Section 12D-1 Definition


What is Section 12D-1?

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

Congress also created exemptions to this rule in the form of investment limits, allowing fund-of-fund agreements 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 investment. Congress also proposed implementing new rules that would repeal Section 12D-1-2 and implement a new standard set of rules.

KEY TIPS

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

Understanding Section 12D-1

Section 12D-1 was created with sub-rules that allow specific exemptions to the restriction of mutual funds that invest with each other. Section 12D-1A provides the exemption limits in which a registered fund may invest in another fund.Section 12D-1B stipulates the exemption limits in which a variable capital fund can sell its securities to another fund.

In 2018, Congress decided to change the way funds can invest with each other. They created Section 12D-1E-G, which allows various fund-of-funds arrangements under specific conditions, effectively terminating Section 12D-1A-B. In doing so, Congress realized that it had created a framework that was inconsistent and inefficient. To simplify the rules, Congress has proposed abolishing 12D-1-2 and the waiver orders and replacing them with a new Section 12D-1-4.

How the Section 12D-1 Limit Applies

The limits of Section 12D-1A restrictions state that a fund may not:

  • Acquire more than 3% of the voting shares of a registered investment company.
  • You invest more than 5% of your assets in a single registered company.
  • Invest more than 10% of your assets in registered investment companies

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

Section 12D-1 Update

In 2018, Congress revised its approach to fund of funds arrangements. In the 1960s, when initial limits were established under the Mutual Fund Act, Congress believed that fund-of-fund arrangements had no real financial purpose.Since then, they believe that fund-of-funds structures have built in dynamics to protect investors as well as provide financial purpose. As such, Congress wrote new rules to allow certain structures to meet certain conditions.

Section 12D-1E allows an investment fund to invest all of its assets in a single fund. This would make the fund a container through which investors can access the acquired fund. Section 12D-1F allows a registered fund to take positions, up to 3% of the assets of another fund, in any amount of funds without limit.Section 12D-1G allows a registered open fund to invest in other open funds that are in the same “group of investment companies.” Additionally, Congress enacted section 12D-1J, which allows the Securities and Exchange Commission (SEC) to exempt any person, transaction, or asset from section 12D-1-AB.

Rescind 12D-1-2

Along with its updates to Section 12D-1, Congress realized that the many rules and exemptions exist as a mosaic that is inefficient and only covers specific funds without including others with similar characteristics. To resolve the situation, Congress has proposed to rescind 12D-1-2 and replace it with 12D-1-4, which would provide a consistent framework, reduce operating costs, and open up new investment opportunities.

Investments allowed under 12D-1-4

Under the proposed new standards, the rules would allow:

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

Currently, the type of fund of funds arrangements allowed is entirely dependent on the type of acquiring fund.The new rule would broaden the scope of allowable 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, swap limits, fees, and avoidance of complex structures.

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Mark Holland

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