On September 20, 2023, the U.S. Securities and Exchange Commission (Commission) tightened the regulation of fund names, a rule change that the Commission expects could affect three out of four registered funds. Among other things, the amendments broaden the scope of funds that are subject to the 80% investment policy requirement required by rule 35d-1 (Names Rule) under the Investment Company Act of 1940, as amended (1940 Act).
As amended, the Names Rule also limits the timeframe of temporary departures from the 80% investment policy to 90 days, requires a fund to use a derivative instrument’s notional amount when determining the fund’s compliance with its 80% investment policy, and generally requires shareholders of unlisted closed-end funds and business development companies (BDCs) to approve any change to the fund’s 80% investment policy.
The Commission staggered compliance dates to ease the costs and burdens of transition to the new requirements (see below).
These amendments represent the Commission’s first overhaul to the 20-year-old Names Rule. While the Commission adopted much of the rule as originally proposed, the final amendments diverge from the proposal in some significant respects, suggesting that the Commission was sensitive to some of the comments it received from industry stakeholders. For example:
- The Commission proposed to require a fund to delineate specific circumstances when it may depart from its 80% investment policy. As amended, the Names Rule retains the current requirement for a fund to invest in accordance with its 80% investment policy “under normal circumstances,” so the funds retain a certain amount of flexibility. The Commission acknowledged that the proposed approach was overly prescriptive and that there could be situations when it is in the best interest of the fund and its investors to depart from its 80% investment policy.
- The Commission’s proposal called for funds to monitor compliance with the 80% investment policy continuously — effectively daily — on an asset-by-asset basis. Acknowledging the potential compliance burden that this requirement would have imposed on funds, sponsors, and administrators, the Commission opted instead to require a fund subject to an 80% investment policy to generally reevaluate treatment of its positions only quarterly.
- The Commission provided some added flexibility when a fund strays from its 80% investment policy due to “drift” or other unusual circumstances. That is, a fund can take up to 90 days, as opposed to 30 days as proposed, to come back into compliance.
- A fund must report on its 80% basket on Form N-PORT on a quarterly basis — not monthly as proposed — which aligns with the quarterly monitoring requirement.
- The Commission expanded the compliance period to 24 months for larger fund groups and 30 months for smaller fund families, a significant departure from the proposal’s shorter compliance period of 12 months.
- The Commission declined to prohibit, as proposed, so-called “integration funds”1 from using environmental, social, and governance (ESG)–related terminology in their names but left open the door to further action on this issue.2 The Commission, however, emphasized that the Names Rule, as amended, would capture a fund with terms in its name that suggest ESG- or sustainability-related characteristics, such as “sustainable,” “green,” or “socially responsible.” The Commission cited the increased use of ESG-related terminology “that may be especially powerful in fund names to attract investors” and the potential for “greenwashing” as considerations behind the amendments.3 As a result, integration funds may wish to review how the rule affects their investment policies.
The Commission also adopted largely as proposed the requirement that a fund must use a derivative’s notional value for purposes of determining compliance with its 80% investment policy; however, in a change from the proposal, funds must exclude certain currency hedges from the calculation.
The amended Names Rule is likely to significantly affect the fund industry. The Commission estimated that the Names Rule, as amended, will increase the percentage of registered funds subject to the Names Rule from 60% to 76%, meaning many funds may have to change their names or their investment strategies and/or adopt new 80% investment policies.
Commissioner Mark T. Uyeda, the lone dissenter, expressed skepticism at what he deemed a “conservative” scope estimate, noting that “practically any term could be subject to the names rule” given the lack of guidance on what is meant by “particular characteristics.” (The new rule applies to fund names with terms that suggest a fund’s investments have “particular characteristics,” as further described below.) The Investment Company Institute also was critical of the final rule, calling it an “enormous expansion” that “insert[s] the [Commission] deeper into funds’ investment decision-making processes.”4
Section 35(d) of the 1940 Act prohibits registered investment companies from adopting names that the Commission finds are “materially deceptive or misleading.”5 The Names Rule as currently in effect 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, the current Names Rule 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 Names Rule, however, does not apply to fund names that suggest a particular strategy or policy (e.g., growth or value). As amended, the Names Rule aims to fill this perceived gap.
The Final Rule
- coverage of names suggesting investment focus
- rules for temporary departure from the 80% requirement
- rules for compliance for derivatives
- rules for unlisted closed-end funds and BDCs
Names suggesting investment focus
The amendments expand the scope of fund names that are subject to the 80% investment policy requirement to include names with terms suggesting that the fund focuses in investments that have, or investments whose issuers have, particular characteristics.
The Commission did not define the term “particular characteristics.” Thus, this term may be understood to mean any feature, quality, or attribute. The Commission, however, gave nonexclusive examples, including terms like “growth” or “value”; terms indicating that the fund’s investment decisions incorporate one or more ESG factors (e.g., “sustainable,” “green,” or “socially responsible”); and terms that reference a thematic investment focus.
The Commission appeared to recognize that fund names containing thematic terms present challenges — for example, thematic terms that do not at first glance suggest a focus in a type of investment or investment in a particular industry or group of industries. Terms such as “drones,” “metaverse,” “big data,” “millennial,” or “Gen Z” or terms that suggest political, economic, or historical themes (e.g., “biothreat,” “gig economy,” or “post-Corona”) fall into this gray area. Without opining on whether these examples suggest a thematic focus, the Commission made it clear that when a fund’s name suggests a thematic focus, it will be in scope of the amended Names Rule.
The Commission responded to concerns that strict prescriptive requirements would prompt funds to adopt more generic names or longer, more complex names by offering an at least somewhat more flexible approach. The Names Rule, as amended, gives funds and managers some flexibility to reasonably define the terms contained in a fund’s name. The Commission also acknowledged that different funds and third-party data providers may use different definitions for the same term in order to best reflect a particular investment strategy. For example, two funds, both with “growth” in their names, may have portfolio managers taking different approaches selecting investments with “growth” characteristics. As long as each fund’s definition of “growth” is consistent with the plain English meaning or established industry use and each fund invests 80% of its investments in accordance with its description of the term “growth,” both funds would comply with the Names Rule. The Commission believes that despite the broadened scope of the rule, the amendments provide funds with flexibility to implement nuanced and innovative investment strategies.
The Commission acknowledged that some fund names use terms that do not communicate a particular investment focus and thus would not be subject to the 80% investment policy requirement: Terms that suggest a portfolio-wide result to be achieved (e.g., “real return,” “balanced,” or “managed risk”), terms that reference a particular investment technique (e.g., “long/short” or “hedged”), and terms that reference asset allocation determinations that evolve over time (e.g., a retirement target date or “sector rotation” funds) along with terms such as “global” and “international” all remain outside the scope of the Names Rule. These are terms that, in general, describe a portfolio’s overall characteristics (rather than particular investments in the portfolio) or describe a fund’s approach to constructing a portfolio (rather than communicating the composition of the portfolio with any specificity) and are thus outside the scope of the Names Rule.
In determining whether a particular investment qualifies for inclusion in a fund’s 80% basket, the Commission reiterated that there must be a “meaningful nexus” between the investment and the investment focus suggested by the name. As an example, the Commission noted that it would be reasonable to find that there is a sufficient nexus between certain securities and a given industry if the investment is in securities issued by companies that derive more than 50% of revenue or income from, or own significant assets in, that industry. In certain cases — for example, where a company is an acknowledged leader in a particular industry — a lower threshold may suffice. However, the Commission stated that the use of text analytics to assign issuers to industries based on the frequency of particular terms in an issuer’s disclosures is not by itself sufficient to establish the required nexus.
The Commission confirmed that the terms in a market index referenced in an index fund’s name would not be subject to the 80% investment policy test (which otherwise would be in addition to the fund’s policy to invest at least 80% of its assets in the index’s components). However, the Commission stated that an index fund’s name can be found to be materially deceptive and misleading, even if the fund invests 80% or more in the index included in its name, if a meaningful nexus does not exist between the components of the index and the investment focus suggested by the fund’s name. Consequently, an index fund should, in a manner consistent with rule 38a-1 under the 1940 Act, generally adopt and implement written policies and procedures reasonably designed to ensure that the indexes selected by the fund do not have materially misleading or deceptive names.
The Names Rule, as amended, retains the current requirement that an 80% investment policy relating to a tax-exempt fund must be a fundamental policy.
Temporary departures from the 80% requirement
The Names Rule, as before, requires funds to comply with the 80% investment policy “under normal circumstances,” leaving it to funds to determine what constitutes other-than-normal circumstances. The Commission gave examples of possible other-than-normal circumstances, which include market fluctuations, index rebalancing, cash flows/inflows, or temporary defensive positions.
Funds that stray from the 80% investment policy must return to compliance as soon as reasonably practicable, with an outer limit of 90 days. The 90-day clock runs from the date the fund identifies a departure from the 80% investment policy (as part of its quarterly review as described below or otherwise) or the date the fund actually first departs from the 80% investment policy intentionally, in other-than-normal circumstances. When a fund identifies a departure, consistent with the current requirement, the fund must invest its portfolio in a way that will bring the fund back into compliance within the applicable time period.
The Names Rule, as amended, also retains the current requirement that a fund must measure compliance at the time of investment. Funds also must reassess their portfolio investments at least quarterly. This means that a fund must determine at the time of investment whether a portfolio asset falls within the 80% basket. Going forward, the fund must measure the value of existing investments, but it would not have to reassess the characteristics of each existing investment at that time. Each quarter, the fund must reevaluate the characteristics of all its investments for consistency with the 80% investment policy. In practice, while the characteristics of an investment are assessed at the time of investment and quarterly, funds also will continue to test for overall compliance with the 80% investment policy upon every trade.
The Names Rule, as amended, allows new funds up to 180 days to comply with the 80% investment policy, starting from the day the fund commences operations. Rather than set a fixed compliance period for funds undergoing reorganizations, the Commission stated that funds must come into compliance as soon as reasonably practicable. A fund also may deviate from its 80% investment policy if it has provided shareholders with notice of a change of the 80% investment policy.
The Names Rule, as amended, generally requires a fund, when calculating compliance with the 80% investment policy, to value each derivative instrument in its portfolio using its notional amount, as opposed to the market value of the derivative. The Names Rule requires or permits certain adjustments to the compliance calculation, which include:
- Certain Derivatives: A fund must exclude currency derivatives from the calculation if the derivative is entered into and maintained by the fund for hedging purposes and the notional amount of the derivative does not exceed the value of the hedged investment by more than 10%. A fund must convert interest rate derivatives to their 10-year bond equivalents and delta adjust the notional amounts of options contracts. A fund is also permitted to exclude any closed-out derivatives if those holdings result in no credit or market exposure to the fund. A fund also must value physical short positions using the value of the asset sold short.
- Cash and Cash Equivalents and Certain U.S. Treasuries: A fund is permitted to deduct cash and cash equivalents and U.S. Treasury securities with remaining maturities of one year or less, up to the notional amounts of the fund’s derivatives, from the calculation.
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 either to the investments suggested by the fund’s name or to one or more market risk factors associated with the investments suggested by the fund’s name. The Commission provided some guidance on how to determine whether a derivative provides exposure to a market risk factor. For example, a fund should consider whether the derivative provides exposure to any explicit input that the fund uses to value its name assets, if a change in that input would affect the value of that asset.
Unlisted closed-end funds and BDCs
The Commission took a more restrictive approach with respect to registered closed-end funds and BDCs that do not list their shares on a national securities exchange and that are required to adopt an 80% investment policy. These funds generally can change the 80% investment policy only with the approval of a majority of the outstanding voting securities of the fund. In effect, the Commission made the 80% investment policy “fundamental” because investors have fewer options to sell their shares if they do not agree with the investment policy change. Funds also may be able to change the 80% investment policy without a vote in connection with a tender or repurchase offer, subject to certain conditions.
Compliance, Disclosure, Recordkeeping, Reporting, and Notice
- written records, at the time of each investment, specifying (i) whether the investment is included in the 80% basket and, if so, the basis for inclusion and (ii) the value of the basket, as a percentage of the value of the fund’s assets
- written records documenting the fund’s quarterly review of its portfolio
- if during the quarterly review or otherwise the fund identifies a departure from the 80% investment policy due to drift, written records noting the date of identification and reason for departure
- if there is a departure from the 80% investment policy in other-than-normal circumstances, written records noting the date of and reason for the departure, including why the fund determined circumstances are other-than-normal
- any notice sent to fund shareholders under the Names Rule, as amended
Funds must maintain these records for at least six years.
In a departure from the proposal, a fund that determines that it is not within scope of the Names Rule is not required to keep records of its analysis that the 80% investment policy is not applicable.
The Names Rule, as amended, goes into effect 60 days after publication in the Federal Register. Fund groups with net assets of $1 billion or more have 24 months from the effective date to comply with the amended Names Rule. Fund groups with net assets of less than $1 billion will have 30 months to comply. The Commission noted that it is reviewing no-action letters and other statements related to the Names Rule to determine what guidance, if any, should be withdrawn in light of the amendments.
1 The proposal describes an “integration fund” as a fund that considers one or more ESG factors alongside non-ESG factors in the fund’s investment decisions, but those ESG factors are generally no more significant than the other factors considered in the investment selection process and thus may not be determinative in investment decisions.
2 The Commission stated that “[b]ecause the proposed provision in the names rule mirrored the separate proposed definition of an integration fund in the ESG Disclosure Proposal, we are continuing to consider comments and are not adopting the proposed approach to integration fund names at this time.” In May 2022, the Commission proposed amendments to require specific disclosure of funds’ and investment advisers’ use of ESG factors as part of their investment decisions and strategies (ESG Disclosure Proposal). See Proposing Release, Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, May 25, 2022, The Commission has yet to vote on the adoption of the ESG Disclosure Proposal.
3 This focus on ESG funds in the amended Names Rule, along with the ESG Disclosure Proposal and the recent enforcement activity of the Commission’s Climate and ESG Task Force, reflect the Commission’s heightened scrutiny on asset managers with respect to ESG strategies and investments.
4 Investment Company Institute, ICI Statement on SEC Fund Names Rulemaking, September 20, 2023.
5 Section 35(d) also applies to BDCs pursuant to Section 59 of the 1940 Act.
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