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SEC Proposes Rule Updates Intended to Prevent Misleading or Deceptive Fund Names

On May 25, the US Securities and Exchange Commission (SEC) proposed amendments to enhance and modernize Section 35(d) of the Investment Company Act, known as the “Names Rule,” to provide protection to investors.[1] In a press release, the SEC noted the importance of a fund’s name in guiding investors’ choices when making investment decisions. The SEC updated the Names Rule to reflect changes in the financial industry over the past two decades. In a statement on the proposed updates, SEC chair Gary Gensler said, “the current Names Rule may undermine investor protection. In particular, some funds have claimed that the rule does not apply to them – even though their name suggests that investments are selected based on specific criteria or characteristics. Today’s proposal would modernize the Names Rule for today’s markets.”
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The Influence of a Fund’s Name

The SEC often cautions investors from relying solely on a fund’s name when making investment decisions. However, it also recognizes that fund names can relay information to investors.[2] Originally, this was the policy rationale for the Names Rule in 2001. In its current form, Section 35(d) of the Investment Company Act prohibits registered investment companies from adopting part of their name or title, words that may be deceptive or misleading. However, the current rule allows funds to depart from their original investment focus over time, which the SEC claims deprives investors of the protection it is meant to provide. The proposed amendment is meant to combat these concerns and modernize the rule.

Generally, the Names Rule requires that a fund must adopt a policy to invest at least 80% value of its assets in investments in a particular industry or geographical region. Under the rule, a fund is required to invest in accordance with its 80% investment policy “under normal circumstances.” If subsequent investments cause the fund to fall out of compliance, the fund’s future investments must be made in a manner that will bring it into compliance.

The proposed amendment retains the notice alternative to provide eligible funds flexibility to respond efficiently to market events or regulatory requirements. This allows funds to change their investment policy or name and allow investors to exit. Similarly, to the current rule, the proposed amendments also require the notice to be provided 60 days prior to the change, in plain English, and separate from other documents. Under the proposed rule, if the notice is delivered in paper form, it may be delivered in the same envelope as other documents.

Names Rule Proposal Addresses Nine Issues

The Rule Proposal is meant to modernize and reinforce investor protection. The proposed amendments seek to accomplish this by addressing the following nine issues:

  1. Expansion in Scope: Currently, the Names Rule requires funds with names including words [that indicate focus in a particular industry or geographic region] to adopt a policy of investing 80% of fund assets in investments the fund determines are suggested by those words. The proposal is intended to expand the scope of the rule to cover fund names, including words that may indicate particular fund characteristics.[3] Some examples include fund names with terms such as “growth,” “value,” or “environment.”
  2. Temporary Departure from a Fund’s 80% investment: The current rule provides that a fund must be in compliance with its 80% investment policy at the time an investment is made, “under normal circumstances.” The amendment will permit the fund to deviate from its 80% investment policy under specific circumstances for a limited time, in most cases, 30 days.[4]Derivatives: To reflect the increasing prevalence of investments in derivatives, the amendment would require funds to use the notional value, rather than market value, of such investments for the purpose of determining compliance with a fund’s 80% policy. The proposal also includes updates to address derivative instruments that funds may include in 80% baskets.
  3. Prospectus Disclosures: The proposal includes amendments to disclosure requirements, including a requirement for funds to define the terms used in fund names and include criteria the fund manager uses to select investments based on those definitions.
  4. Plain English: The proposal requires that any terms used in the fund’s name that suggest investment focus or tax-exempt status must be consistent with a plain English reading or established industry use of such terms.
  5. Material Deceptive and Misleading Use of ESG Terminology: Under the proposal, the amendment would not permit a fund to use ESG or similar terminology if the fund considers ESG facts alongside but not more centrally than other factors.
  6. Modernization of Notice Requirement: The proposed amendment requires funds that use electronic delivery methods to notify investors not only of a change in the fund’s 80% investment policy, but also of a change to the fund’s name that reflects the investment-policy change. The proposed amendments would require that the notice contain a prominent statement in bold-face type titled “Important Notice Regarding Change in Investment Policy [and Name].” Notices in paper form must be accompanied by the statement in the same envelope. Notices in email form must be in the subject line of the email communication.
  7. Form N-PORT Reporting Requirements: The proposed amendment includes changes to Form N-PORT to require increased transparency regarding fund names and corresponding investment choices, and to allow the SEC to evaluate compliance. The proposed rule would require funds subject to an 80% policy to indicate with respect to each investment, whether it is included in the fund’s 80% basket, the value of the fund’s 80% basket as a percentage of the value of the fund’s assets, and, if applicable, the number of days that the value of the fund’s 80% basket fell below 80% of the value of the fund’s assets during the reporting period.
  8. Recordkeeping: The proposed amendment would require funds to keep records that would allow the SEC and the fund’s compliance personnel to evaluate compliance with the rule’s requirements. Funds that do not adopt an 80% policy will be required to maintain a written record of their analysis to show their exemption from the rule. The proposed recordkeeping requirements require the funds to keep records for six-years, and in an easily accessible place for the first two years. Funds not adopting an 80% policy must maintain a written record of their analysis that such a policy is not required, and must maintain these records for six years.

Takeaways

The proposed amendments to the Names Rule are intended to serve the SEC’s mission of investor protection. By addressing the items summarized above, the amended rule will expand requirements for certain funds to adopt a policy to invest 80% of fund assets in investments that reflect an investment focus suggested by their name. By providing enhanced disclosure and reporting requirements, updating notice requirements, and establishing recordkeeping guidelines, the SEC will more closely monitor compliance with the rule and funds’ policies.

The proposed amendment provides additional cause for caution in naming investment funds. Terminology used in a fund name that suggests not only a particular investment focus but also an investment strategy may trip the requirement to adopt a policy to define what that strategy means and how it is determined on an investment-by-investment basis, which will then inform investment decisions and introduce burdensome monitoring and reporting obligations. Fund sponsors should be careful in adopting names with industry buzzwords that may have subjective everyday definitions, but may nonetheless be viewed by the SEC as suggestive of a particular strategy or focus.

Furthermore, the proposed rule changes may introduce new monitoring, investor notice, and reporting requirements fund sponsors should factor into naming decisions. The 30-day requirement to return upon deviating from an 80% policy and a requirement to report the number of days a fund has fallen out of compliance introduces additional complexity in monitoring compliance.

Additional research and writing from Gio Singh, a 2022 summer associate in ArentFox Schiff’s New York office and a law student at New York Law School.


[1] See Press Release, SEC. and EXCH. COMM’N, SEC Proposes to Enhance Disclosures by Certain Investment Advisers and Investment Companies About ESG Investment Practices (May 25, 2022) https://www.sec.gov/news/press-release/2022-91?utm_medium=email&utm_source=govdelivery
[2] See Investment Company Names, Advisers Act Release No. 6,034; Investment Company Act Release No. 34,593 (proposed May 25, 2022) (to be codified at 17 CFR pt. 232, 270, and 274) *Proposed rule: Investment Company Names (sec.gov)
[3]See Fact Sheet, SEC. and EXCH. COMM’N, Amendments to the Fund “Names Rule” (May 25, 2022) https://www.sec.gov/files/ic-34593-fact-sheet.pdf
[4] See Statement, SEC. and EXCH. COMM’N, Statement on Proposed Updates to Names Rule (May 25, 2022)SEC.gov | Statement on Proposed Updates to Names Rule

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