At a Glance
- The U.S. Securities and Exchange Commission (SEC) recently approved amendments to rule 35d-1 (the Names Rule) under the Investment Company Act of 1940 that addresses certain categories of investment company names.
- The Names Rule amendments and related disclosure and record-keeping requirements expand the scope of funds that will need to comply with the rule’s 80% investment policy requirement, impose additional compliance requirements and require funds to provide additional disclosures to investors and the SEC regarding the terms used in a fund’s name, among other information.
On September 20, 2023, during its first in-person open meeting since the COVID-19 pandemic, the U.S. Securities and Exchange Commission (SEC) adopted amendments (the Amendments) to the Names Rule under Section 35(d) of the Investment Company Act of 1940, in a four-to-one vote. The SEC also adopted related disclosure and record-keeping requirements. Commissioner Mark Uyeda dissented, raising concerns about the compliance burden, especially on smaller fund managers, and how the SEC would handle the implementation of the Amendments. Commissioner Hester Peirce raised many questions but approved the Amendments.
I. Overview of the Adopted Amendments to Names Rule and Related Regulatory Requirements
The Amendments are intended to better protect investors from being misled by fund names. The Names Rule amendments and related disclosure and record-keeping requirements expand the scope of funds that will need to comply with the rule’s 80% investment policy requirement, impose additional compliance requirements and require funds to provide additional disclosures to investors in the fund’s prospectus regarding the terms used in a fund’s name. The SEC also adopted additional N-PORT reporting requirements and new record-keeping requirements.
1. Expansion of Scope
Under current regulations — first adopted in 2001 — a fund must adopt a policy to invest at least 80% of the value of its assets in the type of investment, or in investments that matches the name (80% Policy), if the fund name suggests a particular asset type (stocks or bonds), industry, or geographic focus. The Amendments broaden the 80% Policy requirement to apply also to any fund name with terms suggesting that the fund focuses on investments that have, or whose issuers have, particular characteristics (e.g., growth, value, or environmental, social and governance (ESG)).
2. Funds’ Compliance With the 80% Policy Requirement
The Amendments retain the Names Rule’s current requirement for a fund to invest in accordance with its 80% Policy “under normal circumstances,” and apply the 80% test at the time of a fund investing assets. A fund may determine for itself what it believes are normal circumstances. However, the SEC noted that frequent or recurring departures from normal circumstances should cause a fund to re-assess what normal circumstances are, or its name and 80% Policy. Also, the SEC adopted a new compliance requirement for a fund to conduct at least a quarterly review of its portfolio assets included in its “80% basket.”
In case of a temporary deviation from its 80% Policy, either deliberately or unintentionally, the Amendments will require a fund to come back into compliance as soon as reasonably practicable within 90 days from the date of the temporary departure, different from the 30 days proposed. However, a fund may temporarily depart from the 80% Policy beyond 90 days under certain circumstances, such as in connection with a reorganization, for which no time frame is specified for the temporary departure; or a fund launch, for which deviation is not to exceed 180 consecutive days.
In addition, the Amendments codify that a fund’s compliance with the 80% Policy is not dispositive of compliance with the prohibition against materially misleading or deceptive names. The SEC stated that to the extent a fund uses its 20% basket to invest in assets materially inconsistent with the investment focus or risk profile reflected by the fund’s name, the fund’s name would be materially deceptive or misleading.
The SEC clarified that Index funds — funds that generally track a securities index — should generally adopt and implement written policies and procedures under Rule 38a-1 to ensure that the indexes selected do not have materially misleading or deceptive names. However, the SEC confirmed that the terms used in a market index referenced in a fund name, do not subject the fund to the 80% Policy, in addition to the fund's policy to invest at least 80% of assets in the underlying index components.
3. Considerations Regarding Derivatives under the Names Rule
Consistent with the proposal, the Amendments generally require funds to use a derivative instrument’s notional amount, rather than its market value, to determine the fund’s compliance with its 80% Policy. A fund may include in its 80% basket derivatives instruments that provide investment exposure to one or more market risk factors associated with the investment focus suggested by the fund’s name. However, in a change from the proposal, the Amendments require a fund to exclude from the calculation certain derivatives that hedge the currency risk associated with the fund's foreign-currency-denominated investments.
4. Unlisted Registered Closed-End Funds and Business Development Companies
Consistent with the proposed amendments, the Amendments generally prohibit an unlisted registered closed-end fund (CEF) or a business development company (BDC) that is subject to an 80% Policy from changing such policy without a shareholder vote.
In a change from the proposal, the Amendments permit a CEF or BDC to change its 80% Policy without a shareholder vote, if (i) the CEF or BDC provides at least 60 days’ prior notice of such policy change, (ii) conducts a tender or repurchase offer at its net asset value before such policy change, and (iii) the tender or repurchase offer is not oversubscribed.
5. Enhanced Prospectus Disclosure Requirements
Consistent with the proposal, the Amendments require a fund subject to the Names Rule to reasonably define terms used in its name that suggest an investment focus, and the criteria the fund uses in selecting investments to match such terms in its prospectus. Although funds have the flexibility to define the terms, the definitions must be consistent with plain English meaning or established industry use.
6. Form N-Port Reporting Requirements
Consistent with the proposal, the Amendments require a fund to report whether an investment is included in the fund’s 80% basket, and the value of the fund’s 80% basket. In a change from the proposal, the Amendments require a fund to also report on Form N-Port the definitions of the terms used in the fund’s name and the criteria used to select investments.
The above information is required to be reported on Form N-Port for the third month of every quarter, as opposed to each month as proposed.
7. Recordkeeping Requirements
Consistent with the proposal, the Amendments include recordkeeping provisions related to a fund’s compliance with the Names Rule’s requirement. Specifically, a fund with an 80% Policy is required to maintain written records regarding investments included in the 80% basket and the basis for inclusion, the value of the 80% basket (as a percentage of the fund’s assets at the time of investment), the fund’s quarterly review process, dates of any temporary departures from the 80% Policy and reason for departure, and relevant notices sent to shareholders.
In a change from the proposal, for funds that do not adopt an 80% Policy, the Amendments do not require such funds to maintain a record of their analysis that such policy is not required.
8. Using ESG Terms in “Integration Funds”
In a change from the proposal, the Amendments will not take action regarding the use of ESG terms in the names of ESG “integration funds,” which is defined as funds considering one or more ESG factors alongside other non-ESG factors in the fund’s investment decisions but not weighing ESG factors more heavily than other factors. Under the proposal, the names of ESG “integration funds” would have been defined as materially deceptive and misleading if the name includes terms indicating that the fund’s investment decisions incorporate one or more ESG factors.
The SEC indicated that it continues to consider comments and has not adopted the proposed approach. However, as discussed above, the expanded applicable scope of the 80% Policy would require funds with names suggesting ESG focus to adopt an 80% Policy.
II. Compliance Date
The Amendments will become effective 60 days after publication in the Federal Register. Fund groups with net assets of $1 billion or more will have 24 months to comply with the Amendments, and fund groups with net assets of less than $1 billion will have 30 months to comply.
III. Our Thoughts
The SEC estimates that the percentage of funds required to adopt the 80% Policy under the Amendments will increase to 76% from 60% under the old Names Rule. However, how the Amendments will be implemented and enforced remains to be seen.
Although the Amendments impose less compliance burden on funds than the proposed amendments, there will still be a significant compliance burden, especially for smaller firms.
Firms should consider starting early to put together an implementation plan and timeline. Changes to fund names will require board approval and amendments to the fund’s registration statement. We expect that there will be a considerable number of interpretative questions as we go forward, as well as implementation challenges. Hopefully, the SEC will consider providing tools to help with implementation, such as template relief for registration statements or FAQ’s.