SEC Adopts Amendments to Fund “Names Rule”

On September 20, 2023, the U.S. Securities and Exchange Commission, by a vote of four to one, adopted amendments to the current rule regarding registered fund names, as well as certain forms and disclosure requirements.¹ The amendments are intended to modernize and enhance the investor protections provided by Rule 35d-1 under the Investment Company Act of 1940 (Names Rule) given the important information that fund names can convey to investors and industry developments over the last two decades, including the growth of funds that incorporate ESG criteria into their investment processes. As described below, the final amendments depart from the proposed amendments in certain key respects in response to comments received.

The SEC originally proposed the amendments on May 25, 2022.² The final amendments, among other things:

Significantly expand the 80% investment policy requirement³ to include fund names with terms suggesting an investment focus in investments that have, or whose issuers have, “particular characteristics,” including “growth,” “value” and terms indicating that the fund’s “investment decisions incorporate one or more [ESG] factors.”
Require, for funds that adopt an 80% Investment Policy, that any terms used in the fund’s name that suggest either an investment focus or that the fund is a tax-exempt fund be consistent with the plain English meaning or established industry use of those terms.⁴
Define a time period for funds that deviate from their 80% Investment Policy to come back into compliance, generally 90 days.
Require funds to review the classifications of their portfolio assets under their 80% Investment Policies on a quarterly basis.
Require funds to calculate assets for Names Rule purposes, including compliance with the 80% Investment Policy, by valuing derivatives using their notional amount and short sales using the value of the asset sold short (with certain required and permitted adjustments).
Amend the notice requirement associated with changes to a Fund’s name or 80% Investment Policy.
Require additional disclosure within a fund’s prospectus to define terms used in the fund’s name, including related investment criteria for selecting investments described by the name.

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 with the amendments.

Background

Section 35(d) of the 1940 Act prohibits a registered investment company (as does Section 59 of the 1940 Act for BDCs) from adopting as part of its name or title any word or words that the SEC finds are materially deceptive or misleading. The SEC adopted the Names Rule under Section 35(d) of the 1940 Act in 2001. The Names Rule deems certain types of fund names to be materially deceptive or misleading for purposes of Section 35(d) unless certain conditions are satisfied, such as adoption of an 80% Investment Policy. Depending on the circumstances and the type of fund name, an 80% Investment Policy may be fundamental or non-fundamental. Changes in a fundamental 80% Investment Policy require shareholder approval whereas changes in a non-fundamental 80% Investment Policy require 60-days’ prior notice to shareholders (Notice).

The final amendments depart from the proposal in certain important respects. Notably, the SEC did not adopt proposed amendments that would have designated as materially deceptive and misleading the use of ESG terms in the names of integration funds, although funds with names suggesting ESG investments will be required to adopt an 80% Investment Policy nonetheless.⁵ Further, among other significant departures from the proposal, the SEC made clear that the final amendments generally will not apply to terms such as global, international, or intermediate term (or similar) in describing a bond, and changes certain proposed compliance requirements from effectively daily to quarterly. Moreover, the final amendments preserve the current requirements that a fund’s 80% Investment Policy apply “under normal circumstances” and that compliance generally is measured at the time of investment.⁶

Amendments

The core aspects of the amendments are briefly summarized below:

Investment Focus. The SEC has expanded the Names Rule to require a fund to adopt an 80% Investment Policy if its name suggests a focus⁷ “in investments that have, or whose issuers have, particular characteristics.”⁸ The amendments identify growth, value and terms indicating that a fund’s investment decisions incorporate one or more ESG factor(s)⁹as examples of names indicating a focus on investments or issuers having particular characteristics.¹⁰ However, as noted above, the amendments generally will not apply to certain other names that have historically been interpreted as being outside the scope of Rule 35d-1, including global, international, or intermediate term (or similar) bond.¹¹ Funds retain flexibility in defining the contours of their required 80% Investment Policies, ascribing definitions to the terms used in those policies, and determining (in many instances) what investments are appropriate to include in the 80% Investment Policy basket.¹² However, as noted above, any investment focus-related terms used in a fund’s name will be required to be defined “consistent with those terms’ plain English meaning or established industry use.”
Clarifications of “Materially Deceptive or Misleading.” The SEC also codified that compliance with a fund’s 80% Investment Policy is not a safe harbor from the prohibitions on adopting a fund name that is materially deceptive or misleading under Section 35(d).¹³ The following may be deemed to be materially deceptive or misleading practices: “substantial”¹⁴ investments made outside the 80% Investment Policy that are “antithetical” to the fund’s investment focus¹⁵ or an index fund’s 80% Investment Policy to invest in assets connoted by a specific index in circumstances where the reference index’s composition is contradictory to the index’s name.¹⁶The SEC stated that, as a result, index funds generally should adopt and implement written policies and procedures reasonably designed to ensure that an index selected by a fund does not have a materially misleading or deceptive name itself.¹⁷As noted above, the SEC declined to adopt a provision in the proposal that would have designated any “integration fund” with ESG-related terms in its name as per se materially deceptive and misleading.¹⁸
Temporary Departures from an 80% Investment Policy. The amendments retain the current principles-based approach of requiring that funds comply with their 80% Investment Policy “under normal circumstances” and apply the requirement at the time a fund acquires an asset. Generally, a fund will be required to re-attain compliance with its 80% Investment Policy “as soon as reasonably practicable” but, in any event, within 90 consecutive days.¹⁹ The amendments also include a new requirement that a fund review the classifications of its portfolio assets under its 80% Investment Policy at least quarterly.²⁰ The SEC noted that, at a certain point, departures from a fund’s 80% Investment Policy may begin to change the nature of the fund fundamentally (a phenomenon the SEC refers to as “drift”), which could undermine investor expectations created by the fund’s name, and that the time limits are designed to prevent such a fundamental change without investor notification.²¹A fund may also, in other-than-normal circumstances, make investments that are not consistent with the fund’s 80% Investment Policy for a limited period of time, but it would still be required to re-attain compliance within 90 consecutive days after the departure.²²

Derivatives-Related Aspects of the Names Rule

As with the proposal, the amendments address (1) the derivatives instruments that a fund may include in its 80% Investment Policy basket (80% basket) and (2) the valuation of derivatives instruments for purposes of determining compliance with a fund’s 80% Investment Policy. The amendments also address short positions and physical short sales.

As under the proposal, the amendments define the term “derivatives instrument” to mean any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument.²³

Scope of Derivatives Instruments Included in 80% Basket:

The amendments provide that, in addition to any derivatives instrument that the fund includes in its 80% basket because the derivatives instrument provides investment exposure suggested by the fund’s name, a fund may include in its 80% basket a derivatives instrument that provides investment exposure to one or more of the market risk factors associated with the investment focus that the fund’s name suggests. The SEC restated guidance that this approach recognizes that funds may use derivatives instruments to hedge exposures or to obtain exposure to market risk factors associated with a fund’s investments (e.g., interest rate risk and credit spread risk). The SEC also restated certain examples of transactions that provide investment exposure to one or more of the market risk factors associated with investments suggested by a fund’s name and provided a new example. The SEC acknowledged that there may be additional transactions other than the ones it enumerated that provide such exposure and that the examples the SEC provided are not intended to be limiting. The SEC also explained that, to help determine whether a derivatives instrument provides this type of investment exposure, a fund “generally should consider whether the derivative provides investment exposure to any explicit input that the fund uses to value its name assets, where a change in that input would change the value of the security.”

Valuation of Derivatives Instruments and Short Sales and Adjustments:

The amendments require that a fund must, in determining the value of a fund’s assets for purposes of complying with the fund’s 80% Investment Policy:

Value each derivatives instrument, for both the numerator and the denominator in the 80% Investment Policy calculation, using the notional amount of the derivatives instrument.
Adjust the notional value by converting interest rate derivatives instruments to their 10-year bond equivalents and delta adjusting options contracts.²⁴
Exclude from the 80% Investment Policy calculation derivatives instruments used to hedge currency risks associated with one or more specific foreign currency-denominated equity or fixed-income investments held by the fund, provided that such currency derivatives are entered into and maintained by the fund for hedging purposes and that the notional amounts of such derivatives do not exceed the value of the hedged investments (or the par value thereof, in the case of fixed- income investments) by more than 10 percent.²⁵

The amendments also require a fund to value each physical short position using the value of the asset sold short.

The amendments also permit but do not require a fund to reduce the value of its assets (i.e., the denominator in the 80% Investment Policy calculation) by excluding:

Cash and cash equivalents and U.S. Treasury securities with remaining maturities of one year or less, up to the notional amounts of the derivatives instruments and the value of assets sold short.²⁶
Any closed-out derivatives positions if those positions result in no credit or market exposure to the fund.²⁷

Additional Considerations

Disclosures

The SEC added disclosure requirements to a fund’s prospectus.²⁸ The amendments affecting prospectus disclosure will require a fund with an 80% Investment Policy to define in the fund’s prospectus the terms²⁹ used in the fund’s name related to its investment focus and the fund’s investment criteria for selecting the investments described by that term. Funds will have flexibility to use “reasonable definitions” of the terms that their name uses, provided that the meaning of such terms is consistent with plain English or established industry use.³⁰

Form N-PORT

Amendments to Form N-PORT will require registered investment companies that are required to adopt an 80% Investment Policy to report: whether a portfolio investment is included in the 80% basket; the definitions of the terms used in the fund’s name, including the specific criteria the fund uses to select the investments the term describes, if any; and the value of its 80% Investment Policy basket as a percentage of fund assets.³¹ In line with quarterly monitoring for compliance with an 80% Investment Policy, this data must be reported on Form N-PORT for the third month of each quarter. The proposal would have required such reporting on Form N-PORT every month and also would have required a fund to indicate the number of days, if any, that it was not in compliance with its 80% Investment Policy during the reporting period.

Notice Requirement

The content and delivery of Notices have been affected by the amendments as well. As mentioned above, the Names Rule currently requires 60 days’ notice to shareholders of changes in a fund’s non-fundamental 80% Investment Policy. The amendments retain the requirement that Notice must be provided (except for fundamental 80% Investment Policy changes) but also require a fund to describe any related changes to the fund’s name in the Notice. The amendments also provide greater clarity around the content of a Notice, electronic delivery, and what it means for the Notice to be provided “separately from any other document.”³²

Recordkeeping Requirements

The amendments also include certain recordkeeping requirements, which (in relevant part) will require funds with an 80% Investment Policy to document compliance with the amended rule. In a change from the proposal, the amendments do not require a fund without an 80% Investment Policy to document why the fund determined an 80% Investment Policy is not required.³³

Unlisted Closed-End Funds, BDCs and UITs

For registered closed-end investment companies or BDCs that do not have shares listed on a national securities exchange (collectively, Unlisted Funds), the amendments will generally require shareholder approval to change an 80% Investment Policy. Such funds will, however, be permitted to make changes to their 80% Investment Policy without a shareholder vote if the fund conducts a tender or repurchase offer in advance of the change, subject to certain conditions, including that the tender or repurchase offer is not oversubscribed. The SEC explains that this exception provides investors an opportunity to exit the Unlisted Fund within the 60-day notice period permitted under the current Names Rule.³⁴

Additionally, the amendments provide that the 80% Investment Policy and recordkeeping requirements apply to unit investment trusts (UITs) only at the time of initial deposit of securities.

Key Dates and Timing

An upcoming Dechert OnPoint will provide further analysis of the amendments and their potential impact.

Footnotes

1) Investment Company Names, Release No. IC-3500 (September 20, 2023) (Adopting Release). At times, this Newsflash tracks the Adopting Release without the use of quotation marks. Terms not defined in this Newsflash have the meaning assigned to them in the Adopting Release. SEC Chair Gensler and Commissioners Peirce, Crenshaw and Lizárraga voted in favor of the amendments; Commissioner Uyeda voted against the amendments.

2) Investment Company Names, Release No. IC-34593 (May 25, 2022) (Proposing Release).

3) The Names Rule currently requires that funds with names suggesting investment in a particular type of investment, industry, country or geographic region adopt a policy to invest, under normal circumstances, at least 80% of their respective assets (net assets plus the amount of any borrowings for investment purposes) in such type, industry, country or geographic region (80% Investment Policy). The Names Rule also contains a similar requirement for funds with names suggesting that the funds’ distributions are exempt from federal income tax or from both federal and state income tax. Unless otherwise specified, the term “fund” as used in this Newsflash refers to a registered investment company and business development company (BDC).

4) The SEC did not change the requirement in current Rule 35d-1 that funds with names suggesting that their distributions are exempt from federal income tax or from both federal and state income tax must adopt a fundamental 80% Investment Policy.

5) Integration funds are defined in the Proposing Release as funds that incorporate one or more ESG factors alongside other, non-ESG factors, but the ESG factors are no more significant than the other factors in the investment selection process. See Proposing Release at section II.D.

6) If a fund name includes global or international plus a term suggesting an investment focus, such as fixed income or growth, then it would require an 80% Investment Policy associated with fixed income or growth, as applicable. An 80% Investment Policy would continue to be required with respect to the use of the word “bond.” See Adopting Release at section II.A.1.b. A fund would be required to reassess its compliance with its 80% Investment Policy no less frequently than quarterly. Amended Rule 35d-1(g).

7) Where a fund’s name suggests an investment focus that has multiple elements, the 80% Investment Policy is required to address each element, although there is no minimum or maximum amount of assets that must be dedicated to each element unless the fund’s disclosure indicates otherwise. See Adopting Release at section II.A.1.c.

8) The SEC clarified that the amendments only expand the Names Rule in this area and funds that are currently required to adopt an 80% Investment Policy (i.e., funds whose names suggest a focus in a particular type of investments or industry, or in particular countries or geographic regions, or suggest certain tax treatment) under the Names Rule will still be required to do so. See id. at section II.A.1.

9) For purposes of the amendments, the term “ESG” includes terms such as “socially responsible investing,” “sustainable,” “green,” “ethical,” “impact,” or “good governance” to the extent they describe environmental, social, and/or governance factors that may be considered when making an investment decision. In response to comments, the SEC recognized that terms such as “sustainable” could refer to the overall result the fund seeks to achieve, rather than an ESG connotation, and a name including “sustainable growth,” for example, could be a suitable name for a non-ESG fund, in a departure from the Proposing Release. See id. at section II.A.1.d.

10) Under the current rule, such names are generally considered by many fund sponsors to be investment strategies not subject to the 80% Investment Policy requirement.

11) Names that do not indicate a specific investment focus – instead referencing fund-level portfolio characteristics, investment techniques, or possible results (e.g., duration, balanced, long/short, real return) – continue to be outside the scope of Rule 35d-1.

12) For funds of funds or other “acquiring” funds, the SEC indicated that it would be reasonable, under the amendments, for a top-tier fund to count its entire position in an underlying fund towards the 80% Investment Policy in certain circumstances, such as where the underlying fund itself has an 80% Investment Policy. See id. at section II.A.1.c.

13) That is, a fund’s name may still be materially deceptive or misleading for purposes of Section 35(d) in certain circumstances. Amended Rule 35d-1(c). See Adopting Release at section II.A.5.

14) “Substantial” investment could include, for example, investing in a way “such that the source of a substantial portion of the fund’s risk or returns is materially different from that which an investor reasonably would expect based on the fund’s name.” See id.

15) The SEC provided the following examples of fund investments that could be materially deceptive or misleading for purposes of Section 35(d): a “green energy and fossil fuel-free” fund making a substantial investment in an issuer with fossil fuel reserves and a “conservative income bond” fund using the 20% basket to invest in highly volatile equity securities that introduce significant volatility into a fund that investors would expect to have lower levels of volatility associated with lower-yielding bonds. See id.

16) In addition, the SEC reiterated its view that an index fund generally would be expected to invest more than 80% of its assets in investments connoted by the applicable index. See id.

17) In response to commenters, the SEC confirmed that, while index funds should generally implement written policies and procedures ensuring that they comply with the requirements of section 35(d), the terms in a market index referenced in an index fund’s name would not be subject to an 80% Investment Policy test that would be in addition to the fund’s policy to invest at least 80% of its assets in the index’s components required under the rule. See id.

18) The SEC is “continuing to consider comments” because this proposed provision implicates a companion rulemaking on ESG matters issued the same day as the Proposing Release. See id. at section I.C.2; see also Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, Release No. IC-34594 (May 25, 2022). Under this companion rulemaking, a fund that has a name that includes terms indicating that its investment decisions incorporate one or more ESG factors would meet the definition of an “ESG-focused fund.” As compared to integration funds, ESG-focused funds would be subject to more onerous disclosure requirements.

19) Amended Rule 35d-1(b)(1)(i). This does not apply to fund launches (which are permitted up to 180 consecutive days from the “date the fund commences operations” to come into compliance), reorganizations (no specified time period for re-attaining compliance), and situations where 60 days’ notice of a change in a non-fundamental 80% Investment Policy was provided to shareholders. The Proposing Release clarified that “as soon as reasonably practicable” does not require re-attaining compliance “as soon as possible” in all instances. Instead, this phrase would allow “for consideration by the adviser of how to return to compliance in a manner that best serves the interest of the fund and its shareholders.” See Proposing Release at n. 57.

20) The proposal would have required continual or daily compliance monitoring. See Adopting Release at section II.A.2.

21) See id.

22) Amended Rule 35d-1(b)(1)(ii).

23) The definition of derivatives instrument does not include physical short sales (which were not addressed in the proposal). However, the amendments address short sales within the valuation of derivatives instruments and short sales.

24) The use of notional value and the adjustments mirror the proposal.

25) The SEC explains that exclusion of specified currency hedging derivatives instruments, which was not included in the proposal, addresses commenters’ concerns that the proposal’s approach to derivatives could limit the use of derivatives for hedging purposes (providing as an example a U.S. equity fund that invests up to 20% of its assets in stocks of non-U.S. companies and hedges the associated currency exposure). The SEC also noted that, in contrast with currency hedging derivatives instruments, other types of hedging transactions executed through derivatives are difficult to distinguish from transactions that create exposures that contribute to (or detract from) the investment focus that a fund’s name suggests.

26) The proposal would have required, not permitted, this deduction, and did not include U.S. Treasury securities.

27) The proposal did not address closed-out derivatives instruments directly, but a request for comment suggested that derivatives that were closed out with the same counterparty and result in no credit or market exposure to the fund could be eliminated from the names rule calculation. The Adopting Release clarifies that the Final Rule does not require “closed-out positions to be closed out with the same counterparty in order for a fund to exclude them from the calculation of its assets.”

28) Prospectus requirements apply to Form N-1A, Form N-2, Form N-8B-2, and Form S6. See Adopting Release at section II.B.

29) The phrase “terms” would “mean any word or phrase used in a fund’s name, other than any trade name of the fund or its adviser, related to the fund’s investment focus or strategies.” See id. at n. 323.

30) The failure to do so could result in such terms being deemed to be materially deceptive or misleading for purposes of Section 35(d). See id. at section II.B; amended Rule 35d-1(a)(2)(iii) and (3)(ii).

31) See Adopting Release at section II.E. Such requirements do not apply to money market funds or BDCs.

32) Although “separately from any other document” is phrased differently than the current requirement, the proposal is intended to be “functionally the same as the current rule’s requirement.” See id. at section II.D.

33) The current Names Rule and other recordkeeping requirements under the 1940 Act do not require recordkeeping with respect to the Names Rule. See id. at section II.F.

34) See id. at section II.A.4.