In a 3-1 vote, the US Securities and Exchange Commission on May 25 proposed amendments to Rule 35d-1 under the Investment Company Act of 1940 (the Names Rule) that, if adopted as proposed, could cause new entrants and existing issuers alike in the registered funds’ space to reevaluate not only the names of their funds, but also the investment policies required under the Names Rule and related prospectus disclosure.
Among other things, the proposed amendments to the Names Rule (the Proposal) would expand the universe of funds subject to the Names Rule to include funds with names that suggest “focus in investments that have, or whose issuers have, particular characteristics.”[1] Other particularly noteworthy proposed changes include the specification of circumstances under and timeframes during which a fund may depart from its 80 Percent Policy, the inclusion and valuation of derivatives for purposes of measuring compliance with an 80 Percent Policy, enhanced prospectus disclosure defining certain terms used in a fund’s name, and new recordkeeping and reporting requirements.
The public comment period for the Proposal will end 60 days after it is published in the Federal Register.
Section 35(d) of the Investment Company Act of 1940 prohibits all funds from using a name that the Securities and Exchange Commission (SEC) finds by rule, regulation, or order to be materially deceptive or misleading. The SEC adopted the Names Rule in 2001 to address certain broad categories of investment company names that were likely to mislead investors about an investment company’s investments and risks. Currently, the Names Rule requires a fund with a name suggesting that the fund focuses on (1) a particular type of investment, (2) a particular industry, or (3) a particular geographic area, to adopt a policy to invest, under normal circumstances, at least 80% of its assets in the type of investment suggested by its name (an 80 Percent Policy).
Additionally, tax-exempt funds (or funds with names suggesting that the fund’s distributions are exempt from federal income tax or from both state and federal income tax) must also adopt an 80 Percent Policy specific to the tax-exempt nature of the fund. The Names Rule also generally provides that a fund can elect to adopt an 80 Percent Policy as a non-fundamental policy, meaning that a fund can change its 80 Percent Policy if it provides shareholders with at least 60 days’ prior notice of such change. Tax-exempt funds, however, must adopt an 80 Percent Policy that can only be changed by a vote of shareholders.
Recently, the SEC began considering the need for potential updates to the Names Rule. For example, in March 2020, the SEC released a Request for Comments on Fund Names that sought industry input on a number of aspects of the Names Rule, including, but not limited to, how derivative instruments should be considered under the Names Rule, challenges presented by index funds, and funds that have investment mandates requiring qualitative assessment or judgement (including ESG funds).
Now, in the May 25 proposed amendments (Proposing Release), the SEC stated that developments in the fund industry over the last two decades necessitate improvements to the Names Rule for it to continue to effectively protect investors. Specifically, the SEC expressed concern that particular fund names could mislead investors about a fund’s investment focus, particularly with respect to a fund’s name that suggests investments in companies that meet certain ESG criteria.
Additionally, the SEC staff noted the increase in filings for funds in “thematic” areas such as blockchain and artificial intelligence. Further, the SEC stated that the current structure of the Names Rule could permit funds to depart from their investment focus over time, which could deprive investors of the protections of the Names Rule. It stated that the current scope of the Names Rule has created problematic interpretive issues that have resulted in some fund names being inappropriately excluded from the Names Rule requirements.
Expansion of the Scope of the Rule to Include Fund Names Suggesting Investment in Instruments or Issuers with “Particular Characteristics”
Under the Proposal, in addition to the 80 Percent Policy requirement for a fund whose name suggests focus on investment in (1) a particular type of investment (e.g., stocks and bonds); (2) a particular industry (e.g., utilities or healthcare); or (3) a particular geographic area (e.g., a Japan fund or a European Fund), a new category requiring an 80 Percent Policy would be added for names suggesting a focus on investments that have, or investments whose issuers have, “particular characteristics.” The SEC did not define the meaning of “particular characteristics,” but used the terms “value,” “growth,” and “ESG” as examples of terms in fund names that would trigger the 80 Percent Policy requirement under this category of the Proposal.
This would be a significant change because, as the SEC pointed out in the Proposing Release, historically, “value” and “growth” have connoted an investment objective, strategy, or policy (investment strategies) and therefore were not within the scope of the 80 Percent Policy requirement. The SEC, however, noted that regardless of whether a fund’s name connotes a strategy, if it also connotes an investment focus, it may be materially deceptive or misleading unless required to adopt an 80 Percent Policy. Moreover, citing academic research, the SEC stated that a significant number of funds follow an investment strategy that does not align with the investment strategy identified in the fund’s name, and noted the proposed scope expansion was intended to help prevent materially deceptive and misleading fund names in light of these concerns.
New Requirements on Use of Certain Common Terminology in Fund Names
Despite the expansion of the scope of the Names Rules to include a fund name suggesting focus on investments or issuers with particular characteristics, the SEC made clear in the Proposing Release that it did not intend for fund names that suggest “characteristics of the fund’s overall portfolio” to be subject to the expanded Names Rule. Examples provided are funds that have “duration,” “balanced,” “long/short,” and “real return” in their name. However, including the aforementioned terms in a fund’s name does not except a fund from Names Rule requirements where the fund’s name also includes terms that suggest an investment focus.
As an example, the SEC noted a fund with the name “XYZ Technology and Real Return Fund” would be required to adopt an 80 Percent Policy with respect to the term “technology” despite the phrase “real return” also appearing in the name. Further, the Proposal would apply to other fund names that historically may have not required an 80 Percent Policy (depending on the context), such as names that include terms like “global,” “international,” “income,” or “intermediate term (or similar) bond,” to which the staff of the Division of Investment Management has stated the Names Rule does not apply.
In addition to expanding the scope of the Rule, the SEC notably addressed certain specific Names Rule issues that have arisen in the fund industry over the years and sought to clarify the application of the Names Rule in those contexts. For example, under the Names Rule as it exists today, funds may define terms used in their names in a “reasonable” way. The Proposing Release makes clear that any terms used in the fund’s name that suggest an investment focus must be consistent with the plain English meaning or established industry use of those terms. For a defined term to be reasonable, the SEC stated, “requires a meaningful nexus between the given investment and the focus suggested by the name.”
As an example, the SEC stated its belief that it is reasonable for a fund to define securities in a given industry as securities issued by companies that “derive more than 50% of their revenue or income from, or own significant assets in, the industry.” However, the SEC left open the possibility that the 50% figure could be smaller, such as where a large company is a dominant firm in a given industry.
Further, the SEC noted that, consistent with prior staff positions, whether an issuer is included in an industry may not be solely determined by reference to the issuer’s own disclosure documents—i.e., that the SEC does not believe it is reasonable to include an issuer in any given industry “because the issuer’s disclosure documents frequently include words associated with the industry.”
A More Prescriptive 80% Test
The Proposal would eliminate language from the 80 Percent Policy that indicates that a fund will adhere to such policy “under normal circumstances” in favor of a more specific, prescriptive set of circumstances outlined in the Proposal. Under the Proposal, a fund would be permitted to deviate temporarily from its 80 Percent Policy only (1) 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; (2) to address unusually large cash inflows or unusually large redemptions; (3) 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; or (4) to reposition or liquidate a fund’s assets in connection with a reorganization, to launch a fund, or when notice of a change in the fund’s 80 Percent Policy has been provided to shareholders at least 60 days before the change.
In addition, a fund falling below its 80 Percent Policy would be required to come back into compliance with its 80 Percent Policy “as soon as reasonably practicable,” and in any case, within 30 consecutive days, except in circumstances that involve a fund launch, a fund reorganization, or where the 60-day shareholder notice requirement has been satisfied. The SEC further stated that the “as soon as reasonably practicable” standard does not necessarily mean “as soon as possible” and is intended to allow for consideration by the fund’s adviser of how to return to compliance in a manner that best serves the interest of the fund and its shareholders.
For fund launches, the SEC stated that a departure from the 80 Percent Policy could not last for longer than a period of 180 consecutive days. For fund reorganizations and instances where shareholders have received 60 days’ notice of a policy change, the SEC stated that it did not believe a time limit was necessary for such departures from the 80 Percent Policy except that, in all cases, funds should seek to resolve such a departure as soon as reasonably practicable.
Treatment of Derivatives Under an 80 Percent Policy
Under the current Names Rule, a fund is permitted to include synthetic instruments, such as derivatives, in the fund’s 80 Percent Policy if the synthetic instrument has economic characteristics similar to the securities included in the 80 Percent Policy. Under the Proposal, a “derivatives instrument” is defined as “any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or a similar instrument,” and may still be counted towards the 80 Percent Policy, so long as it is done in accordance with the requirements of the Proposal. Under the Proposal, a fund must value a derivatives instrument that it counts towards its 80 Percent Policy using the derivatives instrument’s notional amount, and not its market value.
The SEC also provided for certain adjustments to a derivative’s notional value discussed below, and would require a fund to reduce the value of its assets by excluding cash and cash equivalents up to the notional amount of the derivative instrument. Interest rate derivatives and options contracts are required to be valued at their notional amounts, with adjustments. (Consistent with the new Derivatives Rule, under the Proposal, interest rate derivatives must be converted to 10-year bond equivalents and options contracts delta adjusted. See our white paper for more detail on the Derivatives Rule.)
The SEC explained that because the Names Rule is designed to ensure that a fund’s investment activity supports the investment focus its name communicates, and a derivative instrument’s notional value is generally more reflective of the investment exposure of a derivatives instrument, the use of notional value when counting derivatives towards the 80 Percent Policy is appropriate. The use of the notional value of derivatives would apply to both the numerator and the denominator in the calculation to determine compliance with its 80 Percent Policy. The SEC noted that a fund’s use of notional amounts when determining the value of the fund’s assets in the 80 Percent Policy would not affect the fund’s valuation practices under the new valuation rule, Rule 2a-5 under the Investment Company Act.[2]
Additionally, in the Proposal, the SEC expanded how derivatives instruments can be counted towards the 80 Percent Policy by not only allowing a fund to count a derivatives instrument that has investment exposure to the investments its name suggests, but also to count a derivatives instrument that “provides investment exposure to one or more of the market risk factors associated with the investments suggested by the fund’s name” (for example, interest rate risk, credit spread risk, and foreign currency risk). As a result, the SEC reasoned, the derivatives instruments included in a fund’s 80 Percent Policy would either be functioning as a substitute for direct investments in the securities suggested by the fund’s name or used to facilitate the fund’s investment in those securities by increasing or decreasing the fund’s exposure to risk factors associated with those securities.
Enhanced Prospectus Disclosure
In addition to proposing amendments to the Names Rule, the Proposal would amend fund registration forms, including Forms N-1A, N-2, N-8B-2 and S-6, to require each fund having an 80 Percent Policy to include disclosure in its prospectus defining any term used in its name, including the specific criteria the fund uses to select the investments that the term describes. For purposes of this requirement, “terms” would mean any word or phrase in a fund’s name, other than any trade name of the fund or its adviser, relating to the fund’s investment focus or strategies.
The SEC noted that where a fund’s name suggests an investment focus that has multiple elements, the fund’s 80 Percent Policy must address each element of the name. For example, the SEC stated that for a fund named “ABC Wind and Solar Power Fund,” the fund’s 80 Percent Policy could provide that each security included in the 80 Percent Policy 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. Under the Proposal, fund registrants will be required to tag any new information or changes it has made in response to this requirement using Inline XBRL.
Amended Names Rule Not a “Safe Harbor” – Especially for ESG Funds
The SEC made clear in the Proposing Release that the Names Rule is not a safe harbor from the requirement that a fund name not be materially deceptive or misleading. In other words, a fund may be in compliance with its 80 Percent Policy, but nevertheless may be materially deceptive or misleading. In particular, the SEC stated that “integration funds” would per se be materially deceptive or misleading under the Proposal should they include ESG or related terms in their name. “Integration funds” are defined as funds that consider one or more ESG factors alongside other, non-ESG factors in the fund’s investment decisions but those ESG factors are generally no more significant than other factors in the investment selection process. The SEC stated that use of the terms “ESG” and “sustainable” in a fund’s name, where such factors do not figure as prominently or consistently in the investing process of a portfolio, would be considered materially deceptive and misleading.
Additionally, consistent with its prior statements, the SEC noted that index funds generally would be expected to invest more than 80% of the value of their assets in investments connoted by the applicable index. However, the SEC also reiterated that an index that includes components that are contradictory to the index’s name may cause a fund’s name that includes the index’s name to be materially misleading or deceptive even if the fund otherwise complies with the Names Rule requirements. Further, the SEC stated that a fund that is perpetually out of compliance with its 80 Percent Policy on account of temporary departures may have a name that is materially deceptive or misleading under Section 35(d), even if each temporary departure is permissible under the Proposal.
Other Key Elements of the Proposal
In addition to the foregoing, the SEC modernized the 60-day notice requirement to shareholders by permitting delivery of such notice to be electronic, subject to certain conditions, if such shareholder has elected to receive information in that medium.
Further, the SEC noted that it would generally be reasonable for a fund of funds or other acquiring fund to include the entire value of its investment in an acquired fund when calculating compliance with the 80 Percent Policy requirement without looking through the acquired fund’s investments, provided that the acquired fund itself has an appropriate 80 Percent Policy.
In addition, the Proposal would require that registered closed-end funds and business development companies whose shares are not listed on a national securities exchange and are required to adopt an 80 Percent Policy, to make the 80 Percent Policy a fundamental policy (i.e., a policy that could not be changed without a shareholder vote). The SEC stated that the intent of this proposed requirement is to protect investors from changes to an 80 Percent Policy where an investor does not have the ability to vote on the change or readily exit the fund.
The SEC also proposed amendments to Form N-Port and new recordkeeping requirements. Specifically, the SEC proposed amending Form N-PORT to require registered funds, other than money market funds, to report (1) the percentage value of a fund’s assets counted towards the 80 Percent Policy, and (2) if applicable, the number of days that the percentage value of such assets fell below 80% of the value of the fund’s assets during the reporting period. Funds that have adopted an 80 Percent Policy would also be required to indicate, with respect to each portfolio investment, whether the investment is counted towards a fund’s 80 Percent Policy.
Perhaps more notably, under the proposed recordkeeping requirements, not only would funds that adopt an 80 Percent Policy be required to create and maintain records documenting their compliance with the Names Rule requirements as described below, but funds that do not adopt an 80 Percent Policy would also be required to maintain a written record of their analysis supporting the position that an 80 Percent Policy is not required. The SEC noted that this provision was designed to assist not only SEC staff in overseeing funds’ application of the Names Rule requirements, but also a fund’s compliance personnel and fund boards in their efforts to evaluate the fund’s analysis.
Finally, the proposed amendments would except unit investment trusts (UITs) that made their initial deposit of securities prior to the effective date of any final Names Rule from complying with the requirement to adopt an 80 Percent Policy and the recordkeeping requirements, unless a UIT adopted, or was required under the current Names Rule to adopt, an 80 Percent Policy at the time of its initial deposit. As support for the exception, the SEC noted that the proposed approach is consistent with both the treatment of UITs under the current Names Rule and the passive nature of UITs. All UITs would be required to comply with the other elements of the Proposal.
The SEC proposed a one-year compliance period after the effective date of the final rule. For the time being, clients should evaluate the key aspects of the Proposal and consider how the new and amended requirements may impact their funds’ prospectuses and other disclosure documents, how 80 Percent Policies are calculated and monitored, and if fund names continue to be appropriate in light of the Proposal.
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If you have any questions or would like more information on the issues discussed in this alert, please contact any of the following Morgan Lewis lawyers:
Boston
Lea Anne Copenhefer
Barry N. Hurwitz
Roger P. Joseph
Jeremy B. Kantrowitz
Paul B. Raymond
Toby R. Serkin
Mari Wilson
New York
Elizabeth L. Belanger
Orange County
Laurie A. Dee
Philadelphia
David W. Freese
Sean Graber
Timothy W. Levin
Christine M. Lombardo
John J. O’Brien
Washington, DC
Laura E. Flores
Thomas S. Harman
Christopher D. Menconi
W. John McGuire
Beau Yanoshik
Mana Behbin
Magda El-Guindi Rosenbaum
[1] The Proposal would include environmental, social, or governance (ESG)–related fund names within the ambit of the Names Rule. The SEC separately proposed amendments to rules and disclosure forms to achieve more standardized and comparable disclosure and reporting of ESG information to both investors and the SEC.
[2] For more information on the new valuation rule, please refer to our white paper on this topic.