§ 5.12 Statutory Investment Limits

• Jurisdiction: United States
• Publication year: 2022

§ 5.12 Statutory Investment Limits

[1]—Investment Company Act Section 12(d)(1)

As discussed previously,⁶⁸⁶ hedge funds typically rely on Section 3(c)(1) or Section 3(c)(7) to claim exemption from registration under the Investment Company Act. Nonetheless, funds that are otherwise exempt from registration under those sections are deemed to be investment companies for purposes of the investment limitations set forth in certain provisions of Section 12(d)(1) under the Investment Company Act. This limitation on the extent to which a private fund can invest in certain registered investment companies can impact potential investments in smaller ETFs and similar registered fund products.

Section 12(d)(1) prohibits a private fund from acquiring securities of a registered investment company, if immediately after such acquisition, the private fund, or any company or companies controlled by it, would hold in the aggregate more than 3% of the voting securities of the acquired company.⁶⁸⁷

Section 12(d)(1)(E), however, allows an unregistered private fund to invest all of its assets in a registered investment company pursuant to a master-feeder arrangement, subject to certain conditions.⁶⁸⁸

Certain Investment Company Act rules work to ease the restrictions of Section 12(d)(1), including Rule 12d1-1, which allows funds to invest unlimited amounts in shares of money market funds for short periods of time, in an investment referred to as a "cash sweep" arrangement.⁶⁸⁹ The SEC determined that the fund investments in money market funds were not the type of investments that caused the concern underlying the section.⁶⁹⁰ In October 2020, the SEC adopted new rule 12d1-4 and certain related amendments intended to streamline the regulation of fund-of-funds arrangements.⁶⁹¹ The new rule permits funds to acquire shares of other funds in excess of the Section 12(d)(1) limits, subject to certain conditions, without obtaining an exemptive order from the SEC. However, private funds do not fall within the new rule's scope of "acquiring" funds, and so cannot rely on the new rule when investing in registered funds in excess of the investment limits described in Section 12(d)(1) of the Investment Company Act.⁶⁹²

[2]—Bank Holding Company Act

Under the Bank Holding Company Act of 1956 ("BHC Act"), any entity that acquires a "controlling" interest in a U.S. bank or bank holding company ("BHC") must, itself, register as a BHC with the Board of Governors of the Federal Reserve Board ("Federal Reserve Board").⁶⁹³ Becoming a BHC subjects the entity to regulatory supervision, capital requirements, and significant activity and investment restrictions. A similar consequence would also ensue for any entity that acquires a controlling interest in any non-U.S. bank that maintains a branch or agency office in the Unites States or that controls a commercial lending company in the United States (each such non-U.S. bank is referred to as a "foreign banking organization" or "FBO" and is subject, in large part, to the BHC Act as if it were a BHC).⁶⁹⁴

To avoid these consequences, hedge funds must limit themselves to "noncontrolling" investments in U.S. banks, BHCs and FBOs. Generally, in order for an interest to be viewed as noncontrolling under federal banking law, it must be less than either: (1) 25% of any class of the target's voting securities and one-third of its total equity.⁶⁹⁵

Depending on all of the facts, however, an entity may be deemed to control a banking institution with an interest as low as 5% of any class of the target's voting securities. Historically, in most cases where an investor wished to make a non-controlling investment of between 10% and 24.99% of any class of the target's voting securities, the investor was required to enter into certain "passivity commitments" with the Federal Reserve Board, whereby the investor essentially agrees not to enter into any business relationships with the target or make any attempts to influence its business, other than through: (1) voting their securities in the ordinary course of business; (2) non-coercive discussions with management; or (3) having one board representative (or, in some very limited cases, two representatives).⁶⁹⁶ More recently, however, the Federal Reserve Board adopted a more relaxed and practical approach to defining control, which became effective on September 30, 2020.⁶⁹⁷ When doing so, the Federal Reserve indicated that, in general, it would no longer require the aforementioned passivity commitments. Moreover...