SEC Proposes to Expand Fund Names Rule

Our Take

The Proposed Names Rule represents the Commission’s attempt to introduce sweeping changes to how registered funds present themselves to investors, because a name is the introduction to the fund and may represent an important factor in an investment decision. The Commission also has made it clear that enforcement actions may be initiated when a fund’s name is “materially deceptive or misleading” even if the fund complies with Rule 35d-1 or, if adopted, the Proposed Names Rule. Thus, compliance with Rule 35d-1, as amended, would not serve as a safe harbor from liability for otherwise misleading fund names.

If the Proposed Names Rule is adopted as proposed, many funds may have to change their names or their investment strategies and/or adopt new 80% investment policies. The Proposed Name Rule would outright prohibit integration funds from using ESG-related terminology in a fund name if ESG inputs are only one factor among many that drive investment decisions. 

Funds are likely to incur higher costs to address name changes and related compliance and reporting. Moreover, in times of market uncertainty, funds may be faced with the choice either to make an adverse investment decision or face a compliance violation. While the Proposed Names Rule builds in some flexibility to temporarily deviate from the 80% requirement, they must come back into compliance within 30 days — a period that may not be long enough and may force costly divestments.

Commissioner Hester M. Peirce dissented, citing this along with several other concerns. Among other things, she said that applying the 80% investment policy requirement, as amended, to investment strategies “may have the detrimental effect of forcing homogeneity in the way funds are managed.” She said she prefers enhanced prospectus disclosures in the alternative. She also criticized the “intentionally inflexible” 30-day limit on temporary departures

Comments to the Proposed Names Rule are due 60 days after publication in the Federal Register. We expect that industry stakeholders will have much to say about the proposed rules.

Background

Section 35(d) of the Investment Company Act of 1940 prohibits registered investment companies from adopting names that the Commission finds are “materially deceptive or misleading.”¹ The Names Rule, which the Commission adopted in 2001, generally requires that if a fund’s name suggests a focus in a particular “type of investment” or “investment in a particular industry,” the fund must adopt a policy to invest at least 80% of the value of its assets in that type of investment or in investments in the industry, country, or geographic region suggested by its name (the 80% investment policy). The 80% investment policy requirement also applies to names suggesting that a fund’s distributions are tax exempt.

For example, Rule 35d-1 currently applies when a fund’s name suggests that it invests in

• a type of security (e.g., stocks or bonds)
• a particular industry (e.g., utilities or healthcare)
• a particular geographic region (e.g., Japan or Latin America)
• securities that pay tax-free dividends

The current Rule 35d-1, however, does not apply to fund names that connote a particular strategy or policy (e.g., growth and value).

The Commission is proposing to amend Rule 35d-1 to address this limitation. In particular, the Commission has stated that the current scope of the rule “has created interpretive issues,” as there is uncertainty as to whether the current rule applies to “thematic” funds, such as those that focus on ESG strategies, rather than simply invest in particular types of investments, industries, or geographic regions. The SEC now believes that Rule 35d-1 (and the 80% investment policy requirement) should apply to thematic funds, on the theory that their names may raise the same types of concerns that motivated the original rulemaking.

The Commission’s stated concern with respect to ESG is “greenwashing” and the prospect that investors may be misled when a fund’s name suggests that it uses ESG-related strategies but is not subject to the 80% investment policy requirement and may even have only limited exposure to ESG-themed investments.

The Proposed Amendments

Scope of the Proposed Names Rule — the 80% Investment Policy Requirement

The Proposed Names Rule has five key components: (a) coverage of names suggesting investment focus; (b) rules for temporary departure from the 80% requirement; (c) rules for compliance for derivatives; (d) rules for unlisted closed-end funds and BDCs; and (e) a prohibition that would apply to ESG “integration funds.”

Names suggesting investment focus  

The Proposed Names Rule would expand the reach of the Names Rule to any fund name with terms suggesting that the fund focuses investments on issuers that have particular characteristics. Specifically, the Proposed Names Rule would require funds to adopt an 80% investment policy in accordance with the investment focus or tax treatment suggested by the fund’s name.

The Proposed Names Rule specifically would apply the 80% investment policy requirement to fund names that include terms such as “growth” or “value,” or terms suggesting that the fund’s investment process incorporates one or more ESG factors. Fund names that suggest a fund’s overall characteristics (e.g., “duration” or “balanced”) would not necessarily be subject to the 80% investment policy requirement but would be subject to the Section 35(d) prohibition of “materially deceptive or misleading” names. The Adopting Release states that funds would have some flexibility to define the fund’s investment focus in its principal investment strategies in light of its name, especially when a fund name suggests more than one focus. The SEC staff asks for comments on how the Proposed Rule should address specific situations, such as when a fund name suggests that the fund is “inverse,” “hedged,” or “long/short” and suggests that short investing is part of the investment strategy.

Rule 35d-1 currently requires funds to reasonably define terms used in the name, but in a departure from the current rule, the Proposed Names Rule would require funds to define such terms to be consistent with plain English meanings or established industry use.² This would require many funds that already have 80% investment policies to review how they describe those policies in light of the new standards.

Temporary departures from the 80% requirement

The Proposed Names Rule would allow funds to depart temporarily from the 80% investment requirement (also referred to as “drift”) only

• as a result of market fluctuations or other situations when the departure is not a result of a fund’s trading activities
• to address unusually large cash inflows or redemptions
• to take a position in cash, cash equivalents, or government securities to avoid a loss in response to adverse market positions
• to reposition or liquidate a fund’s assets in connection with a reorganization, fund launch, or when the fund, upon 60 days’ notice to shareholders, changes its 80% investment policy

In each case (other than fund launches, reorganizations, or changes in 80% investment policy), a fund departing from the 80% investment policy must return to compliance as soon as possible, but the maximum time of departure cannot exceed 30 consecutive days (except for 180 days for a fund launch, a reorganization, or when the fund changes its 80% investment requirement with proper notice).

Derivatives

Derivatives have always presented a challenge for compliance with the current names rule because they have the potential for outside investment impact based on what may be a relatively limited exposure if considered only on a fair market value basis.

The Proposed Names Rule would require a fund, when calculating compliance with the 80% investment policy, to value each derivative instrument using its notional amount, subject to certain adjustments, and reduce the value of its assets by excluding cash and cash equivalents up to the notional amounts of the derivatives. A fund can include the notional value in its 80% basket and thus would get credit for the derivatives exposure for purposes of compliance with the 80% investment policy test when the derivative provides exposure to the investments suggested by the fund’s name.

Unlisted closed-end funds and BDCs

The Proposed Names Rule would require that a fund’s 80% investment policy must be a “fundamental” investment policy for registered closed-end funds and BDCs that do not list their shares on a national securities exchange. As a result, these funds could not change these fundamental investment policies without shareholder approval. The current Names Rule provides that these funds — like all registered funds — can change a nonfundamental 80% investment policy upon 60 days’ notice.

ESG integration funds

The Commission refers to “integration funds” as funds that consider one or more ESG factors alongside other, non-ESG factors in the fund’s investment decisions, but those ESG factors are generally no more significant that the other factors in the investment selection process and thus may not be determinative in investment decisions. The Proposed Names Rule would prohibit a fund from using ESG-related terminology in a fund name if ESG inputs are merely one factor among many that drive investment decisions. The Commission said that including ESG terminology in fund names “would be materially deceptive and misleading unless a fund prioritizes those ESG considerations that their names suggest, as contracted to funds that analyze ESG factors only as part of a broader investment selection process.”

Compliance, Disclosure, Recordkeeping, Reporting, and Notice

Compliance is not a safe harbor

The Proposed Names Rule would provide that a fund’s name may be materially deceptive or misleading under Section 35(d) even if the fund complies with the names rule. This addition would codify, meaning record in the rule, past SEC statements to this effect.

Enhanced prospectus disclosure

The Commission proposes to amend various fund registration forms to require each fund that is required to have an 80% investment policy to include prospectus disclosure that defines the terms used in its name, including the specific criteria the fund uses to select the investments that the term describes, if any. As noted, all defined terms under an 80% investment policy would have to be by reference to either their plain English meaning or established industry use. The amendments would also require Inline XBRL tagging of new information.

Notice requirement

The Proposed Names Rule would modify the notice requirements when funds want to change a nonfundamental 80% investment policy and would better address electronic communications.

N-PORT reports

The Commission proposes to amend Form N-PORT to require registered investment companies (other than money market funds) that are required to adopt an 80% investment policy to report (1) the value of the fund’s 80% basket, as a percentage of the value of the fund’s assets, and (2) if applicable, the number of days that the value of the fund’s 80% fund basket fell below 80% of the value of its assets during the reporting period. In a significant departure from current requirements, the Proposed Rule would require funds to identify whether each individual asset falls within the 80% investment policy.

Recordkeeping

Funds required to adopt an 80% investment policy would be required to document compliance with that policy and must maintain, among other things, records of investment included in the 80% basket, the value of the basket, and the dates of and reasons for any departures. Funds that would not be required to adopt an 80% investment policy must keep records of their analysis that the 80% investment policy is not required under the Proposed Names Rule.

Transition and Compliance Date

The Proposed Names Rule includes a one-year transition period for funds to comply with the final rule, if and when adopted. The Commission said it is evaluating outstanding no-action letters and other guidance concerning compliance with the names rule to determine what guidance, if any, it will withdraw in connection with adopting a final rule. The transition discussion in the Proposing Release does not address the kinds of filings that will be needed to implement the proposed changes, whether the staff will provide “selective review,” and the possibility of allowing “rolling compliance” based on complexwide annual update cycles.