SEC Permits Certain “Master-Feeder” Arrangements

Although obstacles remain

BRENDAN C. FOX, BRENDEN P. CARROLL, COLMAN O’LOGHLEN, PRIYA H. PATEL, DECHERT LLP

The Staff of the US Securities and Exchange Commission (SEC) on March 8, 2017 issued a no-action letter (Staff Letter) in response to a request from Dechert LLP for assurance under Section 12(d)(1) of the Investment Company Act of 1940 (1940 Act).1 The Staff Letter provides no-action assurance to global investment managers and sponsors seeking to offer investment products across non-US jurisdictions using a “master-feeder” arrangement that may conflict with certain “fund of funds” restrictions under the 1940 Act. More specifically, the Staff Letter contemplates non-US feeder funds (Non-US Feeder Funds) investing in a single US open-end investment company registered under the 1940 Act (US Master Fund), in excess of the investment restrictions under Section 12(d)(1) of the 1940 Act. The Non-US Feeder Funds would also be permitted to invest in Foreign Currency Instruments (as defined below) that could, among other things, enable the shareholders of a Non-US Feeder Fund to achieve a return on their investment, as measured in the Designated Currency (as defined below), similar to that of the other shareholders of the US Master Fund, as measured in US Dollars, by reducing the impact of currency fluctuations between the Designated Currency and the US Dollar.

The Staff Letter is significant because it removes obstacles under the 1940 Act to efficiently offering a “master-feeder” investment product across non-US jurisdictions, with off-shore feeder funds and a single US registered master fund. However, a number of other obstacles remain. These include legal restrictions in non-US jurisdictions that may limit certain types of Non-US Feeder Funds with respect to investing in other investment funds (including US Master Funds). An investment in a US Master Fund by a Non-US Feeder Fund may also have adverse tax consequences under the Internal Revenue Code (Code), depending on the structure and investment strategy of the US Master Fund.

Background
Section 12(d)(1) of the 1940 Act is designed to address potential abuses and concerns arising from certain “fund of funds” arrangements.2 Generally, under Section 12(d)(1)(A), the acquisition by a registered or unregistered investment company (acquiring fund) of shares of any registered investment company (underlying fund) is limited, at the time of purchase, to:

  • 3% of the underlying fund’s outstanding voting shares;
  • 5% of the acquiring fund’s total assets in any one underlying fund; or
  • 10% of the acquiring fund’s total assets in all underlying funds.3

Section 12(d)(1)(B) imposes complementary restrictions and limits the ability of registered open-end investment companies knowingly to sell their shares to a registered or unregistered investment company.4  However, Section 12(d)(1)(E) provides a conditional exemption from the three restrictions discussed above and permits master-feeder arrangements, subject to the following conditions:

  • The principal underwriter for the acquiring fund is a broker or dealer registered under the Securities Exchange Act of 1934 (1934 Act) or a person controlled by such broker or dealer;
  • The only “investment securities” held by the acquiring fund are those of the acquired fund; and
  • The purchase or acquisition by the acquiring fund is made pursuant to an arrangement with the acquired fund or its principal underwriter whereby the acquiring fund is obligated: (i) to utilize either “pass-through” or “echo” voting;5 and (ii) in the event that the acquiring fund is not a registered investment company under the 1940 Act, to refrain from substituting the acquired fund’s shares unless the SEC approves of the substitution in the manner provided in Section 26 of the 1940 Act.

Discussion
The Staff Letter provides no-action assurance under Section 12(d)(1) of the 1940 Act to permit:

  • A Non-US Feeder Fund to acquire (1) shares of a single US Master Fund in excess of the limits in Section 12(d)(1)(A) and (2) Foreign Currency Instruments; and
  • The US Master Fund, its principal underwriter and any broker or dealer to sell such shares to the Non-US Feeder Fund in excess of the limits in Section 12(d)(1)(B).

The structure above (Proposed Structure) would be subject to several conditions, a number of which are described below, including modified requirements under Section 12(d)(1)(E). In issuing the Staff Letter, the Staff appeared to support the public policy reasons outlined in the Request Letter, including the potential benefit to the US mutual fund industry.

Non-US Feeder Funds and Affiliations Among the Parties
Under the Staff Letter, a Non-US Feeder Fund must be limited to foreign publicly-offered investment vehicles whose securities are generally redeemable upon demand to the fund or foreign publicly-traded investment vehicles whose securities are listed on one or more foreign securities exchanges. Moreover, a Non-US Feeder Fund must be organized in, and regulated under the laws of, a “Permitted Foreign Jurisdiction,” which is a jurisdiction whose securities regulator has entered into a cooperative arrangement with the SEC to facilitate consultation and cooperation between the SEC and the foreign securities regulator.6

In addition, a Non-US Feeder Fund must:

  • Limit its distribution activities to non-US jurisdictions;7 and
  • Be managed by either: (i) the registered investment adviser to a US Master Fund or (ii) an investment adviser not registered with the SEC that controls, is controlled by, or is under common control with, the investment adviser to, and the principal underwriter for, a US Master Fund (Feeder Fund Adviser).8

Permissible Hedging by the Non-US Feeder Funds
Notwithstanding the requirement in Section 12(d)(1)(E) that the shares of the US Master Fund must be the only “investment securities” held by a Non-US Feeder Fund, the Non-US Feeder Fund would be permitted to invest in foreign currency and foreign currency-related instruments (Foreign Currency Instruments9) to mitigate the effects of currency fluctuations between or among the currency of the foreign jurisdiction in which shares of the Non-US Feeder Fund are primarily offered and sold (Designated Currency) and the US Dollar and/or other foreign currencies. However, the scope of a Non-US Feeder Fund’s currency hedging would be limited as follows:

  • For all Non-US Feeder Funds, a Non-US Feeder Fund could seek to hedge the performance of the applicable US Master Fund, as measured in US Dollars, back to its Designated Currency;10 and
  • For Non-US Feeder Funds that seek to approximate the returns of an index, a Non-US Feeder Fund could seek to hedge the US Dollar and/or foreign currency exposure associated with the applicable US Master Fund’s portfolio holdings back to its Designated Currency, subject to certain conditions discussed in the Staff and Request Letters (including that: (i) the US Master Fund seeks to approximate the returns of an index; (ii) the US Master Fund’s currency exposure does not materially deviate from the currency exposure of the index; and (iii) the index provider is not a first- or second-tier affiliate of the investment adviser to the US Master Fund).11

A Non-US Feeder Fund may purchase Foreign Currency Instruments for the hedging purposes described above and not for speculative purposes (i.e., for the purpose of generating excess investment returns).

SEC Jurisdiction Over the Proposed Structure
Under Section 12(d)(1)(E)(i), the principal underwriter for the acquiring fund must be a broker-dealer registered under the 1934 Act, or a person controlled by such a broker-dealer. Section 12(d)(1)(E)(i) appears designed to ensure that the SEC has sufficient jurisdiction to monitor and pursue claims against a principal underwriter with respect to its activities in connection with an acquiring fund. The Request Letter noted that the Non-US Feeder Funds might not have a principal underwriter that is, or that is controlled by, a broker-dealer registered under the 1934 Act, or, for that matter, might not have any principal underwriter at all. However, on the basis of the affiliations among the parties to the Proposed Structure (as described above), the Staff accepted that these jurisdictional concerns would be addressed, provided that the Feeder Fund Adviser:

  • Designates the investment adviser to the US Master Fund as agent in the United States for service of process in any suit, action or proceeding before the SEC or any appropriate court with respect to the Non-US Feeder Fund, and consents to the jurisdiction of the US courts and the SEC with respect to its activities in connection with the Non-US Feeder Fund;
  • Upon receipt of an administrative subpoena, demand or request for voluntary cooperation made during a routine or special inspection or otherwise with respect to the activities of the Non-US Feeder Fund, promptly provides to the SEC and its Staff copies of its books and records with respect to the activities of the Non-US Feeder Fund (and, to the extent the Feeder Fund Adviser is prohibited by applicable law from doing so, it will use its best efforts to secure permission to do so);12 and
  • Files with the SEC a written representation, signed by a duly authorized officer, which agrees to these conditions.13

Non-US Feeder Fund Voting
As described above, under Section 12(d)(1)(E), a Non-US Feeder Fund is required to utilize either “pass-through” or “echo” voting. However, the Request Letter stated that a Non-US Feeder Fund might not be able to comply with either the “pass-through” or “echo” voting requirements because the laws and/or market practices of a non-US jurisdiction in which the Non-US Feeder Fund operates may preclude compliance (or could be interpreted to preclude compliance) with these requirements. Accordingly, depending on the circumstances, a Non-US Feeder Fund may: (i) abstain from voting; (ii) withhold voting; or (iii) refrain from voting. The Staff agreed that these alternative voting methods provide the same safeguards against the potential for undue influence as the “pass-through” or “echo” voting requirements under Section 12(d)(1)(E).

Substitution Order
A Non-US Feeder Fund must comply with Section 12(d)(1)(E)(iii)(bb) by refraining from substituting its investment in the US Master Fund (i.e., a complete redemption of the shares of one US Master Fund and subsequent purchase of shares of another US Master Fund), unless the SEC has approved the substitution by order issued to the Non-US Feeder Fund. This condition was not modified by the Staff Letter.

Non-US and Tax Issues
The Staff Letter is significant because it removes obstacles under the 1940 Act to efficiently offering a “master-feeder” investment product across non-US jurisdictions, with off-shore feeder funds and a single US registered master fund. However, a number of other obstacles remain. For example, there may be legal restrictions in some non-US jurisdictions that may limit certain types of Non-US Feeder Funds with respect to investing in other investment funds (including US Master Funds). Importantly, under the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, which generally permits retail pooled investment vehicles to be managed and marketed on a cross-border basis in Europe, UCITS are currently prohibited from investing solely in the shares of a US registered investment company. This limitation effectively prohibits the ability of a UCITS to serve as a Non-US Feeder Fund – an unfortunate outcome given the popularity of UCITS in Europe among retail investors.14 Although certain pooled investment vehicles that operate under the Alternative Investment Fund Managers Directive (AIFMD) may serve as a Non-US Feeder Fund, the AIFMD imposes certain limitations that should be considered before relying on the Staff Letter.

Moreover, income distributed by the US Master Fund to a Non-US Feeder Fund would generally be subject to US withholding tax at a rate of 30%. Depending on the tax structure and investment strategies of the funds, such withholding tax may be reduced to the extent distributions by the US Master Fund are derived from certain qualifying sources (e.g., interest income from US borrowers and capital gains from the sale of securities). Additionally, depending on the circumstances, such withholding tax may be reduced under an applicable income tax treaty and/or be creditable against the non-US tax liability of non-US investors in the jurisdictions in which they are tax resident. As such, US Master Funds that are structured to limit the potential impact of US withholding tax may be the most likely funds to avail themselves of the relief provided in the Staff Letter.

Conclusion
The Staff Letter is a significant next step in the evolution of the global “master-feeder” arrangement, and the Staff Letter may permit this type of an arrangement in certain non-US jurisdictions. Global investment managers and sponsors that seek to rely on the Staff Letter should carefully consider all of the conditions outlined in the Staff and Request Letters and understand the unique fund formation, distribution, tax and other requirements in non-US jurisdictions.

Footnotes

1. See Dechert LLP, SEC No-Action Letter (Mar. 8, 2017). See also Letter from Brendan C. Fox and Brenden P. Carroll, Dechert LLP, to Douglas J. Scheidt, Associate Director and Chief Counsel, Division of Investment Management, SEC (Mar. 8, 2017) (Request Letter).
2. These concerns include potential undue influence by an acquiring fund (as defined below) and its affiliates over the underlying fund (as defined below) and its affiliates; pyramiding of control; layering of fees; and overly complex fund structures.
3. Similarly, a registered investment company’s acquisition of shares of any registered or unregistered investment company is limited, at the time of purchase, to the three limitations described above. However, under certain circumstances, the 5% and 10% limitations under Section 12(d)(1)(A) do not apply with respect to a non-US investment company’s acquisition of shares of a US registered investment company. See Dechert LLP, SEC No-Action Letter (Aug. 4, 2009). Similarly, under certain circumstances, the 3%, 5% and 10% limitations under Section 12(d)(1)(A) do not apply with respect toa US registered investment company’s acquisition of shares of a non-US investment company. See Red Rocks Capital, LLC, SEC No-Action Letter (June 3, 2011).
4. A company relying on Section 3(c)(1) or 3(c)(7) of the 1940 Act (e.g., hedge funds, private equity funds) is not an “investment company” under the 1940 Act. However, Sections 3(c)(1) and 3(c)(7) provide that such a company is nonetheless an “investment company” for purposes of the 3% limitation described in Section 12(d)(1)(A) and (B), but only with respect to the company’s purchase or other acquisition of shares issued by any registered investment company and the sale of shares by any registered open-end investment company to the company relying on Section 3(c)(1) or 3(c)(7). Accordingly, no more than 3% of a registered investment company’s voting shares may be purchased by, or sold to, a company relying on Section 3(c)(1) or 3(c)(7) of the 1940 Act (i.e., the 5% and 10% limitations described above do not apply).
5. “Pass-through voting” would require a Non-US Feeder Fund to seek voting instructions from its shareholders regarding the voting of all proxies with respect to the US Master Fund and to vote such proxies only in accordance with such instructions. “Echo voting” would require a Non-US Feeder Fund to vote the shares held by it in the same proportion as the vote of all other shareholders of the US Master Fund.
6. The Permitted Foreign Jurisdictions are limited to: Australia; Brazil; Canada; France; Germany; Hong Kong; Ireland; Japan; Luxembourg; Mexico; Singapore; South Africa; Switzerland; and the United Kingdom.
7. More specifically, (i) a Non-US Feeder Fund may not offer or sell its shares in the United States, either publicly or privately, or sell its shares to any “US person” (as defined in Regulation S under the Securities Act of 1933); (ii) each Non-US Feeder Fund’s transactions with its shareholders must be consistent with the definition of “offshore transactions” (as defined under Regulation S); and (iii) a Non-US Feeder Fund and certain of its related persons, and persons acting on behalf of such persons, may not engage in any “directed selling efforts” (as defined under Regulation S) with respect to shares of the Non-US Feeder Fund in the United States. However, over time, a Non-US Feeder Fund may include investors that are US persons due to the independent actions of shareholders (e.g., relocation of security holders to the United States, secondary market transactions), consistent with Section 7(d) of the 1940 Act and SEC and Staff guidance thereunder. See, e.g., Investment Funds Institute of Canada, SEC No-Action Letter (pub. avail. Mar. 4, 1996); Goodwin, Procter & Hoar, SEC No-Action Letter (pub. avail. Feb. 28, 1997).
8. To the extent a Non-US Feeder Fund has a principal underwriter, that underwriter (Feeder Fund Principal Underwriter) must control, be controlled by, or be under common control with, the Feeder Fund Adviser as well as the investment adviser to, and the principal underwriter for, a US Master Fund. On the basis of these conditions, all of the parties would be affiliated persons of each other.
9. Foreign Currency Instruments include foreign currency futures contracts, options on foreign currency futures contracts, forward foreign currency contracts, options on foreign currency and foreign currency swap agreements.
10. This currency hedging would enable the shareholders of the Non-US Feeder Fund to achieve a return on their investment, as measured in the Designated Currency, similar to that of the other shareholders of the US Master Fund, as measured in US Dollars, by reducing the impact of currency fluctuations between the Designated Currency and the US Dollar. This currency hedging is similar to the currency hedging permitted in a previous no-action letter received by Dechert LLP. See PIMCO Funds, SEC No-Action Letter (pub. avail. July 9, 2002).
In PIMCO Funds, the Staffdid not concur with the view that, solely for purposes of Section 12(d)(l)(E), the term “investment security” does not include the Foreign Currency Instruments under the circumstances described in the incoming letter. Nevertheless, the Staff took the position that “the Investing Fund’s proposed use of the [Foreign Currency Instruments], under the circumstances described in [the incoming] letter, would be consistent with the purposes underlying Section 12(d)(l) of the [1940] Act.” Moreover, the Staff was “persuaded by [the applicant’s] arguments that the Investing Fund’s proposed use of the [Foreign Currency Instruments] would not create any incentive to exercise any improper influence over the Underlying Fund because the same investment adviser advises both of these funds, and would not create a complex pyramidal structure.” (emphasis added)
11. This currency hedging would enable the shareholders of the Non-US Feeder Fund to achieve a return on their investment, as measured in the Designated Currency, similar to that of the index whose returns the US Master Fund seeks to approximate, by reducing the impact of currency fluctuations between or among the Designated Currency and the US Dollar or other foreign currency exposure of the index.
12. To the extent any books and records are not kept in English, the Feeder Fund Adviser would cause such books and records to be translated into English upon reasonable advance notice by the SEC or its Staff.
13. These requirements would not apply if: (i) the Feeder Fund Adviser is registered with the SEC; or (ii) the Feeder Fund Principal Underwriter, if any, is a broker-dealer registered under the 1934 Act or a person controlled by such a broker-dealer. In addition, if the Feeder Fund Principal Underwriter, if any, is not a broker-dealer registered under the 1934 Act or a person controlled by such a broker-dealer, the Feeder Fund Principal Underwriter would need to similarly designate an agent for service of process, consent to jurisdiction, and commit to the other undertakings described above.
14. Pursuant to Article 58 of the UCITS Directive, a UCITS that is classified as a feeder fund may invest only in a master fund that is also a UCITS.