquiring and acquired funds to assess the risks associated with the transaction. The investment advisors of those funds must make sure that the fees are not duplicative, says Domenick Pugliese, partner at Sullivan & Worcester.

The board of the acquiring fund is not responsible for undertaking this assessment as it previously was, he notes.

This doesn't absolve the board of oversight responsibilities, but it lightens their obligations and allows them to rely on experts who are better situated to make certain determinations, says Andrew Davalla, partner at Thompson Hine.

The new rule also codifies the SEC's view on pyramiding, Pugliese notes.

The rule restricts most fund-of-fund arrangements to two tiers. Under the new rule, certain acquired funds will be permitted to invest up to 10% of their total assets in other funds, regardless of the size of the investment in any one fund. An acquired fund, for example, may use the 10% bucket for cash management or portfolio management purposes, the SEC says.

"Although we acknowledge that three-tier structures may provide efficient and cost-effective exposure to certain market segments in certain circumstances, we continue to believe that multi-tier structures can obfuscate the fund's investments, fee and related risks," the SEC notes in its final rule.

The SEC also adopted amendments to Rule 12d1-1, which limits the ability of a fund to invest substantially in securities issued by another fund. The amendment would allow funds that invest mostly in funds within the same family to continue to invest in unaffiliated money market funds. This largely reflects what was proposed, Pugliese notes.

The new rule will expand the scope of funds that are able to acquire others or be scooped up, the SEC says. It will allow open-end funds, ETFs and UITs to invest in unlisted closed-end funds and BDCs beyond current limits. In addition, closed-end funds would be permitted to look beyond ETFs to invest in open-end funds, UITs, BDCs and other closed-end funds, the regulator adds.

However, as set out in the proposal, the new rule will not permit private funds and unregistered investment companies — such as foreign funds — that want to buy large shares of other funds to rely on the rule, notes John Grady, partner at Practus. Such funds will have to use the exemptive process if they seek relief from the statute, he explains.

Overall, the SEC wanted to make the rule broad so it would cover different types of funds, since providers are constantly evolving their investment approaches, Thompson Hine's Davalla says.

The rule will also get stacks of exemptive orders off the SEC's desk, Sullivan Law's Pugliese adds. Last year, the agency passed a rule that eliminated the need for companies to receive exemptive relief when looking to launch most types of ETFs. And earlier this year, it adopted a rule amendment that would expedite exemptive relief applications that are "substantially identical to recent precedent."

"The rule will allow the commission, as well as funds and advisors seeking exemptions, to focus exemptive order review resources on novel products or arrangements," the SEC says.

Contact the reporter on this story at rrao@ignites.com or 212-390-7334.

New SEC Rule to Make It Easier for Funds to Invest in Funds

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