The Securities and Exchange Commission (the “Commission”) today is proposing for public comment new rules 12d1-1 [17 CFR 270.12d1-1], 12d1-2 [17 CFR 270.12d1-2], and 12d1-3 [17 CFR 270.12d1-3] under the Investment Company Act of 1940 [15 U.S.C. 80a] (the “Investment Company Act” or the “Act”) that address the ability of an investment company (“fund” or “acquiring fund”) registered under the Act to invest in shares of another investment company (“fund” or “acquired fund”). We also are proposing amendments to Forms N-1A [17 CFR 239.15A; 17 CFR 274.11A], N-2 [17 CFR 239.14; 17 CFR 274.11a-1], N-3 [17 CFR 239.17a; 17 CFR 274.11b], N-4 [17 CFR 239.17b; 17 CFR 274.11c], and N-6 [17 CFR 239.17c; 17 CFR 274.11d] to require that prospectuses of funds of funds disclose all of the expenses investors in the fund will bear, including those of any acquired funds. Forms N-1A and N-2 are the registration forms used by open-end management funds and closed-end management funds, respectively, to register under the Act and to offer their shares under the Securities Act of 1933 [15 U.S.C. 77a] (“Securities Act”). Form N-3 is the registration form used by separate accounts that are organized as management investment companies and offer variable annuity contracts to register under the Act and to offer their shares under the Securities Act. Forms N-4 and N-6 are the forms used by separate accounts organized as unit investment trusts (“UITs”) that offer variable annuity and variable life insurance contracts, respectively, to register under the Act and to offer their shares under the Securities Act.
Table of Contents
A. Rule 12d1-1: Investments in Money Market Funds
1. Scope of Exemption
B. Rule 12d1-2: Affiliated Funds of Funds
1. Investments in Unaffiliated Funds
2. Investments in Other Types of Issuers
3. Investments in Money Market Funds
C. Rule 12d1-3: Unaffiliated Funds of Funds
D. Amendments to Forms N-1A, N-2, N-3, N-4, and N-6
III. General Request for Comments
IV. Cost-Benefit Analysis
A. Background on Proposed Rules 12d1-1, 12d1-2, and 12d1-3
B. Proposed Amendments to Forms N-1A, N-2, N-3, N-4, and N-6
C. Request for Comments
V. Paperwork Reduction Act
A. Proposed Rule 12d1-1
B. Forms for Registration Statements
1. Form N-1A
2. Form N-2
3. Form N-3
4. Form N-4
5. Form N-6
C. Request for Comments
VI. Consideration of Promoting of Efficency, Competition, and Capital Formation
A. Proposed Rules 12d1-1, 12d1-2, and 12d1-3
B. Proposed Amendments to Forms N-1A, N-2, N-3, N-4, and N-6
C. Request for Comment
VII. Summary of Initial Regulatory Flexibility Analysis
VIII. Statutory Authority
Text of Proposed Rules and Form Amendments
Today, the federal securities laws restrict substantially the ability of a fund to invest in shares of other funds. Before the enactment of the Investment Company Act in 1940, however, a fund was free to purchase an unlimited number of shares of another fund. These “fund of funds” arrangements yielded numerous abuses, which were catalogued in the Commission's study of funds that preceded the Act (“Investment Trust Study”).2
2Investment Trusts and Investment Companies, Report of the Securities and Exchange Commission, pt. 3, ch. 7, H.R. Doc. No. 136, 77th Cong., 1st Sess. 2721-95 (1941).
Using a relatively small amount of money, individuals could acquire control of a fund and use its assets to acquire control of the assets of another fund, which, in turn, could use its assets to control a third fund.3
As a result, a few individuals effectively could control millions of dollars in shareholder assets invested in various acquired funds. These “pyramiding” schemes were used to enrich the individuals at the expense of fund shareholders in a number of ways. In some cases, controlling individuals caused the acquired funds to purchase securities in companies in which theindividuals had an interest. In other cases, these individuals caused funds to direct underwriting and brokerage business to broker-dealers they controlled—often on terms favorable to the broker-dealer. Controlling persons also profited when fund shareholders paid excessive charges due to duplicative fees at the acquiring and acquired fund levels.4
SeeInvestment Trust Study,supranote 2, pt. 3, ch. 4, at 1031-39 and 1040-41, nn. 58-59 (discussing how individuals and other investors were able to make relatively small investments and gain control of funds); ch. 7, at 2742-50.
SeeInvestment Trust Study,supranote 2, pt. 3, ch. 7, at 2725-39, 2760-75.
The complex structures that resulted from pyramiding created additional problems for shareholders. These structures permitted acquiring funds to circumvent investment restrictions and limitations, and made it impossible for shareholders to understand who really controlled the fund or the true value of their investments.5
A fund shareholder might know that he owned shares in a fund that invested in equity securities of large companies without understanding that the large companies were large funds that exposed him to substantial risks associated with smaller issuers, foreign currencies, or interest rates.6
See id.at 2776-77 (discussing examples of fund investment policy changes that conformed to management interests), 2781-82 (discussing examples of management policies that resulted in confusing or misleading asset valuations).
See id.at 2721-95.
In response to these findings in the Investment Trust Study, Congress included in the Act a provision designed to restrict fund of funds arrangements. As originally enacted, section 12(d)(1) prohibited a registered investment company (and any companies it controlled) from purchasing more than five percent of the outstanding shares of any fund that concentrated its investments in a particular industry, or more than three percent of the shares of any other type of fund.7
SeePub. L. No. 76-768, 54 Stat. 789, 809-10 § 12(d)(1) (1940) (codified at 15 U.S.C. 80a-12(d)(1) (1940)).
Section 12(d)(1) proved flawed, however, because it did not preventunregisteredinvestment companies from acquiring the securities ofregisteredfunds. In the 1960s, Fund of Funds, Ltd., an unregistered fund operated in Geneva, Switzerland, began to exploit that flaw by marketing to members of the U.S. military stationed overseas shares of foreign investment companies that had controlling interests in several registered U.S. funds.8
Fund of Funds, Ltd. engaged in many of the abusive activities identified in the Investment Trust Study. These included charging duplicative advisory fees at the acquiring and acquired fund levels, providing sales loads to an affiliated broker for each investment the acquiring fund made in an acquired fund, and directing brokerage business to an affiliate of the fund of funds (which then rebated half the commission).9
In addition, Fund of Funds, Ltd. could exert undue influence on the management of acquired funds by threatening advisers to those funds with large redemptions.10
SeeH.R. Rep. No. 1382, 91st Cong., 2d Sess., 23 (1970) (“H.R. Rep. No. 1382”); Charles Raw,et al.,Do You Sincerely Want to be Rich? 61-66 (1971). Fund of Funds, Ltd. was incorporated in Ontario, Canada.SeePublic Policy Implications of Investment Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess., 312-24 (1966) (“1966 Study”).
See Arthur Lipper Corp. et al.v.SEC,Securities Exchange Act Release No. 11773, 46 S.E.C. 78 (Oct. 24, 1975),sanction modified, 547 F.2d 171 (2d Cir. 1976).
See1966 Study,supranote 8, at 315-16.
In 1970, Congress revisited section 12(d)(1) of the Act. Among other things, it tightened the restrictions on funds of funds and extended them to unregistered funds that invest in registered funds.11
Today, funds are subject to two sets of prohibitions. First, section 12(d)(1)(A) prohibits a registered fund (and companies or funds it controls) from—
SeePub. L. No. 91-547, 84 Stat. 1413, 1417 § 7 (1970) (“1970 Amendments”) (codified at 15 U.S.C. 80a-12(d)(1)(A)).See alsoSen. Rep. No. 184, 91st Cong., 1st Sess., at 31 (1969) (“Sen. Rep. No. 184”).
• Acquiring more than three percent of a fund's voting securities;
• Investing more than five percent of its total assets in any one acquired fund; or
• Investing more than ten percent of its total assets in all acquired funds.12
See15 U.S.C. 80a-12(d)(1)(A). If the acquiring fund is not registered under the Act, the prohibitions apply only with respect to its acquisition of securities in funds that are registered under the Act.
Second, section 12(d)(1)(B) prohibits a registered open-end fund from selling securities to any fund (including unregistered funds) if, after the sale, the acquiring fund would—
• Together with companies and funds it controls, own more than three percent of the acquired fund's voting securities; or
• Together with other funds (and companies they control) own more than ten percent of the acquired fund's voting securities.13
See15 U.S.C. 80a-12(d)(1)(B).
By limiting thesaleof registered fund shares to other funds, section 12(d)(1)(B) prevents the creation of a fund of registered funds regardless of the limitations of U.S. law to regulate the activities of foreign funds, such as Fund of Funds, Ltd. Together, these two provisions of section 12(d)(1) have proven quite effective in putting a stop to the abusive practices that characterized previous fund of funds arrangements.
Congress recognized that these restrictions would have the effect of preventing legitimate fund of funds arrangements and has, over the years, created three exceptions under which different types of fund of funds arrangements are permitted today:
Conduit Arrangements.The Act permits arrangements under which a registered fund investsallof its assets in shares of one other fund so that the acquiring fund is, in effect, a conduit through which investors may access the acquired fund.14
The exception currently provided in section 12(d)(1)(E) was originally designed to preserve the arrangements under which periodic payment plan certificates were issued.15
Today, this section is relied upon by most insurance company separate accounts, which are organized as UITs,16
and invest the proceeds from the sale of interests in variable annuity and variable life insurance contracts in shares of a mutual fund.17
This exemption also is used by “master-feeder funds”—arrangements in which two or more funds with identical investment objectives pool their assets by investing in a single fund with the same investment objective. Investors purchase securities in the “feeder”fund, which is an open-end fund and a conduit to the “master” fund.18
See15 U.S.C. 80a-12(d)(1)(E).
15The exception for periodic payment plan arrangements originally was set forth in section 12(d)(1)(B). Section 12(d)(1)(E) was added by the 1970 Amendments.SeeS. Rep. No. 184,supranote 11, at 31; 1970 Amendments,supranote 11, § 7 (codified at 15 U.S.C. 80a-12(d)(1)(E)). Section 12(d)(1)(E) permits a fund's acquisition of securities issued by another fund provided that (i) the acquiring fund's depositor or principal underwriter is a broker or dealer registered under the Securities Exchange Act of 1934, (or a person the broker-dealer controls), (ii) the security is the only investment security the acquiring fund holds (or the securities are the only investment securities the acquiring fund holds if it is a registered UIT that issues two or more classes or series of securities, each of which provides for the accumulation of shares of a different fund), and (iii) the acquiring fund is obligated (a) to seek instructions from its shareholders with regard to voting the acquired fund's securities or to vote the acquired fund's shares in the same proportion as the vote of all other acquired fund shareholders, and (b) if unregistered, to obtain Commission approval before substituting the investment security.
16The Act defines a “unit investment trust” as a fund that (i) is organized under a trust indenture, contract of custodianship or agency, or similar instrument, (ii) does not have a board of directors, and (iii) issues only redeemable securities, each of which represents an undivided interest in a unit of specified securities, but does not include a voting trust. 15 U.S.C. 80a-4(2).
SeeSecurities and Exchange Commission, Protecting Investors: A Half Century of Investment Company Regulation 373-74 (1992) (“1992 Study”); Request for Comments on Issues Arising Under the Investment Company Act of 1940 Relating to Flexible Premium Variable Life Insurance, Investment Company Act Release No. 13632 (Nov. 23, 1983) [48 FR 54043 (Nov. 30, 1983)].
SeeH.R. Rep. No. 622, 104th Cong., 2d Sess., at 41 (1996) (“H.R. Rep. No. 622”); Exemption for Open-End Management Investment Companies Issuing Multiple Classes of Shares; Disclosure by Multiple Class and Master Feeder Funds; Voting on Distribution Plans; Final Rules and Proposed Rule, Investment Company Act Release No. 20915 (Feb. 23, 1995) [60 FR 11876, 11876-77 (Mar. 2, 1995)]; Division of Investment Management, Securities and Exchange Commission, Hub and Spoke Funds: A Report Prepared by the Division of Investment Management, submitted with letter to the Honorable John D. Dingell, Chairman, Committee on Energy and Commerce, U.S. House of Representatives from Richard C. Breeden, Chairman, Securities and Exchange Commission (Apr. 15, 1992),available inLEXIS, Fedsec library, Noact File.
Unaffiliated Fund of Funds Arrangements.The Act also permits a registered fund to take small positions in an unlimited number of other funds (an “unaffiliated fund of funds”).19
A fund taking advantage of the exception provided in section 12(d)(1)(F) of the Act (and its affiliated persons) may acquire no more than three percent of another fund's securities;20
cannot charge a sales load greater than 11/2percent;21
is restricted in its ability to redeem shares of the acquired fund;22
and is unable to use its voting power to influence the outcome of shareholder votes held by the acquired fund.23
The exception was designed to give limited relief to fund of funds arrangements in existence in 1970 when section 12(d)(1) was amended, subject to restrictions designed to prevent abuses.24
See15 U.S.C. 80a-12(d)(1)(F).
20A registered fund relying on section 12(d)(1)(F) may acquire securities issued by another fund if, immediately after acquiring the securities, not more than three percent of the total outstanding stock of the acquired fund is owned by the acquiring fund and all its affiliates.See15 U.S.C. 80a-12(d)(1)(F)(i). Section 12(d)(1)(F) does not limit acquiring fund investments in securities other than those issued by other funds.
21A fund relying on section 12(d)(1)(F) may not offer or sell (or propose to offer or sell through a principal underwriter) a security it issues at a public offering price that includes a sales load of more than 11/2percent.See15 U.S.C. 80a-12(d)(1)(F)(ii).
22A fund whose shares are acquired pursuant to section 12(d)(1)(F) is not obligated to redeem more than 1 percent of those securities during any period of less than 30 days. 15 U.S.C. 80a-12(d)(1)(F).
23Section 12(d)(1)(F), by reference to section 12(d)(1)(E), requires the acquiring fund to vote shares of an acquired fund either by seeking instructions from the acquiring fund's shareholders, or to vote the shares in the same proportion as the vote of all other shareholders of the acquired fund.Id.
SeeH.R. Rep. No. 1382,supranote 8, at 11.
Affiliated Fund of Funds Arrangements.The Act also permits a fund to invest in one or more funds in the same fund complex. Enacted as part of the National Securities Markets Improvement Act of 1996 (“NSMIA”),25
section 12(d)(1)(G) permits a registered open-end fund or UIT to acquire an unlimited amount of shares of other registered open-end funds and UITs that are part of the same “group of investment companies.”26
A fund taking advantage of this exception (an “affiliated fund of funds”) is restricted in the types of other securities it can hold in addition to shares of registered funds in the same group of investment companies.27
The acquired funds must have a policy against investing in shares of other funds in reliance on section 12(d)(1)(F) or 12(d)(1)(G) (to prevent multi-tiered structures),28
and overall distribution expenses are limited (to prevent excessive sales loads).29
Under this provision, which codified Commission exemptive orders,30
several large fund complexes offer a fund of funds, which allocates and periodically reallocates its assets among funds in the complex.31
25Pub. L. No. 104-290, 110 Stat. 3416 (1996).
See15 U.S.C. 12(d)(1)(G). For purposes of the exception, the term “group of investment companies” means “any 2 or more registered investment companies 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).
27In addition to investing in securities of registered funds in the same group of investment companies, the Act permits these funds to invest only in government securities and short-term paper.See15 U.S.C. 80a-12(d)(1)(G)(i)(II).
See15 U.S.C. 80a-12(d)(1)(G)(i)(IV).
See15 U.S.C. 80a-12(d)(1)(G)(i)(III). The provision permits a fund to invest in shares of another fund only if either (i) the acquiring fund does not charge a sales load or distribution-related fee or does not pay (and is not assessed) sales loads or distribution-related fees on securities of the acquired fund, or (ii) the aggregate distribution-related fees (or loads) charged by the acquiring fund on its securities and paid by the acquiring fund on acquired fund securities are not excessive under rules adopted under section 22(b) [15 U.S.C. 80a-22(b)] or 22(c) [15 U.S.C. 80a-22(c)] by a securities association registered under section 15A of the Securities Exchange Act of 1934 (the “Exchange Act”) [15 U.S.C. 78o-3] or the Commission. The NASD has adopted limits on sales loads and distribution-related fees applicable to funds as well as to funds of funds.SeeNASD Rule 2830(d)(2), (3) (“NASD Sales Charge Rule”).
Under the NASD Sales Charge Rule for funds of funds, if neither the acquiring nor acquired fund has an asset-based sales charge (12b-1 fee), the maximum front-end and deferred sales charge that can be charged by the acquiring fund, the acquired fund, and both in combination cannot exceed 8.5 percent of the offering price of the shares.SeeNASD Sales Charge Rule 2830(d)(3)(A). Any acquiring or acquired fund that has an asset-based sales charge must individually comply with the sales charge limitations on funds with an asset-based sales charge, provided, among other conditions, that if both funds have an asset-based sales charge, the maximum aggregate asset-based sales charge cannot exceed .75 of 1 percent per year of the average annual net assets of the fund; and the maximum aggregate sales load may not exceed 7.25 percent of the amount invested, or 6.25 percent if either fund pays a service fee.SeeNASD Sales Charge Rule 2830(d)(2)(A), (B).
SeeVanguard STAR Fund, Investment Company Act Release No. 21372 (Sept. 22, 1995) [60 FR 50656 (Sept. 29, 1995)] (notice), Investment Company Act Release No. 21426 (Oct. 18, 1995) (order) (revising conditions on the 1985 Vanguard Order); T. Rowe Price Spectrum Fund, Investment Company Act Release No. 21371 (Sept. 22, 1995) [60 FR 50654 (Sept. 29, 1995)] (notice), Investment Company Act Release No. 21425 (Oct. 18, 1995) (order) (revising conditions on the 1989 T. Rowe Price Order); T. Rowe Price Spectrum Fund, Investment Company Act Release No. 17198 (Oct. 31, 1989) [54 FR 47010 (Nov. 8, 1989)] (notice), Investment Company Act Release No. 17242 (Nov. 29, 1989) (order) (“1989 T. Rowe Price Order”); Vanguard Special Tax-Advanced Retirement Fund, Investment Company Act Release No. 14153 (Sept. 12, 1984) [49 FR 36582 (Sept. 18, 1984)] (notice), Investment Company Act Release No. 14361 (Feb. 7, 1985) (order) (“1985 Vanguard Order”).
See, e.g.,T. Rowe Price, Retirement Funds, Prospectus 1-4 (Mar. 14, 2003).
Since 1940 we have provided limited relief for funds to acquire shares of other funds when the proposed arrangements did not present the risk of abuses that section 12(d)(1) was designed to prevent. We issued those orders under our general exemptive authority in section 6(c) of the Act.32
In 1996, when Congress added section 12(d)(1)(G), it gave us specific authority 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.33
The House Report accompanying NSMIA urged the Commission to use the additional exemptive authority under section 12(d)(1)(J) “in a progressive way as the fund of funds concept continues to evolve over time.”34
3215 U.S.C. 80a-6(c). Section 6(c) provides that “[t]he Commission, by rules and regulations upon its own motion, or by order upon application, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this title or of any rule or regulation thereunder, if and to the extent that 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 this title.”
SeeNSMIA,supranote 25, § 202 (codified at 15 U.S.C. 80a-12(d)(1)(J)). Congress added section 12(d)(1)(J) to resolve questions regarding the scope of our authority under section 6(c).See1985 Vanguard Order,supranote 30, dissenting opinion of Commissioners Treadway and Peters (concluding that applicants failed to establish an adequate record on which Commission could find exemption from section 12(d)(1)(A) to meet the standards of section 6(c) of the Act).
34H.R. Rep. No. 622,supranote 18, at 44-45. The House Report explained that, in exercising its exemptive 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 Act's restrictions against funds investing in other funds.See id.at 45.
Today we are proposing three new rules. Two of these provide exemptionsin addition to the statutory exceptions to the fund of funds limits. The third provides an exemption from a statutory condition for a fund of funds arrangement. These rules would codify and expand upon a number of exemptive orders we have issued that permit funds to invest in other funds. We also are proposing amendments to Forms N-1A, N-2, N-3, N-4, and N-6 that will require funds of funds to disclose in their prospectuses the expenses of acquired funds, which investors in a fund of funds will bear indirectly.
A. Rule 12d1-1: Investments in Money Market Funds
We are proposing a new rule that would permit funds to invest in shares of money market funds. Rule 12d1-1 would permit “cash sweep” arrangements in which a fund invests all or a portion of its available cash in a money market fund rather than directly in short-term instruments.35
Since 1982, we have issued more than 80 exemptive orders permitting these types of arrangements.36
Funds have represented that use of a money market fund may be expected to achieve greater efficiencies, reduce fund management expenses, and increase returns.37
Moreover, use of a money market fund may permit fund portfolio managers to focus on the management of the principal investments of the fund.
35A fund may have uninvested cash from new purchases of shares by investors, receipt of dividends and interest from portfolio investments, and matured investments, as well as cash collateral from securities lending activities. The proposed rule would permit a fund to invest in one or more money market funds.
See, e.g.,Diamond Hill Funds, Investment Company Act Release No. 26058 (May 28, 2003) [68 FR 33213 (June 3, 2003)] (notice), Investment Company Act Release No. 26079 (June 24, 2003) (order); SEI Index Funds, Investment Company Act Release No. 26008 (Apr. 22, 2003) [68 FR 22423 (Apr. 28, 2003)] (notice), Investment Company Act Release No. 26048 (May 19, 2003) (order). These orders contain a number of conditions, including: (i) Shares of the acquired money market fund will not be subject to sales loads, distribution-related fees, or service fees, or if they are, the acquiring fund's adviser will waive its advisory fee in an amount to offset the amount of fees incurred by the acquiring fund; (ii) before approving any advisory contract for the acquiring fund, its board of directors, including a majority of directors who are not interested persons under section 2(a)(19) of the Act [15 U.S.C. 80a-2(a)(19)] (“independent directors”), will consider the extent to which (if any) the advisory fees charged by the adviser should be reduced to account for reduced services as a result of investing cash in the money market fund; (iii) the acquiring fund's investment in money market funds will be limited to 25 percent of the acquiring fund's total assets; (iv) the acquiring fund's investment in the money market fund is consistent with the acquiring fund's policies as set forth in its registration statement; (v) the acquiring fund and money market fund are advised by the same adviser (or are part of the same group of investment companies); and (vi) the acquired money market fund will not acquire securities in another fund in excess of the limits of section 12(d)(1)(A) of the Act.