On March 2, 2020, the Securities and Exchange Commission (SEC) issued a request for public comment from funds, investors and other market participants on the framework for addressing misleading fund names under Rule 35d-1 (Names Rule) under the Investment Company Act of 1940. The SEC is seeking public input as part of its assessment of whether the Names Rule is effective in preventing misleading or deceptive fund names and whether there are alternatives to the Names Rule.
The Names Rule prohibits a fund from adopting as part of its name any word or words that the SEC finds materially deceptive or misleading. Fund names are also subject to the antifraud provisions of the federal securities laws. The SEC adopted the Names Rule in 2001 as an additional tool to help the SEC protect investors from being misled or deceived by a fund’s name.
The Names Rule generally requires a fund to invest at least 80% of its assets in the manner suggested by the fund’s name. In particular, if a fund’s name suggests a type of investment or geographic focus, the fund is required to invest at least 80% of its assets in the type of investment, industry, country or geographic region suggested by its name.
Fund Developments and Considerations
In its Request for Comments, the SEC identified the following fund developments since adoption of the Names Rule and the challenges in applying the Names Rule in light of those developments:
- Increasing Use of Derivatives by Funds. An asset-based requirement may not necessarily capture significant exposure to a type of investment when leverage is involved. For example, the market value of derivatives may be relatively small, but its derivatives use may create significant exposure for a fund.
- Increasing Use of Hybrid Instruments by Funds. Hybrid financial instruments, such as convertible securities, may have some, but not all, of the characteristics of the asset types used in a fund’s name.
- Growing Number of Index Funds. A fund may include the name of the index that it is tracking in its name. Indexes are not subject to the Names Rule and the index constituents may not be closely tied to the type of investment suggested by an index’s name.
- Use of Qualitative Assessments, such as ESG. An increasing number of funds have an investment mandate that requires certain qualitative assessments, such as environmental, social and governance-oriented (ESG) characteristics, and use those parameters in the funds’ names. The SEC noted that certain funds treat terms like “ESG” as an investment strategy, which is not subject to the Names Rule, and some funds treat “ESG” as a type of investment, which is subject to the Names Rule.
- Competitive Market Environment. An increasingly competitive market environment may drive asset managers to select fund names that are more likely to attract assets but not be consistent with the purpose of the Names Rule.
Comment Period and Request for Comment
Comments are due 60 days after the SEC publishes the Request for Comments in the Federal Register. The SEC has requested comments on various aspects of fund names and the Names Rule, including the following:
- Fund Names and the Names Rule Generally
- To what extent do investors and funds rely on fund names to invest in or market funds?
- Is the Names Rule effective in protecting investors? Should the Names Rule be repealed?
- Are there ways the Names Rule could be modified to provide greater investment flexibility while still protecting investors?
- Should the Names Rule apply to ticker symbols?
- Should the Names Rule apply differently to closed-end funds or business development companies?
- 80% Investment Requirement
- Does the 80% requirement continue to be appropriate? Should the minimum threshold be higher or lower? Should the requirement be different for different types of investments? Should a fund be required to continue to maintain the required level of investment rather than only satisfy it at the time of investment?
- Is an asset-based test appropriate? For example, would notional value rather than market value be appropriate for funds that use derivatives? What are the operational or interpretive challenges associated with a different approach?
- Industry Determination
- How do funds determine whether a portfolio investment is part of a particular industry?
- Should there be flexibility under the Names Rule for funds that intend to focus their investments in emerging industries or companies that rely on emerging technologies?
- Certain Terms Used in Fund Names
- Should the Names Rule apply to the following terms, all of which are currently not regulated under the Names Rule: “growth” and value”; “ESG” and “sustainable”; “global” and “international;” “actively managed,” “tax managed,” “long-term” and “short-term”; and terms that identify a particular affinity group or population of investors, such as “veterans” or “municipal employees”?
- To what extent do investors rely on fund names that use “ESG” or “sustainable,” which reflect certain qualitative characteristics of an investment, and should there be limits or requirements on a fund’s ability to characterize its investments as ESG or sustainable?
- Are there other terms used in fund names that are especially prone to mislead investors or create other challenges?