What Is Section 12D-1?

Section 12D-1, under the Investment Company Act of 1940, restricts investment companies from investing in one another. The rule was enacted to prevent fund of funds arrangements from one fund acquiring control of another fund to benefit its investors at the expense of the shareholders of the acquired fund. This use of control could come through exercising controlling power of voting shares or under the threat of large-scale redemptions out of the acquired fund.

Congress also created exemptions to this rule in the form of investing limits, which allows for fund of funds arrangements as long as the limits are met. In 2018, Congress updated the rules with new terms under Section 12D-1, allowing for greater flexibility in investing. Congress has also proposed to implement new rules that would rescind Section 12D-1-2 and implement a new standard set of rules.

KEY TAKEAWAYS

  • Section 12D-1 of the SEC Investment Company Act was created to restrict investment funds from investing in each other.
  • Section 12D-1A and B stipulated rules that allowed for investing under certain limits.
  • In 2018, Congress refined the rules under 12D-1 to allow greater flexibility in fund of funds arrangements.
  • Congress has proposed Section 12D-1-4 to completely replace and rescind 12D-1-2.

Understanding Section 12D-1

Section 12D-1 was created with sub-rules that allow for specific exemptions to the restriction of investment funds investing in each other. Section 12D-1A stipulates the exemption limits in which a registered fund can invest into another fund. Section 12D-1B stipulates the exemption limits in which an open-ended fund can sell its securities to another fund.

In 2018, Congress decided to change the way in which funds can invest in each other. They created Section 12D-1E-G, allowing various fund of funds arrangements under specific conditions, which effectively rescinded Section 12D-1A-B. In doing so, Congress realized it had created a framework that was inconsistent and inefficient. To streamline the rules, Congress has proposed to abolish 12D-1-2 and the exemption orders and to replace it with 12D-1-4.

How the Section 12D-1 Limit Is Applied

Section 12D-1A's restrictions limits state that a fund cannot:

  • Acquire more than 3% of a registered investment company's voting shares.
  • Invest more than 5% of its assets in a single registered company.
  • Invest more than 10% of its assets in registered investment companies.

Section 12D-1B applies to the selling of securities by a fund and prohibits the sale if it results in the acquiring company owning more than 3% of the acquired fund's voting securities.

Updating Section 12D-1

In 2018, Congress revisited its approach to fund of funds arrangements. In the 1960s, when the initial limits were established under the Investment Company Act, Congress believed that fund of funds arrangements served no real financial purpose. In the time since, they believe that the fund of funds structures have incorporated dynamics to protect investors as well as providing a financial purpose. As such, Congress drafted new rules to permit certain structures that met certain conditions.

Section 12D-1E allows an investment fund to invest all of its assets into one fund. This would make the fund a vessel by which investors can access the acquired fund. Section 12D-1F allows a registered fund to take positions, up to 3% of another fund's assets, in any number of funds without limit. Section 12D-1G allows a registered open-ended fund to invest in other open-ended funds that are in the same "group of investment companies." Furthermore, Congress enacted section 12D-1J, that allows the Securities and Exchange Commission (SEC) to exempt any person, transaction, or asset from Section 12D1-A-B.

Rescinding 12D-1-2

In conjunction with its updates to Section 12D-1, Congress realized that the many rules and exemptions exist as a patchwork that is inefficient and only cover specific funds while not including others that have similar characteristics. To remedy the situation, Congress has proposed to rescind 12D1-2 and replace it with 12D-1-4, which would provide a consistent framework, reduce operational costs, and open up new investment opportunities.

Investments Allowed Under 12D-1-4

Under the proposed new standards, the rules would permit:

  • A registered investment fund to acquire the securities of another registered investment fund above the limits stated in 12D-1.
  • An acquired fund to sell its securities to an acquiring fund.
  • An acquired fund to redeem its securities in the acquiring fund.

Currently, the type of fund of funds arrangements allowed depends entirely on the type of acquiring fund. The new rule would broaden the scope of permitted funds allowed in a fund of funds arrangement and therefore increase investment opportunities for investors. The new arrangements would only be allowed if certain conditions are met in the areas of voter control, redemption limits, fees, and avoidance of complex structures.