Thursday, May 26, 2022

SEC proposes to sharpen rule preventing misleading fund names

By Rodney F. Tonkovic, J.D.

By a 3-1 vote, the SEC has issued a proposed rule amending the Investment Company Act's "Names Rule." The rule prohibits certain categories of investment company names that have the potential to mislead investors about an investment company’s investments and risks. The proposed amendments are intended to address changes in the market since the rule was adopted two decades ago by expanding a requirement that a fund invests the majority of its assets to match the investment focus suggested by its name. The proposal would also provide new disclosure, reporting, and recordkeeping provisions and update the current notice requirements. Comments are due 60 days after publication in the Federal Register (Investment Company Names, Release No. IC-34593, May 25, 2022).

The names rule. The proposal would amend Investment Company Act Rule 35d-1. The "Names Rule", which has not been amended since its adoption, prohibits registered investment companies from using materially deceptive or misleading names. Among other restrictions, the rule requires any fund that has a name focusing on a particular type of investment type or investment in a particular industry to invest at least 80 percent of its assets in that type of investment. The rule is not meant to be a safe harbor for misleading names, and fund names are also subject to the antifraud provisions of the securities laws. As the commissioners observed during the open meeting adopting the proposal, a fund’s name is an important piece of information that investors use in selecting a fund, and the names are chosen by fund managers as a means of communicating information about a fund to investors.

In March 2020, the Commission issued a public request for comment to address potentially misleading fund names. The request for comment reflected the Commission's concerns over market developments since 2001 that may have impacted the rule's efficacy. The request noted that the increased use of hybrid financial instruments by funds and the varying consideration of environmental, social, and governance as an investment strategy versus an investment policy may be affecting the application of the fund-names rule. The Commission also asked whether the rule should apply to terms such as "ESG" or "sustainable" that reflect qualitative characteristics of investments. A few dozen comments were received.

Proposed updates. Foremost among the proposed changes is a modernization of the requirement that funds with certain names adopt a policy to invest 80 percent of their assets in the investments suggested by that name. This requirement would be expanded to apply to fund names suggesting that the fund focuses on investments with particular characteristics, such as "growth," "value," or terms indicating a focus on ESG factors. The Commission has previously taken the position that such names connote an investment objective or strategy (as opposed to types of investments) and are not within the scope of the 80 percent requirement. In the case of derivatives, a fund would be required to use the derivative instrument's notional amount, rather than its market value, in determining compliance.

If a fund "drifts" below the 80 percent requirements, it must bring its investments back into compliance as soon as reasonably practicable. The maximum time allowed for such a departure would be 30 consecutive days. The Commission explained that this would allow for market fluctuations and cash inflows or outflows from redemption requests; reorganizations and fund launches would be given up to 180 days.

The proposal also includes amendments that would provide enhanced information about how fund names track their investments. For example, fund prospectuses would disclose how the terms used in a fund's name are defined, and amendments to Form N-PORT would require greater transparency on how the fund’s investments match its investment focus. In addition, the proposal updates the rule's notice requirement to address funds using electronic delivery methods to provide information to shareholders.

ESG terminology. The proposed amendments also address "integration funds," which the Commission defines as funds that consider ESG factors alongside other, non-ESG factors in the fund's investment decisions, but those ESG factors do not play a central role in the fund's strategy. These funds would not be permitted to use "ESG" or similar terminology in their names, and doing so would be defined as materially deceptive or misleading.

Commissioner Gensler said: "A lot has happened in our capital markets in the past two decades. As the fund industry has developed, gaps in the current Names Rule may undermine investor protection," said SEC Chair Gary Gensler. "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."

Peirce objects. The sole objection to the proposal came from Commissioner Peirce, who declined to support the proposal, stating that the amendments would "create more fog than they dissipate." Peirce said that terms such as "ESG," "growth," and "value" are broad, and applying the 80 percent rule to them would require subjective judgments from the industry and the SEC. A better approach, she said, would be to require better disclosure about the strategies managers use. She also objected to the strict 30-day limit on departures from the 80 percent rule, stating that such an inflexible limit could induce managers to make undesirable investments or even shut down in times of market stress. Finally, she said, the proposed one-year implementation period is too short.

The release is No. IC-34593.