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Daily Rules, Proposed Rules, and Notices of the Federal Government

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 239, 274, and 275

[Release Nos. 33-8297; IC-26198; File No. S7-18-03]

RIN 3235-AI30

Fund of Funds Investments

AGENCY: Securities and Exchange Commission.
ACTION: Proposed rules.
SUMMARY: The Commission is proposing three new rules under the Investment Company Act of 1940 that address the ability of an investment company to acquire shares of another investment company. Section 12(d)(1) of the Act prohibits, subject to certain exceptions, so-called "fund of funds" arrangements, in which one investment company invests in the shares of another. The proposed rules would broaden the ability of an investment company to invest in shares of another investment company consistent with the protection of investors and the purposes of the Act. The Commission also is proposing amendments to forms used by investment companies to register under the Investment Company Act and offer their shares under the Securities Act of 1933. The proposed amendments would improve the transparency of the expenses of funds of funds by requiring that the expenses of the acquired funds be aggregated and shown as an additional expense in the fee table of the fund of funds.
DATES: Comments must be received by December 3, 2003.
ADDRESSES: To help us process and review your comments more efficiently, comments should be sent by hard copy or e-mail, but not by both methods. Comments sent by hard copy should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 5th Street, NW., Washington, DC 20549-0609. Comments also may be submitted electronically to the following E-mail address:rule-comments@sec.gov.All comment letters should refer to File No. S7-18-03; this file number should be included on the subject line if E-mail is used. Comment letters will be available for public inspection and copying in the Commission's Public Reference Room, 450 5th Street, NW., Washington, DC 20549. Electronically submitted comment letters will be posted on the Commission's Internet Web site (http://www.sec.gov).1

1We do not edit personal, identifying information, such as names or E-mail addresses, from electronic submissions. Submit only information you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Penelope W. Saltzman, Senior Counsel, or C. Hunter Jones, Assistant Director, Office of Regulatory Policy, (202) 942-0690, Division of Investment Management, Securities and Exchange Commission, 450 5th Street, NW., Washington, DC 20549-0506.
SUPPLEMENTARY INFORMATION:

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 I. Background II. Discussion A. Rule 12d1-1: Investments in Money Market Funds 1. Scope of Exemption 2. Conditions 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 1. Benefits 2. Costs B. Proposed Amendments to Forms N-1A, N-2, N-3, N-4, and N-6 1. Benefits 2. Costs 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 I. Background

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

3 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.

4 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

5 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).

6 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

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

8 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”).

9 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).

10 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—

11 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

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

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

14 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).

17 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)].

18 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

19 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.

24 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).

26 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).

28 See15 U.S.C. 80a-12(d)(1)(G)(i)(IV).

29 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).

30 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”).

31 See, e.g.,T. Rowe Price, Retirement Funds, Prospectus 1-4 (Mar. 14, 2003).

II. Discussion

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.”

33 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.

36 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.

37 See, e.g.,Pioneer America Income Trust, First Amended and Restated Application pursuant to Section 12(d)(1)(J) of the Investment Company Act of 1940, section IV (filed June 4, 2002) (“Pioneer Application”); Bear Stearns Funds,et al.,Amended Application for an Order under Section 12(d)(1)(J) of the Investment Company Act of 1940, section III.C (filed Jan. 8, 1999).

Fund investments in money market funds, which did not exist in 1940, do not appear to raise the concerns that underlie section 12(d)(1). Money market funds are designed to accommodate significant daily inflows and outflows of cash and therefore their management seems unlikely to be influenced by investors who could threaten large redemptions.38 There is little value to obtaining a control position in a money market fund, and money market funds do not control valuable brokerage commissions that can be directed to affiliates.39 A fund's investment in shares of a money market fund does, however, present the opportunity for layering of advisory fees and distribution expenses, which we propose to address as discussed in section II.D below.

38 SeeRevisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 21837 (Mar. 21, 1996) [61 FR 13956, 13957 (Mar. 28, 1996)] (among money market fund objectives is preservation of capital and liquidity); Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 17589 at text preceding n.7 (July 17, 1990) [55 FR 30239 (July 25, 1990)] (many investors use money market accounts as alternatives to checking accounts).

39We note that in the context of rule 2a-7, the Commission has permitted an exception that allows money market funds to invest in other money market funds in excess of the diversification requirements for other issuers provided the board of directors of the acquiring fund reasonably believes that the acquired fund is in compliance with rule 2a-7.See17 CFR 270.2a-7(c)(4)(ii)(E). Under rule 2a-7, shares of money market funds are considered first-tier securities that without the exception would be subject to the rule's issuer diversification standards for first-tier securities.See17 CFR 270.2a-7(a)(12).

1. Scope of Exemption

(a)Affiliated Money Market Funds.Funds that intend to invest in money market funds in the same fund complex (“affiliated money market funds”) also need exemptions from sections 17(a)40 and 17(d) of the Act, and rule 17d-1 thereunder,41 which restrict transactions and joint arrangements with affiliated persons. In addition, a fund that acquires more than five percent of the securities of a money market fund in another fund complex would become an affiliated person of the money market fund, and would need relief from these section 17 prohibitions before making any additional investments in the money market fund.42 Proposed rule 12d1-1 would provide this relief. An acquiring fund's purchase and redemption ofmoney market fund shares at the net asset value would seem to provide little opportunity for insider self-dealing or overreaching, and thus an exemption from these provisions appears to be appropriate. We seek comment on this proposal. Does an acquiring fund's investment in an affiliated money market fund create other opportunities for self-dealing or overreaching?

40Section 17(a)(1) prohibits an affiliated person of a registered fund, a promoter or principal underwriter for a registered fund, or an affiliated person of the foregoing, acting as principal, from selling securities or other property to the fund, unless (A) the buyer is the issuer of the securities, (B) the seller is the issuer of the securities and the securities are part of a general offering to the holders of a class of the seller's securities, or (C) a depositor has deposited the securities with the trust of a UIT or periodic payment plan. 15 U.S.C. 80a-17(a)(1). Section 17(a)(2) prohibits an affiliated person from knowingly buying from a registered fund (or companies it controls) any security or other property unless the seller is the issuer of the securities. 15 U.S.C. 80a-17(a)(2). Affiliated persons of a fund include any person directly or indirectly controlling, controlled by, or under common control with the fund.See15 U.S.C. 80a-2(a)(3)(C) (definition of “affiliated person”). Most funds today are organized by an investment adviser that advises or provides administrative services to a number of other funds in the same fund complex. Funds in a fund complex are under the common control of an investment adviser or other person when the adviser or other person exercises a controlling influence over the management or policies of the funds.See15 U.S.C. 80a-2(a)(9). Not all advisers control funds they advise. The determination of whether a fund is under the control of its adviser, officers, or directors depends on all the relevant facts and circumstances.SeeInvestment Company Mergers, Investment Company Act Release No. 25259, n.14 (Nov. 8, 2001) [66 FR 57602 (Nov. 15, 2001)]. For purposes of this release, we presume that funds in a fund complex are under common control because funds that are not affiliated persons would not require, and thus not rely on, the proposed exemptions from section 17(a) and rule 17d-1.

41Section 17(d) of the Act makes it unlawful for an affiliated person of a registered fund (“first-tier affiliate”), an affiliated person of an affiliated person of a registered fund (“second-tier affiliate”), the fund's principal underwriters, or affiliated persons of the fund's principal underwriters, acting as principal, to effect any transaction in which the fund, or a company it controls, is a joint or a joint and several participant “in contravention of such rules and regulations as the Commission may prescribe for the purpose of limiting or preventing participation by such registered or controlled company on a basis different from or less advantageous than that of such other participant.” 15 U.S.C. 80a-17(d). Rule 17d-1(a) prohibits first- and second-tier affiliates of a registered fund, the fund's principal underwriter, and affiliated persons of the fund's principal underwriter, acting as principal, from participating in or effecting any transaction in connection with any joint enterprise or other joint arrangement or profit-sharing plan in which the fund (or company it controls) is a participant “unless an application regarding such joint enterprise, arrangement or profit-sharing plan has been filed with the Commission and has been granted by an order * * *.” 17 CFR 270.17d-1. When an acquiring fund purchases securities from an affiliated money market fund on the advice of an adviser who also manages the money market fund, the arrangement and transactions could be deemed to be a joint enterprise in which the two funds and the adviser are joint participants.

42An affiliated person of a fund includes: (i) Any person directly or indirectly owning, controlling, or holding with power to vote, five percent or more of the outstanding voting securities of the fund; and (ii) any person five percent or more of whose assets or securities are directly or indirectly owned, controlled, or held with power to vote by the fund.See15 U.S.C. 80a-2(a)(3)(A), (B) (definition of “affiliated person”).

(b) Unaffiliated Money Market Funds.Although our exemptive orders have permitted funds to invest their cash only in money market funds advised by the same adviser, we are proposing to expand that relief to funds that do not share the same adviser.43 As a result, funds would be able to invest cash in money market funds that are members of other fund complexes. The exemption would permit funds in smaller complexes that do not have a money market fund to engage in a cash sweep arrangement.44 Because of the nature of money market funds, which we discussed above, we do not believe that investments in money market funds that do not share the same adviser would create any greater risks than investments in money market funds with a common adviser.

43Some applicants have sought, and we have granted, broader exemptive relief permitting funds to invest in funds that are not part of the same group of investment companies in excess of the limitations of section 12(d)(1).See infranotes 73, 75. Under those orders, funds in which the applicants could invest include money market funds.

44 SeeH.R. Rep. No. 622,supranote 18, at 43 (“The Committee intends the rulemaking and exemptive authority in new Section 12(d)(1)(J) to be used by the Commission so that 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.”).

If a fund acquires more than five percent of a money market fund's securities, the two funds would become affiliated persons of each other.45 As a result, principal transactions other than purchases and redemptions of fund shares would not be exempt under the proposed rule, and thus the two funds would be precluded from entering into certain types of transactions with each other.46 Moreover, the acquiring fund would be restricted with respect to the purchase or sale of securities through a broker-dealer affiliated with the money market fund.47 We seek comment on whether funds would be likely to invest cash in money market funds in other fund complexes? If so, would additional exemptive relief under the proposed rule be appropriate?48

45 See15 U.S.C. 80a-2(a)(3)(A), (B).

46 Seediscussion above in section II.A.1(a). We note that rule 17a-7 provides an exemption for purchase and sale transactions between registered funds (or series of registered funds) that are affiliated and that meet certain conditions regardless of the nature of the funds' affiliation. 17 CFR 270.17a-7.

47Section 17(e) of the Act prohibits a first or second-tier affiliate of a registered fund that acts as broker, in connection with the sale of securities to or by the fund, from receiving from any source a commission, fee, or other remuneration for effecting the transaction that exceeds specified limits.See15 U.S.C. 80a-17(e)(2).

48We have provided relief for transactions between a fund and another entity that are affiliated as a result of the fund's investments in a money market fund that is affiliated with the other entity.See, e.g.,Credit Suisse Asset Management, LLC, Investment Company Act Release No. 25789 (Oct. 29, 2002) [67 FR 67220 (Nov. 4, 2002)] (notice), Investment Company Act Release No. 25832 (Nov. 22, 2002) (order) (“Credit Suisse Notice and Order”). This relief generally has been provided in connection with applications regarding securities lending programs. We are considering separate rulemaking in this area that would address those issues.

(c) Unregistered Money Market Funds.Proposed rule 12d1-1 also would codify our exemptive orders that permit funds to invest in money market funds that are not registered investment companies (“unregistered money market funds”).49 Unregistered money market funds are typically organized by a fund adviser for the purposes of managing the cash of other funds in a fund complex and operate in almost all respects as a registered money market fund, except that their securities are privately offered and thus not registered under the Securities Act of 1933.50 Although a fund's investments in unregistered money market funds is no longer restricted by section 12(d)(1),51 these investments are subject to the affiliate transaction restrictions in the Act and rules thereunder and thus require exemptions from sections 17(a) and 17(d), and rule 17d-1.52

49 See, e.g.,Pioneer America Income Trust, Investment Company Act Release No. 25607 (June 7, 2002) [67 FR 40757 (June 13, 2002)] (notice), Investment Company Act Release No. 25647 (July 3, 2002) (order) (“Pioneer Notice and Order”); Bear Stearns Funds et al., Investment Company Act Release No. 25467 (Mar. 20, 2002) [67 FR 13809 (Mar. 26, 2002)] (notice), Investment Company Act Release No. 25527 (Apr. 16, 2002) (order); GE Funds, et al., Investment Company Act Release No. 22187 (Aug. 29, 1996) [61 FR 46876 (Sept. 5, 1996)] (notice), Investment Company Act Release No. 22247 (Sept. 25, 1996) (order). The exemptive relief provided in these orders includes conditions requiring that: (i) The unregistered money market fund comply with rule 2a-7; (ii) the investment adviser to the unregistered money market fund (or the fund with approval of its board of directors) adopt and monitor the procedures described in rule 2a-7 and take any other actions required to be taken under the procedures; (iii) an acquiring fund purchase shares of an unregistered money market fund only if the unregistered money market fund's adviser determines on an ongoing basis that the unregistered money market fund is in compliance with rule 2a-7 and preserves for a period not less than six years from the date of determination, the first two years in an easily accessible place, a record of the determination and the basis on which it was made, and the record is subject to examination by Commission staff; (iv) the unregistered money market fund comply with the requirements of sections 17(a), (d), and (e), 18, and 22(e) of the Act as if it were a registered open-end fund; (v) the investment adviser to the unregistered money market fund adopt procedures designed to ensure that the fund complies with those provisions of the Act, periodically reviews and updates as appropriate the procedures, and maintains books and records describing the procedures; (vi) the investment adviser to the unregistered money market fund maintains the records required by rules 31(a)-1(b)(1), 31a-1(b)(ii)(2), and 31a-1(b)(9) under the Act for a period of not less than six years from the end of the fiscal year in which any transaction occurred, the first two years in an easily accessible place and subject to examination by Commission staff; (vii) the net asset value per share with respect to unregistered money market fund shares is determined by dividing the value of the assets belonging to the fund, less the liabilities of the fund, by the number of outstanding shares of the fund; (viii) the acquiring fund purchase and redeem shares of the unregistered money market fund as of the same time and at the same price, and receive dividends and bear its proportionate share of expenses on the same basis, as other shareholders of the unregistered money market fund; and (ix) a separate account is established in the shareholder records of the unregistered money market fund for the account of the acquiring fund. These orders provide exemptions for funds with the same adviser as the unregistered money market funds. The proposed rule would permit funds to invest in unregistered money market funds with the same or a different adviser.

50 See, e.g.,Pioneer Application,supranote 37, conditions 78. See also15 U.S.C. 80a-3(c)(1) (excepting from the definition of “investment company” issuers whose securities are owned by no more than 100 persons and which is not making and does not presently propose to make a public offering of its securities); 15 U.S.C. 80a-3(c)(7) (excepting from the definition of “investment company” issuers whose securities are owned exclusively by “qualified purchasers” and which is not making and does not presently propose to make a public offering of its securities).

51Before 1996, a fund that was excepted from the definition of “investment company” by section 3(c)(1) of the Act (because its shares were held by fewer than 100 beneficial owners and was not making and did not propose to make a public offering of its securities) was nonetheless deemed to be an “investment company” for purposes of section 12(d)(1). In 1996, Congress narrowed this provision of section 3(c)(1) to make section 12(d)(1) limitations inapplicable to an investment by a registered fund in shares of a fund that is not registered with us in reliance on section 3(c)(1).SeeNSMIA,supranote 25 § 209(a). A parallel provision was incorporated into section 3(c)(7), which excepts from the definition of “investment company” funds whose outstanding securities are owned exclusively by “qualified purchasers” and that is not making and does not propose to make a public offering of its securities.Seesection 3(c)(7)(D) [15 U.S.C 80a-3(c)(7)(D)].See also1992 Study,supranote 17, at 105-110.

52 Seediscussion above in section II.A.1(a) of this Release.

Under the proposed rule, the exemption would be available only for investments in an unregistered money market fund that operates like a money market fund registered under the Act.53 To be eligible, an unregistered money market fund would be required to (i) limit its investments to those in which a money market fund may invest underrule 2a-7 under the Act,54 and (ii) undertake to comply with all the other provisions of rule 2a-7.55 In addition, the acquiring fund would have to reasonably believe that the unregistered money market fund operates like a registered money market fund and that it complies with certain provisions of the Act.56 Finally, the unregistered money market fund's adviser would be required to register as an investment adviser with the Commission.57 This final requirement would allow the Commission to examine the activities of the unregistered money market fund to ensure that it is meeting the requirements of the rule.

53Proposed rule 12d1-1(c)(3)(ii).

54Proposed rule 12d1-1(c)(3)(ii)(A).

55Proposed rule 12d1-1(c)(3)(ii)(B).

56Proposed rule 12d1-1(b)(2)(i)(A), (B). The acquiring fund would be required to reasonably believe that the unregistered money market fund (i) operates in compliance with rule 2a-7, (ii) complies, as if it were a registered open-end fund, with provisions of the Act that limit affiliate transactions (sections 17(a), (d), and (e)), issuance of senior securities (section 18), and suspension of redemption rights (section 22(e)), (iii) has adopted, and periodically reviews, procedures designed to ensure compliance with these requirements, and maintains books and records describing the procedures, and (iv) maintains and preserves the books and records required under rules 31a-1(b)(1) [17 CFR 31a-1(b)(1)], 31a-1(b)(2)(ii) [17 CFR 31a-1(b)(2)(ii)], 31a-1(b)(2)(iv) [17 CFR 31a-1(b)(2)(iv)], and 31a-1(b)(9) [17 CFR 31a-1(b)(9)]. Proposed rule 12d1-1(b)(2)(i). The proposed rule would require that the acquiring fund “reasonably believe” that, among other things, the acquired money market fund complies with rule 2a-7 in order to avoid the acquiring fund's loss of the exemption as the result of a minor or inadvertent violation of rule 2a-7 by the acquired money market fund.

57Proposed rule 12d1-1(b)(2)(ii). If an unregistered money market fund does not have a board of directors (because, for example, it is organized as a limited partnership), the proposed rule also would require the fund's investment adviser to perform the duties required of a money market fund's board of directors under rule 2a-7. Proposed rule 12d1-1(c)(3)(ii)(B).

(d) Closed-End Funds of Funds.The restrictions of section 12(d)(1) on a fund of funds also apply to closed-end funds and business development companies,58 which are closed-end funds that are exempted from registration under the Act.59 We have issued several exemptive orders to closed-end funds, subject to similar conditions as open-end funds.60 Today, we propose to make the new rule available to both types of funds so that either can invest available cash in a money market fund.61 Would business development companies benefit from this exemption? Are there reasons not to extend the exemption to business development companies?

58A business development company is any closed-end company that: (i) Is organized under the laws of, and has its principal place 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 [15 U.S.C. 80a-54(a)(1)-(3)] 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 business development companies under the Act.See15 U.S.C. 80a-2(a)(48). Section 60 of the Act [15 U.S.C. 80a-59] extends the limits of section 12(d) to a business development company to the same extent as if it were a registered closed-end fund.

59Section 6(f) of the Act [15 U.S.C. 80a-6(f)] exempts business development companies that have made the election under section 54 [15 U.S.C. 80a-53] from registration and other provisions of the Act.

60 See, e.g.,Pioneer Notice and Order,supranote 49; Credit Suisse Notice and Order,supranote 48.

61The amount of assets a business development company could invest in a money market fund may be limited by Section 55 of the Act [15 U.S.C. 80a-54].

(e) Unregistered Funds of Funds.Unregistered funds also are subject to the section 12(d)(1) restrictions on the acquisition of shares of registered funds.62 The proposed rule would permit unregistered funds to invest their cash in shares of a registered money market fund.63 Thus, a hedge fund could sweep its cash into a registered money market fund pending investment or distribution of the cash to investors. We request comment on whether any special concerns arise with respect to unregistered funds' use of registered money market funds in cash sweep arrangements.

62 See15 U.S.C. 12(d)(1)(A); 15 U.S.C. 12(d)(1)(B). In the case of unregistered investment companies (such as a foreign fund or business development company) the full restrictions of sections 12(d)(1)(A) and (B) apply. Companies that are unregistered because they are excepted from the definition of investment company under sections 3(c)(1) and 3(c)(7) of the Act are prohibited from acquiring more than three percent of a registered fund. Both section 3(c)(1) and section 3(c)(7) deem issuers that rely on these sections to be investment companies for the purposes of sections 12(d)(1)(A)(i) and 12(d)(1)(B)(i) with respect to their acquisition of registered funds. As a result, these companies cannot acquire more than three percent of the shares of a registered fund.See15 U.S.C. 80a-3(c)(1); 15 U.S.C. 80a-3(c)(7)(D).

63Proposed rule 12d1-1(a).

2. Conditions

We propose to eliminate most of the conditions included in the exemptive orders provided to cash sweep arrangements.64 We would not, for example, preclude a fund from investing more than 25 percent of its assets in shares of money market funds and would, instead, rely on a fund's own investment restrictions to provide appropriate limitations. We also would not require directors to make any special findings that investors are not paying multiple advisory fees for the same services. A fund could pay duplicative fees if an adviser invests a fund's cash in a money market fund (which itself pays an advisory fee) without reducing its advisory fee by an amount it was compensated to manage the cash.65 Fund directors have fiduciary duties,66 which obligate them to protect funds from being overcharged for services provided to the fund, regardless of any special findings we might require.67 Moreover, and as we describe in more detail below, we would require a registered fund of funds to disclose to shareholders expenses paid by both the acquiring and acquired funds so that shareholders may better evaluate the costs of investing in a fund with a cash sweep arrangement.68

64 See supranote 36.

65Our earlier orders required the acquiring fund's adviser to waive that portion of the advisory fee attributable to the management service that would be performed by the adviser to the acquired fund.See, e.g.,The Brinson Funds, Investment Company Act Release No. 21814 (Feb. 12, 1996) [61 FR 6398, 6399 (Feb. 20, 1996)] (notice), Investment Company Act. Release No. 21741 (Mar. 11, 1996) (order); Janus Investment Fund, Investment Company Act Release No. 21042 (May 4, 1995) [60 F.R. 24955, (May 10, 1995)] (notice), Investment Company Act Release No. 21103 (May 31, 1995) (order).

66 See15 U.S.C. 80a-35(a).See generally,2 Tamar Frankel, The Regulation of Money Managers, § 9.05 (2001). Section 15(c) of the Act requires the board of directors to evaluate the terms (which would include fees, or the elimination of fees, for services provided by an acquired fund's adviser) of any advisory contract.See15 U.S.C. 80a-15(c). Moreover, we believe that, section 36(b) [15 U.S.C. 80a-35(b)], which imposes on fund advisers a fiduciary duty with respect to their compensation, would require an adviser to waive that portion of its fee that represents compensation for services being performed by another person, such as the adviser to an acquired money market fund.See SECv.American Birthright Trust Management Company, Inc.,Litigation Release No. 9266 (Dec. 30, 1980), available in LEXIS, Fedsec Library, Litrel File (settlement of civil injunctive action in which defendant investment adviser was permanently enjoined from engaging in acts and practices that would constitute violations of sections 36(a) and (b) of the Act, and in which the Commission alleged that the compensation paid to fund's adviser was excessive in light of the services performed, and that most of the advisory services had been provided by a “sub-adviser” retained by the adviser).

67We also would eliminate the prohibition on an acquired money market fund investing in other funds in excess of the limits in section 12(d)(1)(A). This would permit the money market fund itself to have a cash sweep arrangement. As discussed above, we do not believe that investments in money market funds create the concerns that led to the limitations in section 12(d)(1).See supranotes 38-39 and accompanying text. We also would omit a condition that the acquiring fund's investment in the acquired money market fund must be consistent with the policies set forth in the acquiring fund's registration statement. We believe that the fund already is required to make investments consistent with those policies without an additional requirement in the rule. For a discussion of the other conditions,see supranotes 43-44 and accompanying text.

68Although not contained in the text of proposed rule 12d1-1, the proposed disclosure requirements are a critical element of the relief we are proposing today and of our decision that the proposal omit required directors' findings from the rule. We note that when it enacted section 12(d)(1)(G) in 1996, Congress did not include any provision addressing the duplication of advisory fees, although it understood that our previous exemptive orders to permit these arrangements included a requirementthat acquiring fund directors determine that fees for advisory services provided to the acquiring fund are in addition to and not duplicative of fees paid for advisory services provided to the acquired funds. In his testimony before the House Subcommittee considering amendments to section 12(d)(1), the Director of our Division of Investment Management explained that such a condition was unnecessary because “[t]he Commission would be able to use its authority under the Securities Act [of 1933] to * * * address the potential for excessive layering of advisory fees by requiring an acquiring fund to disclose in the prospectus fee table the cumulative advisory fees paid by the acquiring and acquired funds.''Hearing on H.R. 1495 Before the Subcomm. On Telecommunications and Finance of the House Comm. on Commerce,104th Cong., 1st Sess. 19 (1995) (statement of Barry P. Barbash, Director,