44. Stein II, at 31 . through reliance on the skills of the funds' managers both in
45. Thompson Memo, supra . selecting funds for investment and managing sophisticated
46. Stein 11, at 37 . dynamic allocation strategies .
47. Stein, at 46 -47 . However, public funds of funds are burdened with
48. John C . Coffee, Jr., "The Envelope, Please : Best Southern District restrictive laws intended to prevent abuses of control and
Rulings," New York Law Journal, July 20, 2006), available at
http ://www.law.com/jsp/nylj/PubArticleN-Y .jsp?hubtype=corpora
fee layering relating to fund "pyramiding" arrangements .
teUpdate &id=1153299924248 . These laws, while a warranted response to past scandals,
49. United States v. Harrison, 213 F.3d 1206 (9,h Cir. 2000) .
are excessively restrictive and have limited the development
of new types of investments . The SEC has long recognized
50. United States v. Stein, Order issued June 19, 2006.
this and has granted, upon individual application, exemptive
orders that give funds of funds greater flexibility in certain
regards, subject to certain conditions . The proliferation
New SEC Rules Enlarge Scope of of funds of funds, however, has outstripped the ability of
Funds of Funds the exemptive applications office of the SEC's Division of
Investment Management, which has not grown to match the
By Mark D . Perlow, George J. Zornada, and Helen C. Ku o increased demand for these products .
Responding to these pressures, the SEC recently adopted
Mark D . Perlow is a partner in the San Francisco office of
three new rules that expand the ability of all funds to invest
Kirkpatrick & Lockhart, Nicholson, Graham, LLP (K&LNG) .
George J . Zornada is a partner in the Boston office of K&LNG . in money market funds and generally enlarge the investment
Helen C . Kuo is an associate in the San Francisco office of K&LNG . scope of funds of funds .' New Rules 12d1-1, 12d1-2, and
Contact : m perlow@king .co m . 12d1-3 under the Investment Company Act of 1940 (the
1940 Act) create exemptions that : (i) expand a fund's ability
Funds of funds are increasingly significant investment to invest in other registered and unregistered money market
vehicles for individual investors seeking ease -and efficiency funds, both affiliated and unaffiliated, and (ii) expand the
in a sometimes daunting marketplace, as well as for investors investment abilities of funds of funds, including the ability to
pursuing sophisticated strategies through diversification . invest in non-fund securities . The rules largely codify a number
There are several varieties of fund of funds, including mutual of existing exemptive orders permitting "cash sweep" and
funds investing in mutual funds, closed-end funds investing other fund of funds arrangements . In so doing, the SEC will
in hedge funds, and private funds investing in hedge funds be clearing the crowded docket of the exemptive applications
office of many of its most routine orders, in the hope that it will
(or private equity funds) . Each presents an investment op-
expedite consideration of other applications . The SEC adopted
portunity that could be more difficult or expensive to create
these rules substantially as they were originally proposed in
without a fund of funds structure . Partly in response to
demand for such funds, the SEC recently adopted significant October 2003, and the new rules went into effect on July 31,
2006. In addition, the SEC amended fund registration forms
rules addressing funds of funds .
to require each fund that invests in other funds to disclose
Mutual funds of mutual funds frequently embody in the cumulative amount of expenses charged by the acquiring
one investment vehicle a complete portfolio strategy for an fund and any fund in which it invests . These detailed require-
individual . For instance, highly popular "life-cycle" funds are ments will present calculation challenges for many funds and
generally organized as funds of funds offering a "one-stop" especially for closed-end funds of hedge funds .
or "invest and forget" solutions for investors . Such funds use
combinations of investments in mutual funds to structure Background
portfolios that gradually lower risk profiles as the fund Section 12(d)(1) of the 1940 Act places significant
approaches a target withdrawal date, typically coordinated
restrictions on a fund's ability to invest in other funds .
with the investor's retirement . Fund sponsors often can Section 12(d)(1)(A), the most restrictive of these provisions,
construct these vehicles more efficiently by investing in a prohibits a fund from acquiring more than 3% of another
variety of existing funds than by constructing and managing fund's outstanding voting stock, investing more than 5% of
each target date portfolio individually . "Life-cycle" funds, its total assets in a given acquired fund,, and investing more
among other uses, allow participants in defined contribution than 10% of its total assets in acquired funds . Similarly,
plans to choose a single investment that will manage their Section 12(d)(1)(B) prohibits mutual funds from selling more
retirement savings . Such investments are especially valuable than 3% of their shares in aggregate to another fund and
in light of increasing evidence that many plan participants, non-investment companies under common control and from
confused by the number of investment options on the plan selling more than 10 % of their shares in aggregate to another
menu, allocate their savings sub-optimally. In addition, fund and all companies, including investment companies,
funds of hedge funds allow individual investors to pool under common control.
their resources to reach the investment minimums generally
imposed by ,hedge funds and other private funds . Fund of . However, Section 12(d)(1)(F) and Section 12(d)(1)(G)
hedge funds also permit individual investors potentially to create statutory exceptions for funds that invest in unaffiliated
lower the risk of these investments through diversification and and affiliated funds, respectively, under several condition s
0 2006 Thomson/West Legalworks Vol . 10 No . 8, 2006
12
that fund sponsors have found increasingly burdensome or Rule 12d1 - 2 : Investments of Funds of Affiliated
unworkable . Thus, funds often must seek exemptive relief Funds in Other Types of Securities
for investing in other funds, and such relief was routinely
granted for money market fund "cash sweep" investments Section 12(d)(1)(G) of the 1940 Act permits mutual funds
and sometimes granted for funds of funds that diverged from and unit investment trusts (UITs) to acquire unlimited shares
the statutory exceptions . in other mutual funds or UITs in the same fund complex, as
well as government securities and short-term paper . "Life-
Rule 12 0- 1 : Investments in Money Market Funds cycle" funds are generally structured as funds of affiliated
funds . However, under this provision, a fund of affiliated
New Rule 12d1-1 permits all funds to invest unlimite d funds is restricted in the other types of securities it can hold.
amounts of cash in registered and unregistered money market In addition, the acquired funds may not themselves be funds
funds (whether or not affiliated) under specified conditions . of funds and thus may not rely upon Section 12(d)(1)(F) or
The rule applies to money market fund investments by mutual Section 12(d)(1)(G) to invest in shares of other funds . Section
funds, closed-end funds (including business development 12(d)(1)(G) also places on distribution expenses the limits set
companies) and unregistered funds relying on Sections 3 (c) (1) forth in Rule 2830 of the Rules of Conduct of the National
or 3(c)(7) under the 1940 Act.2 This rule eliminates the need Association of Securities Dealers (the NASD) .4
for individual "cash sweep" exemptive orders.
New Rule 12d1-2 permits funds that rely on Section
The rule provides exemptions not only from Section 12(d)(1)(G) to invest in unaffiliated funds, subject to the
12(d)(1) but also from Section 17(a) of the 1940 Act limits of Sections 12(d)(1)(A) and (F) . A fund complex with
and Rule 17d-1 . These two provisions prohibit or limit a weakness in one investment strategy (e .g., international
transactions between or involving a fund and its affiliates . stocks) can now use unaffiliated funds, to an extent, to round
The 1940 Act defines an "affiliated person" to include funds out an offering that otherwise relies on affiliated funds . The
under common control and a fund in which another fund new rule also permits such funds to invest in affiliated or
owns more than 5 % of its voting shares . Thus, without unaffiliated "money market funds" under Rule 12d1-1, as
these exemptions, these provisions could otherwise prohibit well as, importantly, investments in securities offered by is-
a fund's investing in a money market fund in the same fund suers other than funds, such as stocks, bonds and other types
complex or acquiring more than-5% of the shares of a of "securities" (as that term is defined under the 1940 Act),
money market fund in another complex . provided that the investments are consistent with the funds'
The exemption is conditioned on the acquiring fund's not investment objectives and policies . This exemption presents
paying any sales charge or service fee, or waiving advisory funds of affiliated funds with opportunities to adopt new
fees to offset any such fees . However, unlike prior exemptive strategies crafted from derivatives that qualify as "securities ."
orders, Rule 12d1-1 does not place restrictions on advisory However, Rule 12d1-2 could be viewed as not permitting
fees or require special board findings that investors are not funds of affiliated funds to invest in derivatives that are not
paying duplicative fees .' In addition, the rule permits acquir - securities, which would preclude investment strategies such
ing funds to pay commissions, fees, and other remuneration as the "equitization" of cash through broad-based index
to second-tier affiliated broker=dealers in connection with futures . In addition, the ability to invest in "other securities"
transactions in portfolio securities without meeting the allows a "regular" fund such as an equity or bond fund also
quarterly board review and record keeping requirements to allocate to an affiliated equity or bond fund in reliance
of Rule 17e-1, where the affiliation solely results from the on the new rule .
acquiring fund's investment in a money market fund whose
adviser is affiliated with the broker-dealer. Rule 12d1 - 3 : Sales Charge Flexibility for Funds
of Unaffiliated Fund s
The rule also permits investments in unregistered money
market funds, provided that they "operate like" registered Section 12(d)(1)(F), although not widely used, permits a
money, market funds. The acquiring fund must reasonably registered fund to invest in unaffiliated registered funds if,
believe that the unregistered money market fund satisfies among other conditions, the acquiring fund and its affiliates
certain conditions of a registered money market fund-in would not own more than 3% of the total outstanding stock
essence, that it invests only in those investments in which of any such acquired fund, and the sales charge on the acquir-
a money market fund may invest under Rule 2a-7 and ing fund's shares is not greater than 11/z %' New Rule 12d1-3
undertakes to comply with the provisions of Rule 2a-7 . The permits a registered fund that relies on Section 12(d)(1)(F) to
adviser to the unregistered money market fund also must levy sales charges and service fees up to the applicable limits
be a SEC-registered investment adviser . This new possibility set forth in NASD Conduct Rule 2830 . While loosening the
allows fund complexes to operate internal money market sales charge restrictions of Section 12(d)(1)(F), the new rule
pools without the administrative expense and burden of does not alter the other limitations that have resulted in
registering . relatively few funds relying on this section .
wall Street Lawyer 0 2006 Thomson/West Legalworks
13
New Disclosure Requirement s realization or distribution of gains, which are typically paid
upon liquidation of the fund .'
In addition, the SEC significantly amended fund registra -
tion forms to require all registered funds that invest in other Conclusion
funds, and in particular funds of funds, to disclose the fees
charged by underlying funds .' In so doing, the SEC is in part By adopting new exemptive rules, the SEC has given
addressing the question of "fee layering" through disclosure further momentum to the growth of mutual funds of affiliated
rather than proscriptive rules . Specifically, an acquiring fund funds, especially "life-cycle" funds . It also provided greater
must disclose the fund's pro rata portion of the cumulative flexibility to fund managers in their methods of managing
net expenses charged by funds in which the acquiring fund funds' cash . The new rules obviate the need for some forms
invests as a separate line item in the fee table, even if the of exemptive relief, particularly "cash sweep" orders, and
acquiring fund does not rely on the new rules . The SEC also permit funds of funds greater freedom in investing in other
adopted highly detailed new instructions for calculating the funds . The new rules also should alleviate some pressures
amount of acquired funds' fees and expenses . Generally, the
on the overburdened applications office of the Division of
acquiring fund must aggregate the total annual operating
expenses of acquired funds and related transaction fees . Investment Management. However, the SEC also has imposed
The expense calculations must include expenses of private significant new disclosure responsibilities upon all funds that
funds excepted from registration by Section 3(c)(1) or 3(c)(7) invest in other funds, including challenges that registered
of the 1940 Act, if any. The new requirements provide an closed-end funds of hedge funds will find burdensome to
exception if acquired fund expenses are less than 0 .01 % (one address .
basis point), in which case the expenses should be reflected
in general fund expenses . Notes
1. "Fund of Funds Investments," Rel . No . 33-8713 ; IC-27399 (June
Form N-1A (which applies to mutual funds) was amended 20, 2006) (the Adopting Release) .
to add a new line item called "Acquired Fund Fees and Hedge funds and most other private funds generally rely upon
2.
Expenses" 'in the total fund operating expenses section of the these sections to avoid registering with the SEC under the 1940
prospectus fee table, in which the acquired funds' expenses Act.
will be expressed as a percentage of average net assets . These 3. In a footnote to the Adopting Release, the SEC stated that the
expenses must also be included in the "Example" portion of fiduciary duties of fund managers (found in Section 36(b) of the
the fee table, which discloses the cumulative amount of fund 1940 Act) would require the acquiring fund's manager to reduce
expenses for 1, 3, 5, and 10 years based on a hypothetical its fee by the amount of compensation received by the underlying
investment of $10,000 and an annual 5% return . fund's manager for managing the relevant portion of the top
fund's assets . See Adopting Release, n.52 . Although the SEC did
Similarly, Form N-2 (which covers closed-end funds) was not state so expressly, its reasoning applies only to compensation
amended to require registered closed-end funds to include, received for services that duplicate those that the advisory
as a line item in the fee table, their "pro rata portion of contract requires the fund's manager to provide in exchange for
the cumulative expenses charged by the acquired funds, its fee . Thus, whether a manager should reduce its fee is a matter
including management fees and expenses, transaction fees of the business judgment of each fund manager subject to each
and performance fees (including incentive allocations) . " fund's board of directors.
4. NASD Rule 2830 sets forth a detailed series of formulae that
In particular, this applies to registered funds of hedge limit the combined amounts levied through front-end loads,
funds, . which may face significant challenges in preparing deferred sales charges, and Rule 12b-1 fees .
the line item . Because of the nature and variety of hedge 5. Other conditions require that the acquired fund not be-obligated
fund performance fees, the detailed calculations must be to redeem more than 1% of its outstanding securities held by
based on historical expenses . The SEC acknowledged that the acquiring fund in any period of less than 30 days, and
historical hedge fund expenses and future expenses could that the acquiring fund either "mirror" vote the shares of the
vary due to the impact of acquired hedge funds' performance acquired fund or ask the acquiring fund's shareholders for voting
fees . Thus, the SEC required funds of hedge funds to add a instructions .
disclaimer about the variable nature of hedge fund fees and 6. The new requirements do not apply to private funds .
to add a footnote to the new item that discloses the "typical 7. The SEC similarly amended Forms N-3, N-4, and N-6, which
performance fee charged by acquired hedge funds" in which apply to insurance company separate accounts . New registration
they invest . In addition, the SEC permitted funds to exclude statements on Forms N-1A, N-2, N-3, N-4, and N-6, as well as
from the expense ratio in the fee table specified performance post-effective amendments thereto that are annual updates, filed
fees that may be unrelated to the costs of investing in a on or after . January 2, 2007, must comply with the amended
fund of funds, such as fees that are calculated solely on the disclosure requirements .
0 2006 Thomson/West Legalworks Vol . 10 No . 8, 2006