By Seth Gaudreau and Stephen Wilkes
SEC Commissioner Crenshaw reminded us last year that, despite the poetic beauty of Shakespeare’s observation that, “A rose by any other name would smell as sweet”, names really do matter in the investment world. At the end of September, the Securities and Exchange Commission (“SEC”) adopted amendments (the “Amendments”) to the “Names Rule” (found here), Rule 35d-1 under the Investment Company Act of 1940, as amended. The SEC’s intent was to modernize the Names Rule, as well as related disclosure and reporting requirements. Originally adopted in 2001, the Names Rule was designed to prevent registered investment companies and business development companies (referred to collectively as “funds”) from using names that are deceptive or inconsistent with the fund’s investments.
The Amendments:
- broaden the scope of the funds that must comply with the current requirement to adopt a policy to invest at least 80 percent of their assets in accordance with the investment focus the fund’s name suggests;
- Provide enhanced disclosure and reporting requirements related to terms used in fund names; and
- Establish additional recordkeeping requirements
Expansion of Scope of the 80 Percent Investment Policy Requirement
The Amendments broaden the scope of the Names Rule’s 80% investment policy which requires funds whose names suggest a focus in a particular type of investment, or investment in a particular industry or geographic region, to adopt a policy to invest at least 80% of the value of their assets in investments that match the fund’s name. The Amendments require a fund to adopt an 80% Investment Policy if its name suggests a focus in investments that have, or whose issuers have, “particular characteristics.” The SEC did not define the term “particular characteristics,” but it anticipates the Amendments will cover fund names that refer to or contain terms such as “growth” or “value” or that refer to a thematic investment focus, including terms indicating that the fund’s investment decisions incorporate one or more ESG factors. The SEC did not distinguish between a type of investment and an investment strategy because a fund name “might connote a particular investment focus and result in reasonable investor expectations regardless of whether the fund’s name describes a strategy as opposed to a type of investment.” For funds that have names with multiple elements, the 80% investment policy must incorporate all the elements of the name, individually or in the aggregate. The Amendments generally will not apply to certain names that have historically been interpreted as being outside the scope of the Names Rule, including global, international, or intermediate term (or similar) bond without an additional term that suggests an investment focus such as “fixed income” or “growth.”
Enhanced Prospectus Disclosure, Form N-PORT Reporting, and Recordkeeping
The Amendments require a fund subject to the 80% rule to disclose in its prospectus the terms used in its name that are covered under the amended Names Rule. This includes the criteria the fund uses to select the investments that each term used in the fund’s name describes. 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. Funds subject to the 80% rule (excluding money-market funds and business development companies) will be required to disclose on their quarterly Form N-Port, the definitions of terms used in their names, the value of their 80% baskets, and each investment that is included in the 80% basket.
Finally, the Amendments require funds to maintain written records documenting their compliance with the 80% rule for at least six years following the creation of each record, with the first two years of recordkeeping being in an easily accessible place.
Temporary Departures from a Fund’s 80 Percent Investment Policy
The Amendments add a new requirement for a fund to review the positions included in its “80% basket” at least quarterly. However, they retain the current Names Rule requirement for a fund to invest in accordance with its 80% investment policy “under normal circumstances,” and for the 80% investment policy to apply at the time a fund invests its assets. The Amendments include specific time frames, generally 90 days, for getting back into compliance if a fund departs from its 80% investment policy as a result of drift or in other-than-normal circumstances.
Unlisted Closed-End Funds and Business Development Companies and Unit Investment Trusts
The Amendments generally prohibit a registered closed-end fund or business development company (“BDC”) whose shares are not listed on a national securities exchange from changing its 80% investment policy without a shareholder vote, unless (1) the fund conducts a tender or repurchase offer with at least 60 days’ prior notice of the policy change, (2) that offer is not oversubscribed, and (3) the fund purchases shares at their net asset value.
The 80% Investment Policy and recordkeeping requirements only apply to Unit Investment Trusts (UITs) at the time of initial deposit of securities.
Derivatives
Under the Amendments, funds must use the notional amount of a derivatives instrument to check compliance with the 80% investment policy, with some modifications, rather than its market value. Notably, certain currency hedges are excluded from this compliance calculation. Additionally, the Amendments clarify which derivative instruments can be included in a fund’s 80% basket. The SEC advised that 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.”
Modernization of Notice Requirement
The Amendments retain the current rule’s requirement that, unless the 80 percent investment policy is a fundamental policy of the fund, 60 days’ notice must be provided to fund shareholders of any change in the fund’s 80 percent investment policy. The Amendments update the notice requirement to expressly address funds’ use of electronic delivery and incorporate additional specificity about the content and delivery of the notice.
Effective Date
The Amendments are effective for all registered funds, including existing funds, 60 days after publication of the final rule in the Federal Register. All funds falling within the newly expanded scope of the Names Rule, which the SEC expects to be at least 75% of all U.S. registered investment funds, will need to be in compliance (which could entail changing their names, adopting an 80% policy, etc.) by the following dates, depending on their size:
- Larger Entities (funds that have net assets of $1 billion or more as of the most recent fiscal year): 24 months after the Amendments’ effective date.
- Smaller Entities (funds that have net assets of less than $1 billion as of the most recent fiscal year): 30 months after the Amendments’ effective date.
Conclusion
A key aspect of the Amendments is the lack of guidance around what qualifies as an ESG factor and to what extent a fund should incorporate ESG factors in its investment process if it does use an ESG-related term in its name. Notably, the Amendments did not adopt changes in the proposed amendments to the Names Rule that would have deemed the name of an integration fund (i.e., a fund that integrates ESG alongside non-ESG factors) materially misleading if it included ESG terminology in its name. Nonetheless, we believe these Amendments are likely to result in increased compliance costs and oversight. Fund companies should begin to review their existing fund line-up to determine the impact that the Amended Rule 35d-1 will have on their funds.