On September 20, 2023, the Securities and Exchange Commission (“SEC”) adopted amendments to Rule 35d-1[1] (the “Names Rule”) under the Investment Company Act of 1940, as amended (“1940 Act”), as well as amendments to certain investment company registration forms, Form N-PORT and certain recordkeeping requirements (collectively, the “Adopted Rules”). Under Section 35(d) of the 1940 Act, a registered investment company, such as a mutual fund, exchange-listed closed-end fund or an ETF, may not use a name that the SEC finds as materially deceptive or misleading. Rule 35d-1, initially adopted in 2001, required among other things that certain funds using names suggesting investment in certain types of investments or securities, or in certain countries or geographic regions, to adopt a policy to invest at least 80 percent of its assets in those investments, securities, countries or geographic regions (the “80-Percent Policy”). As noted in the Adopting Release, these rule changes are intended to improve and broaden the scope of funds subject to the 80-Percent Requirement.
The Adopted Rules follow amendments and rules proposed by the SEC on May 25, 2022, which we summarized in our Client Alert "SEC Proposes Amendments to Rule 35d-1 under the 1940 Act."
Various aspects of the Adopted Rules are discussed below.
80-Percent Policy Requirement
Broadening the 80-Percent Policy Requirement to Funds with Names Suggesting an Investment Focus
The Adopted Rules expand the scope of Rule 35d-1 to require a registered investment company to adopt an 80-Percent Policy if its name includes terms suggesting that it focuses on investments in a particular industry or group of industries, that have, or whose issuers have, particular characteristics,[2] such as “growth” and “value,” as well as thematic terms or terms that suggest one or more ESG related considerations play a role in the investment decision-making process. These terms are in addition to terms covered by the current Rule 35d-1, that is, names suggesting investments in a particular type of investment or investments or particular countries or geographic regions.
The Adopted Rules also maintain current Rule 35d-1’s prohibitions on names suggesting:
- A guarantee or approval by the U.S. government, including any name that uses the words “guaranteed” or “insured” or similar terms in conjunction with the words “United States” or “U.S. government,” and
- That the registered investment company’s distributions are exempt from federal income tax or from both federal and state income tax unless the registered investment company invests at least 80 percent of its assets in investments, the income of which is exempt from federal or state taxation, or at least 80 percent of the income its distributes is exempt from federal or state taxation.
The Adopting Release notes that the terms “growth” or “value,” or terms indicating that the fund’s investment decisions incorporate one or more Environmental, Social or Governance (“ESG”) factors are examples of the expansion of the scope of Rule 35d-1, and there may be other situations where Rule 35d-1 would also apply. For example, the Adopting Release states that is it expected that Rule 35d-1 would apply to any terms that reference a thematic investment focus. While in the past, certain funds have stated that Rule 35d-1 does not apply to them because a term in the name suggests an investment strategy rather than a type of investment, the Adopting Release notes that Rule 35d-1, as amended, applies to those funds whether or not such terms connote an investment strategy and not a specific type of investment.
If a fund’s name includes multiple terms that would suggest an investment focus, the 80-Percent Policy must address each term, but the Adopting Release notes that a fund may take a reasonable approach to specify how it would incorporate each such element. As an example, the Adopting Release notes that the “XYZ Technology and Growth Fund” could have an investment policy that each investment that is intended to comply with the 80-Percent basket must be in both the technology sector and meet the fund’s growth criteria, or it could have an investment policy that at least 80 percent of its assets be invested in a mix of securities that are either technology investments, growth investments or technology and growth investments.
The Adopting Release also provides a fund with flexibility to describe in its prospectus how it defines the terms used in the name and the criteria that the adviser uses to determine if an investment meets the criteria to be included in the 80-percent basket. With respect to determining if a security is in a specific industry, the Adopting Release notes that there must be “a meaningful nexus between the given investment and the focus suggested by the name.” An example provided in the Adopting Release is that a fund could define a security to be issued by a company in a particular industry if such company derives more than 50 percent of its revenue or income from, or owns significant assets in, the industry. The Adopting Release does note that there could be times when a smaller percentage could be sufficient, such as, for example, if the company is an acknowledged leader in the industry. Conversely, the Adopting Release notes that using text analytics to assign issuers to an industry based on the frequency of certain terms in their disclosure documents would not be a reasonable method to use on its own.[3]
The Adopting Release also notes that there are certain fund names that remain outside Rule 35d-1 and thus, their funds will not be required to adopt an 80-Percent Policy. In particular, names that reference a portfolio’s characteristics as a whole, rather than the specific characteristics of investments - such as “balanced”, “real return”, managed risk, or a name indicating that a fund seeks to achieve a certain portfolio duration (e.g., “intermediate term”) - remain outside the scope of Rule 35d-1. In addition, names that reference investment techniques, such as “long/short”, or “hedged,” or names that reference asset allocation determinations that evolve over time, such as target date funds or sector rotation funds, remain outside the scope of Rule 35d-1. Additionally, fund names that include “global” and “international,” without more, remain outside of Rule 35d-1 and thus, will not require an 80-Percenrt Policy.
With respect to fund of funds or acquiring funds, the Adopting Release notes that it would be reasonable for the fund to include the entire value of its investment in an appropriate acquired fund when calculating compliance with the 80-Percent Policy without looking through to the acquired fund’s underlying holdings, provided that the acquired fund has an 80-Percent Policy that covers the names used by the acquiring fund.[4]
Departures from the 80% Investment Requirement
As is currently the case, for purposes of Rule 35d-1, whether or not an investment fits within the 80-percent basket is determined at the time the investment is made (“time-of-investment test”). Subsequent changes in the market value of the investment or other changes in the issuer or the characteristics of the investment or the fund (such as changes in assets under management) do not cause a position to fall outside of the 80-percent basket. Moreover, if the portfolio would not satisfy its 80-Percent Policy if measured on any particular day, then under normal market circumstances, the fund would need to limit its future investments to positions that comply with the 80-Percent Policy.
However, in a change from current practice, a fund subject to the 80-Percent Policy will have to, at least quarterly, review the fund’s portfolio investments to determine whether they continue to be consistent with the fund’s 80-Percent Policy as measured on that date. If it is identified that a fund is no longer in compliance with its 80-Percent Policy, either during the quarterly review or outside of that quarterly review, the fund will be required to take appropriate action to bring the fund back into compliance “as soon as reasonably practicable” but no longer than 90 consecutive days (the time being measured from when the fund identifies a departure from complying with its 80-Percent Policy). This may require the fund to dispose of securities that no longer fit into its 80-percent basket. The Adopting Release notes that a fund could apply for exemptive relief if it believes it is appropriate and consistent with the protection of investors for the fund to depart from its 80-Percent Policy for a limited amount of additional time past the 90 days.
In “other than normal” circumstances, a fund will be allowed to intentionally deviate from its 80-Percent Policy. In the Adopting Release, the following are noted as events that could fall outside of normal circumstances[5]:
- Temporary departures as a result of market fluctuations, index rebalancing, cash flows/inflows or temporary defensive positions (for up to 90 consecutive days).
- Repositioning or liquidation of assets in connection with a reorganization (there is no specific time limit for this type of departure).
- During a fund launch (fund must be in compliance within 180 consecutive days).
- When a notice of a change in a fund’s policy in certain circumstances has been provided to fund shareholders (fund must be brought into compliance at the end of the notice period).
The Adopting Release notes that whether or not an event is outside of normal circumstances is based on the specific facts and circumstances and therefore a fund has flexibility to determine what would be considered outside of normal circumstances.
Considerations Regarding Derivatives in Assessing Compliance with Amended Rule 35d-1
Amended Rule 35d-1 generally requires that a fund, when calculating its assets for purposes of determining compliance with the 80-Percent Policy, use notional amounts to value derivatives, with certain adjustments. However, a fund must exclude from the calculation certain derivatives that hedge the currency risk associated with a fund’s foreign investments. A fund must exclude currency derivatives if they are: (1) entered into and maintained by the fund for hedging purposes; and (2) the notional amounts of the derivatives do not exceed the value of the hedged investment (or the par value thereof, in the case of fixed income investments) by more than 10%.
Additionally, in calculating notional amounts, a fund will have to convert interest rate derivatives to their 10-year bond equivalents and to delta adjust the notional amount of options contracts. Further, a fund is permitted to exclude any closed-out derivatives positions, whether or not from the same counterparty, when calculating assets for purposes of determining compliance with an 80-Percent Policy, if those positions result in no credit or market exposure to the fund.[6]
A fund will be permitted (but is not required), in determining compliance with its 80-Percent Policy, to deduct cash and cash equivalents and U.S. Treasury securities with remaining maturities of one year or less from assets (i.e., the denominator in the 80% calculation), up to the notional amounts of the fund’s derivatives investments.
Additionally, the amendments allow a fund to include in its 80-percent basket derivatives that provide investment exposure to one or more of the market risk factors associated with the investments suggested by the fund’s name, in addition to derivatives that provide investment exposure to the investments suggested by the fund’s name. The Adopting Release notes however, that including derivatives in the 80% bucket which create exposures inconsistent with a fund’s name could be considered materially deceptive and misleading. For example, including a derivative in the 80-percent basket that eliminates the primary risk factor associated with a fund name would be inappropriate.[7]
Unlisted Closed-End Funds and BDCs
With respect to unlisted closed-end funds and BDCs, the amendments to the Names Rule prohibit a fund with an 80-Percent Policy from changing that policy unless there is approval of the majority of the outstanding voting securities of the fund. However, there is an exception from this requirement for a shareholder vote if: the fund conducts a tender or repurchase offer in advance of the change, the fund provides at least 60 days’ prior notice of any change in the 80-Percent Policy in advance of that offer, that offer is not oversubscribed, and the fund purchases shares at their net asset value.
The Adopting Release notes that the SEC believes this is appropriate because of the inability for shareholders to be able to quickly redeem out of these investments if they do not want to remain invested in a fund that has changed its investment policy.
Effect of Compliance with an 80-Percent Policy – the 20% Bucket
The amendments to the Names Rule include a new provision codifying that a fund’s name could be materially deceptive or misleading under section 35(d) even if the fund has adopted and complies with an 80-Percent Policy. In the Adopting Release, the SEC notes that depending on how a fund invests the other 20% of its assets, the fund name could be misleading; for example, if the fund invests in a way such that the source of a substantial portion of the fund’s risk or return is different from what an investor would reasonably expect based on the fund’s name.
As another example, the Adopting Release notes that terms used in fund names that reference well-known organizations, affinity groups, or that reference a specific population of investors may not require an 80-Percent Policy, but such funds will continue to be subject to section 35(d)’s prohibition on materially misleading or deceptive names. Therefore, there should be sufficient disclosure explaining the connection such organization, affinity group or population of investors has to the fund.
Prospectus Disclosure Defining Terms Used in Fund Name
The Adopting Release also includes amendments to fund registration forms that require each fund that must have an 80-Percent Policy to include disclosure that defines the terms used in its name, including the specific criteria the fund uses to select the investments that the term describes, if any. For this purpose, “term” would mean any word or phrase in a fund’s name, other than any trade name of the fund or adviser, related to the fund’s investment focus or strategies. While funds will have flexibility to use reasonable definitions of the terms in their names, the Adopting Release notes that such definitions cannot be inconsistent with their plain English meaning or established industry use.
For open-end funds that file on Form N-1A, these definitions should be summarized in the summary prospectus and more fully disclosed in the statutory prospectus.
Modernizing the Names Rule’s Notice Requirement
The notice requirements under the Names Rule generally remain consistent with the current requirements, with a few modifications.
- The notice must continue to be provided separately from any other documents.
- If the notice is delivered in paper form, it may be provided in the same envelope as other written documents.
- The notice must have the following, or similar clear and understandable statement, in bold-face type: “Important Notice Regarding Changes in Investment Policy [and Name]. If the notice is delivered in paper form, this statement must be on both the notice itself and the envelope in which the notice is delivered. If the notice is provided electronically, the statement must be in the subject line of the email communication that contains the notice.
- The notice must describe, as applicable, the fund’s 80-Percent Policy, the nature of the change to the 80-Percent Policy, the fund’s old and new names and the effective date of any investment policy and/or name changes.
Funds may not simply post the notice of the changes to their websites without also delivering the notices to shareholders.
Form N-PORT Amendments
The Adopting Release includes amendments to Form N-PORT that require registered management investment companies and exchange-traded funds organized as unit investment trusts, other than money market funds and small business investment companies (collectively, “N-PORT funds’) to report additional information regarding such fund’s compliance with its 80-Percent Policy. N-PORT funds that have an 80-Percent Policy must report on Form N-PORT, with respect to each portfolio investment, whether or not that investment was part of the 80-percent basket, and must report 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. N-PORT funds must also report the value of the fund’s 80-percent basket, as a percentage of the value of the fund’s assets.
Recordkeeping Requirements
Funds that are required to comply with Rule 35d-1 have to maintain certain records documenting their compliance with the rule. Funds will also need to maintain certain records documenting any times that the fund was determined to not be in compliance with its 80-Percent Policy.
Transition Period
The compliance date for the amendments is 24 months following the effective date[8] for larger entities[9] and 30 months following the effective date for smaller entities[10].
A Note on ESG Integration Funds
The Adopting Release notes that, at this time, the SEC is not taking action on the names of funds using ESG integration strategies, which had been part of the proposed rules. The Adopting Release stated that names of funds using ESG integration strategies will be addressed when it comes out with its final rules on ESG disclosures by investment companies and investment advisers. Rule 35d-1, as amended, nevertheless, applies to funds whose names include terms indicating that the funds’ investment decisions include one or more ESG factors.
