SEC Proposes Amendments to Rule Governing Fund Naming Conventions, Including Use of ESG Investing Practices
On May 25, 2022, the U.S. Securities and Exchange Commission, by a vote of three-to-one, proposed for public comment amendments to a current rule governing fund naming conventions – which would cover certain funds that utilize environmental, social and/or governance (ESG) investment practices as part of their investment process – as well as certain forms and disclosure requirements.1 As further discussed below, these proposed amendments could meaningfully impact fund strategies, management and operations.
Section 35(d) of the Investment Company Act prohibits a registered investment company (as does Section 59 of the Investment Company Act for business development companies (BDCs)) from adopting as part of its name or title any word or words that the SEC believes are materially deceptive or misleading. The SEC adopted Rule 35d-1 (Names Rule) under the Investment Company Act in 2001, which deems certain types of fund names to be materially deceptive or misleading for purposes of Section 35(d) unless certain conditions are satisfied. The Names Rule currently requires that funds2 with names suggesting investment in a particular type of investment, industry, country or geographic region adopt a policy to invest, under normal circumstances, at least 80% of their respective assets in such type, industry, country or geographic region (80% Investment Policy). Depending on the circumstances and the type of fund name, an 80% Investment Policy may be fundamental or non-fundamental. Changes in a fundamental 80% Investment Policy require shareholder approval whereas changes in a non-fundamental 80% Investment Policy require 60-day prior notice to shareholders (Notice).
The Names Rule Release explains that the proposed amendments are intended to modernize and enhance the investor protections provided by the Names Rule given the important information that fund names can convey to investors and industry developments over the last two decades, including the growth of funds that incorporate ESG criteria into their investment processes. The Release is intended in part as a complement to the SEC’s contemporaneous proposal to amend the disclosure requirements for funds and advisers that use ESG factors in their investment activities.
In general, the proposed amendments to the Names Rule would:
- Expand significantly the 80% Investment Policy requirement to include fund names with terms suggesting an investment focus on investments that have, or whose issuers have, “particular characteristics,” including “growth,” “value” and terms indicating that the fund’s “investment decisions incorporate one or more ESG factors”;
- Designate as materially deceptive and misleading the use of ESG or related terms in names of “integration funds”;3
- Require, for funds that adopt an 80% Investment Policy, that any terms used in the fund’s name that suggest either an investment focus or that the fund is a tax-exempt fund be consistent with the terms’ plain English meaning or established industry use;4
- Specify situations where a fund may deviate from its 80% Investment Policy and, in certain circumstances, define a 30-day time period for funds to come back into compliance with their 80% Investment Policy;
- Amend the Notice requirement;
- Require additional disclosure within a fund’s prospectus to define terms used in the fund’s name, including related investment criteria for selecting investments described by the name;
- Require additional reporting on Form N-PORT relating to Names Rule compliance and to the 80% Investment Policy basket;
- Add certain recordkeeping requirements relating to fund names for funds with and without an 80% Investment Policy;
- For purposes of compliance with an 80% Investment Policy, require funds to value all derivatives based on notional amounts rather than market value;
- Require registered closed-end investment companies or BDCs that do not have shares listed on a national securities exchange (collectively, Unlisted Funds) to make any 80% Investment Policy fundamental; and
- Exempt, in certain situations, unit investment trusts (UITs) from the 80% Investment Policy requirement consistent with the current exemptions under the Names Rule.
These proposed amendments are briefly summarized below:
Investment Focus and Integration Funds; Deviations from an 80% Investment Policy
The SEC proposes to expand the Names Rule to require that a fund adopt an 80% Investment Policy if its name suggests a focus5 “in investments that have, or whose issuers have, particular characteristics.”6 The Names Rule Release includes growth, value and terms indicating that the fund investment decisions incorporate one or more ESG factor(s)7 as examples of names indicating an investment focus, whereas under the current rule such names are generally considered by many fund sponsors to be investment strategies not subject to the 80% Investment Policy requirement. The proposed amendments would also apply to other names that have historically been interpreted as being outside the scope of Rule 35d-1, including global, international, income, or intermediate term (or similar) bond.8 The Names Rule Release indicates that fund sponsors would retain flexibility in specifying how funds will define required 80% Investment Policies, define the terms used in such Policies, and determine (in many instances) what investments are appropriate to include in the 80% Investment Policy basket.9 However, as noted above, any investment focus-related terms used in a fund’s name would be required to be defined “consistent with those terms’ plain English meaning or established industry use.”
The SEC also proposes to codify that compliance with a fund’s 80% Investment Policy is not a safe harbor to the prohibitions on adopting a fund name that is materially deceptive or misleading under Section 35(d).10 The Names Rule Release makes certain key observations to this point. Specifically, under the proposed amendments, the following may be deemed to be materially deceptive or misleading practices: “substantial”11 investments made outside the 80% Investment Policy that are “antithetical” to the fund’s investment focus12 or an index fund’s 80% Investment Policy to invest in assets connoted by a specific index in circumstances where the reference index’s composition is contradictory to the index’s name.13 The proposed amendments also specifically address “integration funds,” stating that an integration fund using ESG or an ESG-related term in its name that suggests that the fund incorporates ESG factors in the fund’s investment process would be considered materially deceptive and misleading.
Additionally, the proposed amendments would remove the current principles-based approach of requiring that funds comply with their 80% Investment Policy “under normal circumstances” and specifically define situations under which a fund (either a fund with a name suggesting an investment focus or a tax-exempt fund) may temporarily deviate from its 80% Investment Policy. Such deviations could occur as a result of: certain market fluctuations or other circumstances not caused by fund purchase/sale activity; unusually large inflows or redemptions; adverse market, economic, political, or other conditions requiring a fund “to take a position in cash and cash equivalents or government securities to avoid a loss”; or repositioning/liquidating fund assets in connection with reorganizations, fund launches, or when appropriate notice of an 80% Investment Policy change has been provided to shareholders. Generally, a fund would be required to re-attain compliance with its 80% Investment Policy “as soon as reasonably practicable” but, in any event, within 30 consecutive days.14 For comparison, the current Names Rule provides a fund with greater flexibility in its interpretation, only requiring compliance with an 80% Investment Policy “under normal circumstances.”
The SEC is also proposing additional disclosure requirements to a fund’s prospectus.15 The proposed amendments affecting the prospectus disclosure would require a fund with an 80% Investment Policy to define in the fund’s prospectus: the terms16 used in the fund’s name related to its investment focus; and the fund’s investment criteria for selecting the investments described by that term. Funds would have flexibility to use “reasonable definitions” of the terms that their name uses, provided that the meaning of such terms is consistent with plain English or established industry use.17
The proposed amendments to Form N-PORT would require registered investment companies that are required to adopt an 80% Investment Policy to report: the value of its 80% Investment Policy basket as a percentage of fund assets; the number of days that the value of the registered investment company’s 80% basket fell below 80% of the fund’s net assets (if applicable); and whether a portfolio investment is included in the 80% basket.18
The proposed amendments would impact Notices in several ways, including content and delivery. As mentioned above, the Names Rule currently requires 60 days’ notice to shareholders of changes in a fund’s non-fundamental 80% Investment Policy. The proposed amendments would retain the requirement that Notice must be provided (except for fundamental 80% Investment Policy changes) but also require a fund to describe any related changes to the fund’s name in the Notice. The proposed amendments would also provide greater clarity around the content of a Notice, electronic delivery, and what it means for the Notice to be provided “separately from any other document.”19
The proposed amendments also include certain recordkeeping requirements, which would (in relevant part) require funds with an 80% Investment Policy to document compliance with the amended rule and funds without an 80% Investment Policy to document why the fund determined an 80% Investment Policy is not required.20
Under the proposed amendments, a fund would be required to calculate its assets for Names Rule purposes, including a fund’s compliance with its 80% Investment Policy, by valuing derivatives using their notional amount (with certain permitted adjustments) instead of market value and reducing the value of its assets by excluding cash and cash equivalents up to the notional amounts of the derivatives instrument(s).21 Additionally, the proposed amendments would allow funds to include in their 80% Investment Policy basket derivative instruments providing “investment exposure to one or more of the market risk factors associated with the investments suggested by the fund’s name.”22
Unlisted Closed-End Funds, BDCs and UITs
For Unlisted Funds, the proposed amendments would require any 80% Investment Policy to be a fundamental investment policy, which requires shareholder approval to change. In the Names Rule Release, the SEC explains that, in its view, shareholder approval should be necessary to change an Unlisted Fund’s 80% Investment Policy because shareholders do not have an effective way to exit the Unlisted Fund within the 60-day notice period permitted under the currently-effective version of the Names Rule.
Additionally, the proposed amendments would exempt a UIT from the 80% Investment Policy requirement if the UIT existed before the adoption of any proposed amendments (unless the UIT has already adopted or was required to adopt such a Policy at the time of initial deposit of securities).23 This provision is consistent with current UIT exemptions under the Names Rule.
Key Dates and Timing
The SEC proposed a one-year transition period for funds to comply with the proposed amendments. If adopted, the proposed amendments to the Names Rule would become effective one year following Federal Register publication of the final amendments.
Comments on the SEC’s proposal are due 60 days after the proposal is published in the Federal Register.
An upcoming Dechert OnPoint will provide further analysis of this proposal.
1) Investment Company Names, Release No. IC-34593 (May 25, 2022) (Names Rule Release). At the same open meeting, the SEC also voted to propose for public comment amendments to rules under the Investment Advisers Act of 1940 and the Investment Company Act of 1940 relating to the disclosure of ESG investment practices. At times, this NewsFlash tracks the Names Rule Release without the use of quotation marks. Terms not defined in this NewsFlash have the meaning assigned to them in the Names Rule Release.
2) Unless otherwise specified, the term “fund” as used in this Dechert OnPoint refers to a registered investment company and BDC.
3) The SEC defines “integration funds” in the Names Rule Release as funds that consider one or more ESG factors alongside other, non-ESG factors in its investment decisions, but such ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio.
4) The SEC has not proposed to change the requirement in Rule 35d-1 that funds with names suggesting that their distributions are exempt from federal income tax or from both federal and state income tax adopt a fundamental 80% Investment Policy.
5) Where a fund’s name suggests an investment focus that has multiple elements, the 80% Investment Policy would be required to address each element.
6) In the Names Rule Release, the SEC clarifies that amendments only expand the Names Rule in this area and funds that are currently required to adopt an 80% Investment Policy (i.e., funds whose names suggest a focus in a particular type of investments or industry, or in particular countries or geographic regions, or suggest certain tax treatment) under the Names Rule will still be required to do so.
7) For purposes of the proposed amendments, the term “ESG” would encompass terms such as “socially responsible investing,” “sustainable,” “green,” “ethical,” “impact,” or “good governance” to the extent they describe environmental, social, and/or governance factors that may be considered when making an investment decision.
8) However, names that do not indicate a specific investment focus – instead referencing fund-level portfolio characteristics, investment techniques, or possible results (e.g., duration, balanced, long/short, real return) – would continue to be outside the scope of Rule 35d-1.
9) For funds of funds or other “acquiring” funds, the Names Rule Release indicates that it would be reasonable, under the proposed amendments, for a top-tier fund to count its entire position in an underlying fund towards the 80% Investment Policy in certain circumstances.
10) Stated another way, a fund’s name may still be materially deceptive or misleading for purposes of Section 35(d) in certain circumstances.
11) “Substantial” investment could include, for example, investing in a way “such that the source of a substantial portion of the fund’s risk or returns is different from that which an investor reasonably would expect based on the fund’s name.”
12) The SEC noted that, for example, a “fossil fuel-free” fund making a substantial investment in an issuer with fossil fuel reserves could be materially deceptive or misleading for purposes of Section 35(d).
13) In addition, the SEC reiterated its view that an index fund generally would be expected to invest more than 80% of its value in investments connoted by the applicable index.
14) This does not apply to fund launches (which are permitted 180 consecutive days from the “date the fund commences operations” to come into compliance), reorganizations (no specified time period for re-attaining compliance), and situations where 60 days’ notice of a change in a non-fundamental 80% Investment Policy was provided to shareholders. Related, the Names Rule Release clarifies that “as soon as reasonably practicable” does not require re-attaining compliance “as soon as possible” in all instances. Instead, this phrase would allow “for consideration by the adviser of how to return to compliance in a manner that best serves the interest of the fund and its shareholders.”
15) Prospectus requirements would apply to Form N-1A, Form N-2, Form N-8B-2, and Form S6.
16) The Names Rule Release clarifies that the phrase “terms” would “mean any word or phrase used in a fund’s name, other than any trade name of the fund or its adviser, related to the fund’s investment focus or strategies.
17) The failure to do so could result in such terms being deemed to be materially deceptive or misleading for purposes of Section 35(d).
18) Such requirements will not apply to money market funds or BDCs.
19) Although “separately from any other document” is phrased differently than the current requirement, the proposal is intended to be “functionally the same as the current rule’s requirement.”
20) The Names Rule Release notes that the current Names Rule and other recordkeeping requirements under the Investment Company Act do not require recordkeeping with respect to the Names Rule.
21) The use of notional amounts would be subject to certain adjustments outlined in the Names Rule Release.
22) This would be in addition to including derivatives that provide investment exposure to the investments suggested by the fund’s name. As a practical matter, the proposal would have the effect of requiring funds to value all derivatives exposures based on notional amounts for purposes of determining compliance with the fund’s 80% Investment Policy (i.e., those derivatives in both the numerator and denominator).
23) The proposed amendments also exempt UITs from the recordkeeping requirement if the UIT pre-dates the adoption of any amendments.