On May 25, 2022, the US Securities and Exchange Commission (the SEC) proposed amendments (the Proposal) to Rule 35d-1 (the Rule) under the Investment Company Act of 1940, as amended (the 1940 Act).¹ The Proposal comes over 20 years after the original adoption of the Rule and seeks to greatly expand the scope of the Rule in the name of investor protection and modernization. The Proposal includes the following primary amendments to the Rule:

• Expansion of the 80% policy requirement² to include funds³ with names that suggest the fund focuses on investments that have, or whose issuers have, “particular characteristics.”
• A requirement that any unlisted closed-end funds or BDCs that are required to have an 80% policy under the Rule, adopt such policy as a fundamental policy.
• Identification of particular circumstances under which a fund may depart from its 80% policy and specific time frames for getting back into compliance.
• Establishment of the “notional amount” as the appropriate value for a derivative instrument used by a fund when calculating compliance with a fund’s 80% policy.
• Clarification of what the SEC deems a materially deceptive and misleading use of environmental, social and governance (ESG) terminology.
• A requirement that any terms used in a fund’s name that suggest an investment focus or a tax-exempt fund, must be consistent with those terms’ plain English meaning or established industry use.
• Modernization of shareholder notice requirements.
• Establishment of certain recordkeeping requirements related to a fund’s 80% policy.

Additionally, the Proposal sets forth various proposed amendments to Form N-PORT and certain registration statement forms, such as Forms N-2 and N-1A.  

Background

The Rule was enacted in 2001 pursuant to the rulemaking authority provided to the SEC under Section 35(d) of the 1940 Act to address materially deceptive or misleading fund names. Although the SEC has frequently cautioned investors against relying solely on a fund’s name to make an investment decision, the SEC acknowledges, along with other industry constituents, that a fund’s name communicates a great deal to investors, and is an important piece of information that investors use when making a decision to invest in a fund.

Due to the importance of fund names, changes in the industry over the past 20 years, and certain challenges related to interpretation and application of the Rule, in 2020 the SEC published a general request for comments related to fund names (the 2020 Request for Comment).⁴ In the 2020 Request for Comment, the SEC cited specific challenges related to compliance with the Rule, including funds' increased derivatives use and how to treat funds with names that suggest an investment focus but not a focus in a particular investment type or industry (such as funds with ESG in the name).

Expanding the scope

The Rule in its current form limits the 80% policy requirement to funds that have names suggesting tax-exempt status, or a focus on a certain investment type, industry, or region. The amendment, if adopted, would add an 80% policy requirement for funds with names that suggest a fund focuses on investments that have, or issuers that have, “particular characteristics.” Per the SEC, the expansion of the scope of the 80% policy requirement is meant to better align investor expectations created by fund names with the actual investment activity of the fund.

The Proposal specifically states that, if adopted as proposed, terms such as “growth,” “value” and “income” would implicate the Rule. Under current SEC guidance, such terms do not implicate the Rule because they imply focus on a particular strategy rather than an investment type. In the Proposal, the SEC states that the distinction between investment type and strategy (which would essentially be eradicated under the Proposal) has led to interpretive challenges for the SEC and inconsistent application of the Rule for funds with similar names.

The Proposal clarifies that terms suggesting characteristics of a fund’s overall portfolio (such as balanced); terms suggesting a particular investment technique (such as long/short); or terms suggesting a particular investment result (such as real return) would not implicate the Rule even under its expanded scope.

In addition to generally expanding the scope of the 80% policy requirement, the Proposal addresses the treatment of funds that have names with multiple terms implicating the 80% policy requirement. In such cases, under the Proposal, the 80% investment policy must address all of the terms in the name. For example, a fund named “Acme Solar and Water Fund” would be required to address both the “solar” and “water” terms in its 80% policy. The policy must not address each term equally but only take a reasonable approach to incorporate each term.

The SEC continues to request comment on what assets are appropriate to include as part of a fund’s 80% investment policy given the proposed expanded scope. The SEC acknowledges that when defining terms that suggest a focus on investments with “particular characteristics,” it is possible that funds with similar names will come to different reasonable determinations as to what investments qualify for inclusion in their 80% baskets, and this may cause investor confusion.

Non-traded closed-end funds and BDCs

Currently, the Rule allows a fund (other than a tax-exempt fund) to determine whether it will adopt a policy to provide shareholders with 60 days prior notice of a change to its 80% policy, or adopt its 80% policy as a fundamental policy (i.e., a policy that cannot be changed without a majority shareholder vote). The Proposal contains an amendment that, if adopted as proposed, would require any unlisted closed-end fund or BDC that is required to have an 80% policy due to its name, to adopt that 80% policy as a fundamental policy.

In putting forth this Proposal, the SEC expressed concern that shareholders of unlisted closed-end funds or BDCs (unlike mutual funds and listed funds) would not be able to liquidate their positions prior to the 60-day notice period in the event that they disagreed with the fund’s desire to change its 80% policy. Acknowledging that requiring a shareholder vote in order to change an 80% policy may be onerous, the SEC considered alternatives, such as requiring funds to offer a repurchase offer or tender offer prior to implementing a change in policy, however, this alternative raised concerns regarding what percentage of the fund would be subject to such a repurchase offer or tender offer. The SEC continues to request comment on this issue.

The Proposal sets forth a one-year transition period for funds to come into compliance with the amended Rule, however, it is silent regarding whether unlisted closed-end funds and BDCs would be required to hold a shareholder vote during that transition period in order to adopt an 80% policy as a fundamental policy. Although Section 13(a) of the 1940 Act only requires a shareholder vote upon the change of a fundamental policy, it is unclear whether the SEC would expect unlisted closed-end funds and BDCs to request shareholder approval for the initial adoption of a policy, especially in situations where the unlisted closed-end fund or BDC was not required to have an 80% policy under the current version of the Rule and accompanying guidance. 

Departures from the 80% investment policy

The Rule, in its current form, requires that funds comply with their 80% policy at the time of investment, and generally “under normal circumstances.” Under the proposed amendments, temporary departures would be permitted only: (i) as a result of market fluctuations, or other circumstances where the temporary departure is not caused by a fund’s purchase or sale of a security or a fund’s entering into or exiting an investment; (ii) to address unusually large cash inflows or unusually large redemptions; (iii) to take a position in cash and cash equivalents or government securities to avoid a loss in response to adverse market, economic, political, or other conditions; or (iv) to reposition or liquidate a fund’s assets in connection with a reorganization, to launch a fund, or when notice of a change in a fund’s 80% investment policy has been provided to fund shareholders at least 60 days before the change pursuant to the Rule.

Under the Proposal, the permitted departures described in (i), (ii) and (iii) above cannot last for more than 30 consecutive days. For new funds, the Proposal, if adopted, would require funds to be in compliance with their stated 80% policy within 180 consecutive days of the fund launch. The Proposal does not set forth any time restrictions for departures related to pending reorganizations, or when notice of change in a fund’s 80% policy has been provided to shareholders.

Under the Rule, as currently effective, funds are able to determine the meaning of “normal circumstances” taking into consideration their particular strategy, however, the proposed amendments to the Rule eliminate this flexibility. Although it may be true that the majority of funds can comply easily with the proposed amendments, there are many funds that may not be able to comply given the nature of their investments. For example, while an open-end fund with an 80% policy to invest in equities may be able to deploy a large influx of cash in a short period of time, a closed-end fund with an 80% policy to invest in certain types of alternative investments that are privately negotiated (such as certain structured products) may not be able to deploy cash into investments covered under its 80% policy within 30 days. The SEC continues to request comments on the appropriateness of the proposed time frames, and whether the language of the current Rule is effective in addressing materially deceptive or misleading names over time.

Derivatives

The Rule in its current form allows the inclusion of derivatives instruments in a fund’s 80% basket if those derivatives have the same economic characteristics as other instruments in the basket.⁵ The Rule does not specify how such derivatives are valued for purposes of compliance with the fund’s 80% policy, which has led to inconsistencies, because some funds value derivatives instruments at their notional value whereas others use market value. The Proposal, if adopted, would result in the following amendments:

• Clarification of what may be included in a fund’s 80% basket – In addition to any derivatives instrument that the fund includes in its 80% basket because the derivatives instrument provides investment exposure to investments 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 investments suggested by the fund’s name.
• Amendments to the definition of “assets” – In determining the value of a fund’s assets for purposes of compliance with the Rule, as proposed, a fund must value each derivatives instrument using the instrument’s notional amount (which must be converted to 10-year bond equivalents for interest rate derivatives and delta adjusted for options contracts) and reduce the value of its assets by excluding any cash and cash equivalents up to the notional amount of the derivatives instrument(s).

The SEC determined that the notional amount was the most appropriate measure of a derivatives instrument’s value for purposes of calculating a fund’s 80% basket because the investment exposure of derivatives instruments are generally better reflected by their notional values than their market values. Further, a consistent standard will allow for better comparability between funds.  

ESG terms

The current Rule does not directly address fund names that use the term “ESG” or any similar term, which has led to inconsistent application of the Rule to such terms. Further, the use of ESG terms in fund names has greatly increased since the Rule was originally adopted in 2001. In recent years, including in the 2020 Request for Comment, the SEC has expressed concerns with ESG funds and the potential for "greenwashing" and overstating the importance of ESG factors in the selection of portfolio investments.

The Proposal, if adopted would result in an amendment to the Rule stating that the use of ESG terms in a fund’s name is materially deceptive and misleading if a fund considers one or more ESG factors alongside other non-ESG factors in its investment decisions, but those ESG factors are generally no more significant than other factors in the investment process (i.e., the ESG terms are not determinative). The Proposal refers to such funds as “integration funds.” The amendment would essentially prohibit funds from using ESG terms in their names unless ESG factors were the most important factors used in making investment decisions for the fund.  

In addition to the proposed restrictions on the use of ESG terms in fund names, the SEC has separately proposed a new rule that greatly expands the disclosure requirements for funds and investment advisers regarding their ESG practices.⁶ A discussion of this proposal may be viewed here.

Plain English requirements           

Under the Proposal, for funds that are required to adopt an 80% investment policy, the amended Rule would require that any terms used in the fund’s name that suggest either an investment focus or tax-exempt status must be consistent with those terms’ plain English meaning or established industry use. Further, the Proposal sets forth various revisions to registration statement forms, such as N-1A and N-2, that would require funds to include disclosures that define the terms used in the fund’s name, including the specific criteria the fund uses to select investments that the term describes.

In describing the scope of these requirements in the Proposal, the SEC stated that funds have flexibility to use reasonable definitions, however, a fund’s use of reasonable definitions of the terms used in the fund’s name may not otherwise change the meaning of those terms to be inconsistent with their plain English meaning or established industry use. The SEC acknowledged, as noted above, that there could be multiple reasonable definitions for the same term.

N-PORT

The Proposal seeks to establish new reporting requirements on Form N-PORT for funds that are required to adopt 80% policies. Such funds would need to report the following on the new Form N-PORT: (i) the value of the fund’s 80% basket, as a percentage of the value of the fund’s assets; (ii) for each individual portfolio investment, whether that investment is included in the fund’s 80% basket, and (iii) 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. BDCs and money market funds would not be required to file Form N-PORT under the Proposal, and the Proposal does not include any additional reporting requirements for BDCs and money market funds.

Notice requirements and recordkeeping

Under the current Rule, if a fund desires to change its 80% policy, it must provide written notice to shareholders at least 60 days prior to implementation of the change (provided that the fund has not adopted its 80% policy as a fundamental policy). Under the Proposal, the notice requirements have been modified to clarify how funds may provide notice electronically. Additionally, the proposed amendment to the Rule would require additional information in the notice, including a description of the fund’s current 80% policy, the nature of the changes to the policy, the fund’s old and new names, and the effective date of any policy or name change.

The proposed amendments would require funds to maintain written records documenting their compliance with the 80% policy requirement, or, if the fund does not adopt an 80% policy, a written record of the fund’s analysis that such a policy is not required. Written records documenting the fund’s compliance with the 80% policy requirement include: the fund’s record of which investments are included in the fund’s 80% basket and the basis for including each such investment 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; the reasons for any departures from the fund’s 80% policy; and any notice sent to the fund’s shareholders. Under the Proposal, written records documenting the fund’s compliance must be maintained for a period of not less than six years following the creation of each required record (or, in the case of notices, following the date the notice was sent), the first two years in an easily accessible place. The written record made by a fund that does not adopt an 80% policy must be maintained in an easily accessible place for a period of not less than six years following the fund’s last use of its name.        

Conclusion

If adopted, the Proposal would bring substantial changes. Many more funds than are currently required to do so would need to adopt an 80% policy or change their name. Other funds may be forced to decide between changing their investment strategies or their names. The requirement to bring a fund back into compliance with its 80% policy within 30 days would also likely be difficult for funds to manage and may force the sale of portfolio holdings at times that are not economically advantageous to the fund. This proposed requirement may be particularly difficult for certain types of funds, for example, a small-cap fund holding a large position in a company that has grown in size to the point that it can no longer be considered small-cap. The proposed recordkeeping and reporting requirements, particularly the N-PORT changes described above, are also likely to be costly and time-consuming for funds. It is possible that funds will adopt generic names that do not provide investors information about the fund in order to avoid the burdens of the Rule. It is also possible that funds that are subject to the Rule will become more homogeneous as managers avoid volatile investments that could risk compliance with the Rule or require a fire sale to bring the fund back into compliance.  

The proposed amendments will be published in the Federal Register and the comment period will remain open for 60 days after publication. We expect there will be many comments regarding this sweeping Proposal.

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