SEC OKs Fund of Funds Update, New ‘Finders’ Exemption

SEC Chairman Jay Clayton (Photo: Andrew Harrer/Bloomberg)

The Securities and Exchange Commission adopted Wednesday a new rule updating the regulatory framework for fund of funds arrangements, as well as a “finder” exemption for small-business capital formation funding.

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The Commission approved a new rule and amendments under the Investment Company Act of 1940 to streamline and enhance the regulatory framework for funds that invest in other funds.

“Main Street investors have increasingly used mutual funds, exchange-traded funds (ETFs) and other types of funds to access our markets and invest for their future,” said SEC Chairman Jay Clayton, during the virtual open meeting. “To achieve asset allocation, diversification and other objectives, many funds have also invested in other funds. Today’s action will enhance and modernize the regulatory framework for these arrangements.”

Clayton explained that the framework “will provide flexibility to fund managers to allocate and structure investments efficiently, without the costs and delays of seeking individualized exemptive orders, as long as the arrangements satisfy a number of conditions designed to enhance investor protection.”

SEC Commissioner Hester Peirce, a Republican, tweeted after the vote that “transitioning from an exemptive order framework for funds-of-funds won’t be easy, but a consistent, workable regulatory approach is important. For less common arrangements, the exemptive process is still available.”

Approximately 40% of all registered funds hold an investment in at least one other fund, according to SEC staff estimates, with total net assets in mutual funds that invest primarily in other mutual funds growing to $2.54 trillion in 2019.

“Retail investors similarly use fund of funds arrangements as a convenient way to allocate and diversify their portfolio through a single, professionally managed investment,” the SEC said.

Rule 12d1-4 will allow a fund to acquire the shares of another fund in excess of the limits of the Investment Company Act without obtaining an individual exemptive order from the commission if the funds comply with conditions designed to enhance investor protection, according to the SEC.

Finders’ Exemption

The securities regulator also adopted by a 3-2 vote a new limited, conditional exemption from broker registration requirements for “finders” who assist issuers with raising capital in private markets from accredited investors — something Peirce has wanted since 2018.

The plan creates two classes of finders, Tier I and Tier II, that would be subject to conditions tailored to the scope of their respective activities.

The plan establishes “clear lanes for both registered broker activity and limited activity by finders that would be exempt from registration,” the SEC said.

“Many small businesses face difficulties raising the capital that they need to grow and thrive, particularly when they are located in places that lack established, robust capital raising networks. Particularly in these ecosystems, finders may play an important role in facilitating capital formation for smaller issuers,” Clayton stated.

“Significant uncertainty” about finders’ regulatory status, however, has lead “to many calls for Commission action, including from small business advocates, SEC advisory committees and the Department of the Treasury,” Clayton added.

SEC Commissioner Elad Roisman added that “the status of ‘finders’ has been a long-standing grey area in our broker-dealer regulatory regime. Throughout my tenure as an SEC Commissioner, I have discussed the need for the SEC to provide clarity in this area.”

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The two Democratic commissioners, Allison Herren Lee and Caroline Crenshaw, dissented.

With the new finders exemption, Lee stated, the agency is creating “a new exemption that will permit individuals to engage in traditional brokerage activity without the important investor protections that come with registration as a broker-dealer, effectively creating a new category of unregistered financial professionals.”

Lee stated that she “could have supported a proposed rulemaking that offered a scaled registration model for finders that tailored investor protections to the new risks the model creates.”

Instead, the agency permits “unregistered activity that meets the traditional definition of brokerage without adding basic protections such as recordkeeping requirements or the ability to inspect for compliance.”

Crenshaw added that the SEC’s new exemption allows finders to engage “in core broker-dealer activities — actively soliciting and recruiting investors on behalf of issuers, and receiving commissions tied to their sales activities — without having to register with the SEC or FINRA.”

Unlike registered broker-dealers, Crenshaw stated, “Finders would not be subject to periodic inspections or examinations, nor would they be required to maintain records of their activities or comply with basic broker-dealer requirements such as suitability or know your customer rules.”

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