What's next for the SEC? The Fund of Funds Rule
Following the adoption of the long-delayed final Regulation Best Interest in June, what’s next for the U.S. Securities and Exchange Commission (SEC)?
It’s likely that finalizing the proposed rule on Fund of Funds Arrangements (“the Proposal”) is at the top of the list. Since the SEC released the Proposal late in 2018 and requested public comment, more than 100 comment letters have been posted and SEC officials have met with a variety of industry representatives. With the comment period now closed, it seems likely the SEC will revisit the Proposal, reflect on industry reaction and assess how the operations of funds that invest in other funds (“FOFs”) could be affected.
Highlights from the Proposal
The Proposal includes two key regulatory changes that mark an inflection point for FOFs. First, the manner in which FOF arrangements are governed under the Investment Company Act of 1940 (“1940 Act”) is modernized with the Proposal’s introduction of new Rule 12d1-4 under the 1940 Act (“FOF Rule”). Specifically, the FOF Rule imposes a consistent and efficient rules-based framework for the formation and oversight of FOFs to replace the patchwork of statutory exemptions, SEC rules and exemptive orders that FOFs rely on now. Second, the Proposal significantly expands the universe of permissible FOF arrangements, giving funds covered by the rule greater flexibility to meet their investment objectives. Together, these changes simultaneously enable regulatory consistency, reduce fund operational costs and delays, and unlock new investment opportunities that are precluded under the current regulatory regime.
Other changes in the Proposal include:
- an amendment to Rule 12d1-1 under the 1940 Act, permitting funds to invest in money market funds that are not part of the same fund family;
- the rescission of Rule 12d1-2 under the 1940 Act, which is currently relied on for fund of fund arrangements and most related exemptive orders;
- exemptive relief for the selling or purchasing of any security or property of an acquired to an acquiring fund by an affiliated person of the acquired fund; and
- the amendment of Form N-CEN to require fund of funds to report whether they relied on the FOF Rule.
The impact of the FOF Rule on individual FoFs’ operations will depend, in part, on how a fund is structured, its universe of fund investments and its level of investments in additional funds.
The financial services industry has generally applauded the SEC’s efforts, recognizing that the Proposal is largely a step forward for FOFs. Not all aspects of the Proposal have been embraced, however, with the most vociferous dissent focused on the conditions imposed under the FOF Rule. According to the SEC, the conditions are designed to address abuses historically associated with FOFs, such as acquiring funds exerting improper influence over other funds, the prevalence of duplicative or excessive fees and fund sponsors creating overly complex FOF structures. Many of the FOF Rule’s conditions are similar, but not identical to, the conditions found in typical exemptive orders under the existing FOF regulatory regime.
The condition garnering the most opposition is the proposed limitation on redemptions. In general, the condition would restrict FOFs that own more than 3% of another fund’s outstanding shares from redeeming more than 3% of the acquired fund’s outstanding shares in any 30-day period. Multiple commenters on the Proposal have asked the SEC to reconsider or abandon the redemption limitations altogether, arguing that many FOFs will be adversely impacted. The Investment Company Institute has been among the harshest critics, writing that “the proposed redemption restriction would harm investors in [FOFs] by imposing arbitrary liquidity constraints on investments that otherwise offer daily redemptions to all other types of investors and by treating them differently than if they were direct investors in the underlying funds.”
The rescission of Rule 12d 1-2 has also been a hot button issue among commenters, many of whom have asked the SEC to abandon its repeal. Their argument notes that affiliated FOFs currently rely on a combination of Section 12(d)(1)(G) and related Rule 12d1-2 under the 1940 Act to engage in certain investments (e.g. investments in funds not in the same group of investment companies) and to maintain certain multi-tier FOF structures (e.g. FOFs with three or more operational tiers). The SEC is expected to address industry concerns in the Final Rule.
Anticipating Regime Change
We know from the Proposal that FOFs currently relying on exemptive orders will have a yearlong grace period after the effective date of the Final Rule to align their operations with the requirements of the final FOF Rule. It is also highly likely that the reporting requirements included in the Proposal will remain in place, requiring FOF to disclose on Form N-CEN whether it relied on the FOF Rule during the reporting period. Until the Final Rule is published, though, we will not know the exact structural changes, if any, a particular FOF will have to make to operate under this new regulatory regime.
We continue to monitor the regulatory environment and commentary around the Proposal and are actively preparing to meet the new administrative and operational needs of FOFs once the Final Rule is published. To learn how Northern Trust’s team can support your FOFs, contact your Northern Trust representative or visit northerntrust.com/mutualfunds.