How Vain, Without Merit, Is the Name: The SEC Proposed Amendments to Names Rule
In the SEC's latest environmental, social and governance (ESG) rulemaking salvo, the agency proposed two new ESG-focused rules aimed at the advisory and investment company space: 1) proposed amendments to the "Names Rule" under the Investment Company Act, with specific aspects geared toward investment companies with ESG-themed titles; and 2) proposed amendments for investment advisers and investment companies to facilitate enhanced ESG-related disclosures. The SECond Opinions Blog unpacks both proposed rules in this two-part discussion. Today, we cover the proposed Names Rule and offer some key takeaways.
Current Names Rule
Section 35(d) of the Investment Company Act of 1940 prohibits registered investment companies from adopting names that the Commission finds "materially deceptive or misleading." Adopted in 2001, Rule 35d-1 of the Investment Company Act (Names Rule) requires that the fund adopt a policy to invest at least 80 percent of the value of its assets in accordance with its name.1 The current version of the Names Rule is limited to fund names that suggest investments in a type of security, particular industry, geographic region or tax-free securities, or suggest they are backed by the U.S. government. Importantly, the current version of the Names Rule does not apply to fund names that denote a specific investment focus or strategy and permits funds to define terms used in their names in a "reasonable" way.2
The SEC released a Request for Comments on Fund Names in March 2020, whereby the agency sought comment on the rule.3 The agency noted that fund names are often the first piece of information investors see and that names can have a significant impact on an investment decision. The request sought feedback on whether the current requirements were effective and if the Commission should amend existing requirements or implement new ones. In the Request for Comment, the Commission highlighted a number of challenges regarding the application of the Names Rule, including: 1) the increasing use of derivatives, whereby the investment of funds is relatively small compared to the exposure; 2) increasing investment in securities that have some but not all of the characteristics reflected in the fund's name; and 3) the growing "number of funds with investment mandates that include criteria that require some degree of qualitative assessment or judgment of certain characteristics such as funds that include one or more environmental, social, and governance-oriented assessments or judgments in their investment mandates …" The Commission posed a number of questions for commenters, including "[s]hould the Names Rule apply to terms such as 'ESG' or 'sustainable' that reflect certain qualitative characteristics of an investment?"
On May 25, 2022, the SEC, by a 3-1 Commissioner vote,4 proposed the Investment Company Names Rule (Proposed Rule), which seeks to amend the current version of the rule and impose additional requirements.5 There are seven main characteristics of the Proposed Rule: 1) expansion of the current Names Rule to fund names suggesting certain investment characteristics; 2) amendments to various registration forms to include disclosures that define terms used in the fund's name; 3) rules addressing temporary deviations from the 80 percent investment requirement; 4) specific prohibitions for "integration funds"; 5) specific guidance regarding derivative valuation; 6) restrictions on "fundamental" investment policy changes for unlisted closed-end funds and business development companies (BDC); and 7) additional recordkeeping requirements.
First, the Proposed Rule would expand coverage of the current rule to any funds with names suggesting or implying a particular investment focus. This aspect of the Proposed Rule is broad, encompassing not only terms suggesting an ESG focus, but also terms such as "growth" and "value."6 Although the SEC's concerns about misleading ESG disclosures in fund offering materials are well-established, the Proposed Rule would implicate numerous other funds that have little to no ESG investment component. Moreover, in contrast to the current Names Rule, the Proposed Rule would require funds to utilize the plain English meaning or industry-established terms as opposed to setting forth their own definitions.
Additionally, in situations where fund names suggest an investment focus that has multiple elements, the fund's 80 percent investment policy must address all of the elements in the name. The SEC used the example of "ABC Wind and Solar Power Fund" and noted that "[t]he fund's investment policy could provide that each security included in the 80% basket must be in both the wind and solar industries, or instead that 80% of the value of the fund's assets will be invested in a mix of investments, with some solar investments, some wind investments, and some investments in both industries."7
Second, the Proposed Rule includes multiple proposed amendments to various fund forms requiring heightened disclosure. For example, the prospectus for each fund subject to the 80 percent investment requirement would need to include definitions of the terms used in its name.8 Additionally, the Proposed Rule would amend Form N-PORT to require registered investment companies subject to the 80 percent requirement to report: 1) the value of the fund's securities within the 80 percent classifications as a percentage of the fund's overall assets, and 2) the number of days that the 80 percent bucket of securities fell below the threshold during the period.9
Third, the Proposed Rule includes strict limitations on deviation from the 80 percent investment requirement and similarly restrictive cure periods. Unlike the current rule, which limits compliance to the 80 percent threshold at the time of the investment and "under normal circumstances," the Proposed Rule limits deviations to those that are not the result of a firm's investment activities (such as overall market volatility) to address unusually large redemptions or inflows, and to take certain cash and cash equivalent positions to avoid losses in response to certain adverse market positions. With regard to the cure period, whenever a fund deviates from its 80 percent investment policy, the Proposed Rule would require that the fund get back into compliance (with limited exception) "as soon as reasonably practical" but no later than 30 days.10
Fourth, the SEC seeks to place additional limitations on funds that it proposes to classify as "Integration Funds." These funds are those that assess ESG factors alongside non-ESG factors when evaluating investments, but do not hold ESG factors as the salient consideration. Under the Proposed Rule, Integration Funds would be prohibited from incorporating ESG or ESG-related terms in their name.11
Fifth, the current version of the Names Rule permits funds to include derivatives12 in the fund's 80 percent basket if the instrument has similar characteristics to the securities included in the 80 percent basket.13 However, given certain questions about derivative valuation, the SEC proposes to require funds to use (subject to certain adjustments) a derivatives instrument's notional amount – the total value a security theoretically controls – rather than its market value – the value of the security right now – to determine the fund's compliance with its 80 percent investment policy. The SEC specified that such uniformity is needed to increase comparability (some funds currently use notional values, while others use market values) and to better reflect the investment's true exposure.14
Sixth, the Proposed Rule seeks to require a fund's 80 percent investment policy be a "fundamental investment policy" if the fund is a registered closed-end investment company or BDC that does not have shares that are listed on a national securities exchange. A "fundamental investment policy" under the Proposed Rule would be a policy adopted under Section 8(b)(3) of the Act or, if the fund is a BDC, a policy that is changeable only if authorized by the vote of a majority of the outstanding voting securities of the fund. As a result, unlisted closed-end funds and BDCs would not be permitted to change their 80 percent investment policies without shareholder approval. The SEC reasons that "[u]nlisted closed-end funds and BDCs … do not issue redeemable shares or list their shares on a national securities exchange" and that "[a] shareholder in an unlisted closed-end fund 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."15
Seventh, funds subject to the 80 percent investment policy would be required to satisfy new recordkeeping requirements. The proposed amendments would require these funds to maintain written records documenting compliance with the 80 percent investment policy provisions of the rule. Among other things, funds would be required to maintain: 1) a record of investments that comprise the fund's 80 percent basket and the basis for including each investment in the basket; 2) the value of the fund's 80 percent basket as a percentage of the fund's assets; 3) the reasons for and dates of any departures from the 80 percent policy; and 4) any notice sent to the fund's shareholders under the rule. Notably, funds that do not adopt an 80 percent investment policy would still be required to maintain a written record of their analysis that the 80 percent investment policy is not required under the rule. Both requirements would be subject to six-year retention terms.16
- Potentially Dangerous Implications for Advisers … and Investors: Although efforts to bring clarity to a fund's investment focus and activities is a noble aim, the proposed restrictions around deviations from the 80 percent investment policy could have significant consequences for the parties that the rule purportedly aims to protect: fund investors. As SEC Commissioner Hester Peirce noted in her dissenting statement on the Proposed Rule, "the consequence of this intentionally inflexible approach may include inducing portfolio managers to make undesirable investments in order to remain in compliance with the rule or forcing funds to shut down in times of even relatively short-lived market stress." Given some of the recent significant market volatility events triggered by the Russia-Ukraine conflict, the massive ripple effects of the Archegos fallout and general market-moving impacts such as inflation, the strict time window could create difficult investment choices for advisers in times of acute market stress. Furthermore, in Comment 25 to the Proposed Rule, the SEC implicitly acknowledges that compliance with the 30-day limitation could put advisers in a difficult position to comply with other rules.
- Subjectivity Continues: As Peirce noted in her dissenting statement, "[g]iven the breadth of terms such as ESG, growth, and value, how will industry implement the rule and how will we enforce it without engaging in Monday morning asset managing?" This is particularly difficult given that the Proposed Rule is seeking to have funds use plain English or industry-established terms – especially when terms within the ESG space are rapidly evolving and often hard to compartmentalize. Terms such as "socially responsible," "sustainable" and "ethical" are gaining popularity and, although they seemingly fit within the general theme of ESG, they don't fit neatly into "E," "S" or "G." The inability to silo investment strategies into neatly defined terms will likely increase exposure for advisers.
- Not a Safe Harbor: One critical aspect of the Proposed Rule is that compliance with the provisions does not foreclose the SEC from later claiming a fund's name is materially deceptive or misleading. "We are proposing a new provision in the names rule providing that a fund's name may be materially deceptive or misleading under section 35(d) even if the fund adopts an 80% investment policy and otherwise complies with the rule's requirement to adopt and implement the policy."17 Although this is not a new position for the agency,18 a formal codification would heighten the risk. Advisers and practitioners alike should be mindful that compliance with the Proposed Rule would not be a failsafe prophylactic from SEC enforcement.
- Short Implementation Window: In contrast to longer-term phase-in periods in other rule proposals – such as the SEC's Climate Change Rule – the Proposed Rule would require funds to comply within one year. As the Proposed Rule notes, "[t]he proposed amendment also would apply to other fund names that historically may have not required an 80% investment policy (depending on the context), such as names that include terms like 'global,' 'international,' 'income,' or 'intermediate term (or similar) bond.'"19 Given the breadth of funds that would now fall under the Rule's ambit and the significant policy adjustments that would be necessary to ensure compliance, this time frame may prove unworkable.
Return to the of our post covering the Proposed ESG Disclosures Rule for advisers and funds. If you need any additional information on this topic – or anything related to SEC enforcement or internal investigations – please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.
1 See 17 C.F.R. § 270.35d-1(a)(2).
2 See Investment Company Names § II.C.1. n.43, Sec. & Exch. Comm'n Release Notice, Release No. 24828 (Jan. 17, 2001), corrected, Release No. 24828A (Mar. 8, 2001) [66 FR 8509 (Feb. 1, 2001)] [hereinafter Names Rule Adopting Release].
6 See Id. at 23-25. The SEC clarified that the agency does not intend for fund names suggesting "characteristics of the fund's overall portfolio" – such as "balanced," "long/short," and "real return" – to be subject to proposed the requirements.
7 Id. at 25.
8 The Proposed Rule would cover Forms N-1A, N-2, N-8B-2 and S-6. See Id. at 72.
9 See Id. at 95-100.
10 See Id. at 34. The Proposed Rule includes different timeliness requirements when the deviation is due to reorganization, fund launch or changes to the fund's 80 percent investment policy in connection with 60 days' notice to shareholders.
11 See iI. at 81-86.
12 The Proposed Rule defines derivatives as "any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or a similar instrument." Id. at 203.
13 The Commission has interpreted the Names Rule to permit funds to include synthetic instruments, such as derivatives, in the fund's 80 percent basket if the instrument has economic characteristics similar to the securities included in the 80 percent basket. See Names Rule Adopting Release, supra note 2, § II.A.1 n.13.
14 See Proposed Rule, supra note 5, at 48-65.
15 See Id. at 65-68.
16 See Id. at 102-08 ("[N]either the current rule nor the general recordkeeping rule under the Act includes a recordkeeping provision specific to the names rule compliance-related topics the proposed amendments would address." Id. at 103).
17 Id. at 126.
18 See Names Rule Adopting Release, supra note 2, § II.A.1. ("We note, however, that the 80% investment requirement is not intended to create a safe harbor for investment company names. A name may be materially deceptive and misleading even if the investment company meets the 80% requirement.").
19 See Proposed Rule, supra note 5, at 23-24; cf. with questions 8, 9 and 11 in the Frequently Asked Questions about Rule 35d-1 (Investment Company Names) by the SEC's Division of Investment Management.