In a three-to-one vote on May 25, 2022, the U.S. Securities and Exchange Commission (the SEC) proposed amendments (the amendments) to Rule 35d-1 (the Names Rule) under Section 35(d) of the Investment Company Act of 1940, as amended (the 1940 Act). The amendments would address changes in practices regarding Names Rule compliance that have developed in the fund industry over the past twenty years since the Names Rule was first adopted in 2001.
The amendments, if adopted, would:
- Expand the scope of the Names Rule.
- Clarify when a fund’s 80% investment policy must be a fundamental investment policy.
- Address the valuation of derivatives instruments for purposes of determining compliance with the 80% investment policy requirement, as well as the derivatives that may be included in the fund’s 80% basket.
- Provide for prospectus disclosure regarding the criteria that a fund uses in its name selection.
- Require the use of plain English for terms used in fund names.
- Provide guidance on the use of environment, social and governance (ESG) terminology in a fund’s name.
- Confirm that compliance with the 80% investment policy is not a safe harbor for materially deceptive or misleading fund names.
- Provide updates to the notice requirement in the Names Rule, prescribe amendments to Form N-PORT and propose new recordkeeping requirements.
80% Investment Policy Requirement
The amendments as proposed would broaden the scope of the Names Rule, which currently requires an 80% investment policy for funds whose names suggest a focus in a particular type of investments, industry, or in certain countries, or that suggests certain tax treatment. The amendments would require the 80% investment policy to also apply to any fund name with terms that suggest that the fund focuses on investments that have, or investments whose issuers have, characteristics suggested by the fund’s name. For example, the proposal would apply to a fund’s name with terms such as “growth” or “value” or terms that indicate that the fund’s investment decisions incorporate one or more ESG factors (e.g., terms such as sustainable, green or impact). In addition, where a fund’s name suggests an investment focus that has multiple elements (e.g., KLM Solar and Wind Solar Power Fund), the fund’s 80% investment policy must address all the elements in the name.
The proposal also includes requests for comments on certain scenarios where the specific context would dictate what would be appropriate to include in the 80% basket (e.g., funds including or excluding short positions in their 80% baskets). In a fund of funds context, the amendments would permit the acquiring fund to include the entire value of its investment in an appropriate acquired fund when calculating compliance with the 80% test without looking through to the acquired fund’s underlying investments. Further, the amendments would expand the current rule’s guidance that a fund may use any reasonable definition of the terms used in its name and instead require that any terms used in a fund’s name that suggest an investment focus, or that such fund is a tax-exempt fund, must be consistent with those terms’ plain English meaning or established industry use.
Temporary Departures From the 80% Investment Policy
The amendments would permit a fund to depart temporarily from a fund’s 80% investment policy in the following specified circumstances:
- As a result of market fluctuations or other circumstances where the temporary departure is not caused by the fund’s purchase or sale of a security or the fund’s entering into or exiting an investment.
- To address unusually large cash inflows or redemptions.
- To take a position in cash and cash equivalents or government securities to avoid a loss in response to adverse market, economic, political or other conditions.
- To reposition or liquidate a fund’s assets in connection with a reorganization, to launch the fund or when notice of a change in the fund’s 80% investment policy has been provided to fund shareholders at least 60 days before the change.
Under each of these circumstances, a fund would be required to bring its investments back into compliance with its 80% investment policy within 30 consecutive days. In a fund launch context, the amendment would require that the temporary departure not exceed a period of 180 consecutive days. In a fund reorganization context or where the fund has provided notice that it intends to change its 80% investment policy, the amendments would not prescribe a time frame accompanying temporary departures. Notwithstanding, in all cases, a fund would be required to come back into compliance with its 80% investment policy as soon as reasonably practicable.
Considerations Regarding Derivatives Under the Names Rules
For funds to better reflect the investment exposure that derivatives investments create and to increase comparability among fund’s valuation of derivatives instruments when assessing compliance with the fund’s 80% investment policy, the amendments would require that a fund use the notional valuation for derivatives instruments used to provide synthetic exposure to the type of investment suggested by the fund’s name. Accordingly, in complying with its 80% investment policy, a fund would include all derivatives instruments in the denominator of the calculation, as well as any derivatives in the fund’s 80% basket, i.e., the numerator in the calculation. The proposed approach to notional amount valuation does not distinguish between derivatives instruments that are assets versus derivatives that are liabilities of the fund.
Unlisted Closed-End Funds and Business Development Companies
The amendments would require that a fund’s 80% investment policy must always be a fundamental investment policy if the fund is an unlisted registered closed-end fund (CEF) or business development company (BDC). As a result, unlisted CEFs and BDCs would not be permitted to change their 80% investment policies without shareholder approval. The proposed rule release shares a concern that shareholders in an unlisted CEF or BDC generally will have no ready recourse, such as the ability to redeem or quickly sell their shares, if the fund were to change its investment policy and the investment focus that the fund’s name indicates.
Effect of Compliance With an 80% Investment Policy
The amendments add a new provision to the Names Rule that a fund’s name may be materially deceptive or misleading under Section 35(d) of the 1940 Act, even if a fund adopts an 80% investment policy and otherwise complies with the requirement to adopt an 80% investment policy.
Enhanced Prospectus Disclosure
The proposed rule would amend Form N-1A, Form N-2, Form N-8B-2 and Form S-6 to require that a fund, to the extent applicable, include disclosure in its prospectus that defines the terms used in its name, including the specific criteria the fund uses to select the investments the term describes, if any. These funds must also tag new information that would be included using a structured data language (specifically Inline eXtensible Business Reporting Language or Inline XBRL).
Materially Deceptive and Misleading Use of ESG Terminology in Certain Fund Names
The amendments would “address the specific concern that the use of ESG terms in an integration fund’s name overstates the emphasis of ESG considerations in selecting that fund’s portfolio investments.” The proposed rule release defines integration funds as funds that consider one or more ESG factors alongside other, non-ESG factors in the fund’s investment decisions and do not weigh ESG factors more heavily than other factors. The amendments would consider the name of an integration fund to be materially deceptive and misleading if the name includes terms suggesting that the fund’s investment decisions incorporate one or more ESG factors.
Notice Requirement, Reporting and Recordkeeping
The amendments would provide for new modifications to the 60-day notice requirement under the Names Rule, including provisions for electronic delivery and specific items required to be included in the notice. The release also includes modifications to Form N-PORT that would require a fund required to adopt and implement an 80% investment policy to report on Form N-PORT (i) the percentage of the fund’s total assets, by value, that are invested consistent with the fund’s 80% investment policy, and (ii) if applicable, the number of days that the fund failed to meet its 80% investment policy during the reporting period. In addition, the release contains new recordkeeping requirements, including written record of determinations made and the basis for such determinations related to (i) assets deemed to be consistent with the fund’s investment focus (or, as applicable, consistent with the tax treatment suggested by a tax-exempt fund’s name); (ii) reasons for any departures from the 80% investment policy; (iii) the dates of any departures from the 80% investment policy and (iv) the fund’s analysis as to why an 80% investment policy was not required.
Vote and Dissent
The rules were proposed by a three-to-one vote, with SEC Chair Gary Gensler and Commissioners Caroline Crenshaw and Allison Herren Lee voting for the proposed rules and Commissioner Hester Peirce voting against. In her dissent, Commissioner Hester Peirce outlined four areas of concern related to the proposed Names Rule, including (i) that the requirement for an 80% investment policy for funds focusing on investments with “particular characteristics” would rely on subjective judgments, (ii) that the proposal would unduly constrain advisers’ ability to make decisions in the best interest of the funds they manage, (iii) that the outright prohibition on integration funds’ use of ESG in their names could result in substantive changes in the way some funds are managed, and (iv) that the one-year implementation period proposed is too short. In sum, she noted that the amendments may create confusion and could place unnecessary constraints on fund managers.
Request for Comment and Compliance Period
The public comment period will remain open for 60 days following the publication of the proposing release in the Federal Register and includes a one-year compliance period, which may raise implementation challenges for some investment managers if changes to a fund's name and 80% investment policy require prior SEC review. In the proposed rule release, the SEC directs approximately 100 requests for comment to the investment adviser and fund industry relating to each element of the rule proposal as it looks to finalize the rules. Some of the requests for comment include the following:
- Should the Names Rule’s 80% investment policy requirement apply, as proposed, to fund names with terms such as “ESG” and “sustainable” that reflect certain qualitative characteristics of an investment? Why or why not?
- Should we adopt any specific requirements with regards to the portion of the fund’s assets not included in the 80% basket?
- Should we limit the exceptions for market fluctuations, unusually large cash flows, and temporary defensive positions to 30 days as proposed or some other amount of time?
- Is the requirement to bring a fund back into compliance with the 80% investment requirement as soon as reasonably practicable appropriate?
- Is it appropriate to require a fund to use a derivatives instrument’s notional amount, with certain adjustments, and to reduce the value of its assets for this purpose by excluding any cash and cash equivalents up to the notional amount of the derivatives instrument, as proposed?
- Are there any unlisted closed-end funds or BDCs for which our proposed approach may be less necessary to address investor protection considerations?
- Under what circumstances would a fund’s name be misleading or deceptive under section 35(d) even where the fund complies with its 80% investment policy? Should we identify any of these circumstances in the rule?
- Should we, as proposed, define a fund name as materially deceptive and misleading when the fund is an integration fund that uses ESG terms in its name?
- Should we further limit the extent to which funds may use specific ESG-related terms in their names, for example permitting the use of certain terms only if a fund has a certain investment focus?
- Are the proposed new instructions in the applicable fund registration forms requiring funds to define the terms used in their names appropriate and clear?
The amendments to the Names Rule would modernize and expand the current requirements for certain funds to adopt an 80% investment policy in accordance with the investment focus a fund name suggests, provide new enhanced disclosure and reporting requirements and update notice and recordkeeping requirements. The scope expansion seeks to capture additional fund names that are likely to be materially deceptive and misleading unless supported by an 80% investment policy. This scope expansion is a shift in policy and would necessitate funds to make the subjective judgment as to what qualifies under the expanded scope rather than current Names Rule practice of having the SEC staff call balls and strikes on which term in a fund’s name is subject to the Names Rule. Given the SEC has also recently proposed an ESG-related rule for issuers, the trend towards and the SEC’s focus on ESG and related products will likely continue to grow while the fund industry awaits final rule amendments that will have been revised or updated based on industry comments.