SEC Provides No-Action Relief for Index-Based Funds to Exceed Diversification Limits without Obtaining Shareholder Approval

The Staff of the SEC’s Division of Investment Management (Staff) has issued a no-action letter permitting registered open-end and exchange-traded index-based funds to exceed the limits of a “diversified company,” as defined in the Investment Company Act of 1940, in certain circumstances, without obtaining shareholder approval. As described below, this relief relates to situations where, due to changes in relative market capitalization and weightings of certain issuers in a fund’s benchmark index, the fund would exceed the investment limits for a diversified company if it continued to track the composition of its benchmark index. In addition, in order to rely on this relief, a fund must: (i) update its registration statement to reflect the fund’s ability to exceed such diversification limits and the associated risks; and (ii) provide notice to its shareholders regarding the fund’s updated diversification policy.

As set forth in the Incoming Letter, during the past year certain constituents of large-capitalization U.S. equity growth broad-based indices (namely, certain technology-related companies) had grown to represent more than 5% of such indices and, in some cases, in the aggregate, more than 25% of such indices. Due to increases in share prices of technology-related companies, the market capitalization of such companies outpaced that of non-technology-related companies, resulting in increased relative market capitalization and weighting of such technology-related companies within U.S. equity growth broad-based indices.

Accordingly, the Incoming Letter requested that the Staff grant no-action relief to address the concern that an index-based fund, “solely as a result of tracking its unaffiliated target broad-based index, would cease to be a diversified company as a result of a change in relative market capitalization or index weighting of one or more constituents of the index.”2 This no-action relief would permit index-based funds “to continue to invest in accordance with their investment objective and strategy” without the disruption and expense of obtaining shareholder approval.

No-Action Relief: Exceeding Diversified Company Limits Without Obtaining Shareholder Approval

The Staff stated that it “will not recommend … enforcement action under Sections 13(a)(1)3 and 34(b)4 of the [1940 Act], against an index-based fund that exceeds the limits for a diversified company, as defined in Section 5(b)(1)5 of the 1940 Act, with respect to investments in an issuer or several issuers to the extent necessary to approximate the composition of the fund’s target broad-based index,” without obtaining shareholder approval, in cases where the fund:

• “updates its registration statement to reflect the fund’s ability to exceed such limits and associated risks”; and
• “provides notice of the fund’s updated diversification policy to shareholders,” as described in the Incoming Letter.

These registration statement disclosure changes and shareholder notices include:

• Within the fund’s prospectus, the principal investment strategy disclosure must state that the fund “may become non-diversified, as defined under the 1940 Act, solely as a result of a change in relative market capitalization or index weighting of one of more constituents of [benchmark index]”;
• Within the fund’s prospectus, the risks associated with the fund becoming non-diversified must be disclosed as principal risks; and
• Within the fund’s statement of additional information, the fundamental investment policy regarding diversification must reflect that the fund “intends to be diversified in approximately the same proportion as the [benchmark index] is diversified.”

In addition to these registration statement changes, the Incoming Letter states that a fund will include the updated diversification policy “at a minimum” on its website. Further, a fund must send to shareholders a prospectus supplement or other communication on a separate document, which “clearly indicates the updates to the [fund’s] principal investment strategy and risk disclosure … as well as that shareholder approval will not be sought when the fund crosses from diversified to non-diversified status due solely to a change in the relative market capitalization or index weighting of one or more constituents of the [benchmark index].”

In issuing the no-action position, the Staff noted that, to rely on the relief, a fund’s benchmark index must have been “created by an index provider that is not an affiliated person of the index-based fund, its investment adviser or principal underwriter, or an affiliated person of such persons, and was not created solely for the index-based fund or its affiliated persons.”

Conclusion

This no-action relief provides additional flexibility for funds that track indices to continue doing so, in cases of certain market fluctuations, without risking the need to choose between holding a shareholder vote and incurring excessive tracking error.

Footnotes

_{1) Stradley Ronon Stevens & Young, LLP, SEC Staff No-Action Letter (June 24, 2019).
2) Stradley Ronon Stevens & Young, LLP, Incoming Letter (June 24, 2019) (Incoming Letter).
3) Section 13(a)(1) relates to a fund’s ability to change its diversification classification. This section provides that a fund may not change its classification from a diversified company to a non-diversified company without first obtaining approval from the majority of its outstanding voting securities.
4) Section 34(b) provides that it is unlawful to make an untrue statement of material fact, or omit material information necessary to make other statements not misleading, in any document filed pursuant to the 1940 Act.
5) Section 5(b)(1) defines a diversified company as a “management company which meets the following requirements: At least 75 per centum of the value of its total assets is represented by cash and cash items (including receivables), Government securities, securities of other investment companies, and other securities for the purposes of this calculation limited in respect of any one issuer to an amount not greater in value than 5 per centum of the value of the total assets of such management company and to not more than 10 per centum of the outstanding voting securities of such issuer.”}