The Securities and Exchange Commission (the “SEC”) recently adopted amendments¹ to Rule 35d-1 under the Investment Company Act of 1940, the fund “Names Rule” (“Amendments”). In the Release, the SEC noted that the Amendments are designed to increase investor protection by: (1) broadening the scope of the current Names Rule; (2) updating the Names Rule’s notice requirements; and (3) establishing additional recordkeeping requirements.

Background

Originally adopted in 2001,² the Names Rule is designed to prevent a fund name from misrepresenting the fund’s investments and risks. To achieve this goal, the Names Rule generally requires that if a fund’s name suggests a focus in a particular type of investment, industry, or geographic region (e.g., “Bond Fund,” “Utilities Fund,” or “China Fund”), the fund must adopt a policy to invest at least 80% of its assets in investments suggested by its name (“80% Policy”). The SEC had been considering the need for enhancements to the Names Rule in light of market and other developments since the Rule’s adoption in 2001 and had expressed concern that, among other things, certain fund names might mislead investors about a fund’s investment focus. The SEC proposed amendments (“Proposed Amendments”) to the Names Rule in May 2022.³ Although many provisions of the Amendments track the Proposed Amendments, there are several notable differences, which are highlighted, along with a review of the Amendments, below.

Amendments

The changes effected by the Amendments fall into three broad categories: (1) broadening the scope of the Names Rule by requiring a wider range of funds to adopt an 80% Policy; (2) establishing new requirements for monitoring a fund’s compliance with its 80% Policy and adding requirements for returning to compliance after a temporary departure from its 80% Policy; and (3) requiring additional disclosure regarding a fund’s name and its 80% Policy in the prospectus and on Form N-PORT.

I. Broadening the Scope of the Names Rule

The Amendments broaden the scope of the Names Rule to require an 80% Policy for funds with names “that include terms suggesting that the fund focuses in investments that have, or whose issuers have, particular characteristics.” According to the Release, this specifically encompasses funds with names that include terms such as “growth,” “value,” or terms that reference a thematic focus, such as environmental, social, and governance (“ESG”) factors. The Release does not define the term “particular characteristics” but states that “this term will be adequately understood to mean any feature, quality, or attribute.”

In addition to describing the terms in a fund’s name to which the Names Rule will apply, the SEC also provides guidance on types of fund names that will not implicate the Names Rule. Included are names that: (i) suggest portfolio-wide objectives or characteristics, such as “real return,” “balanced,” “managed risk,” or terms like “intermediate term” included in, for example, a “bond” fund⁴; (ii) reference a particular investment technique, like “long/short” or “hedged”; (iii) reference asset allocation determinations that evolve over time, such as retirement target date or “sector rotation” funds; and (iv) describe a fund’s approach to constructing a portfolio (but do not communicate the composition of the fund’s portfolio with any particularity), like “international” or “global.”

II. Compliance with an 80% Policy

a. Temporary Departures from 80% Policy

The Names Rule will continue to require a fund to comply with its 80% Policy “under normal circumstances.” The Amendments permit a fund to reasonably determine what constitutes something other than “under normal circumstances,” providing greater flexibility than the permitted reasons for departure outlined in the Proposed Amendments. If a fund departs from its 80% Policy, it will generally be required to come back into compliance as soon as reasonably practicable, with an outer limit of 90 days (as opposed to 30 days provided in the Proposed Amendments), measured from the time the fund identifies the departure.

A new fund subject to the Names Rule will have up to 180 days to comply with an 80% Policy. If a fund departs from its 80% Policy due to repositioning or liquidation of assets as part of a reorganization, there is no set time limit in which the fund must return to compliance. Rather, the Release notes that the fund should come back into compliance as soon as reasonably practicable.

b. Time-of-Investment Test and Quarterly Review of 80% Policy

The Amendments retain the requirement that a fund measure compliance with its 80% Policy at the time of investment (the “Time-of-Investment test”). The Time-of-Investment test requires that a fund determine, at the time of investment, whether an asset falls into the basket of investments included in its 80% Policy (“80% basket”).

Instead of requiring daily compliance as was proposed, a fund must assess the characteristics of its portfolio of investments at least quarterly to determine compliance with its 80% Policy. If a fund determines, as part of the quarterly assessment or otherwise, that it is no longer in compliance with its 80% Policy, any future investments it makes must be made in a manner to bring the fund back into compliance, within the period described above.

c. Considerations Relating to Derivatives

The Amendments require a fund to value its derivatives holdings at their notional value, rather than market value, for purposes of measuring compliance with its 80% Policy. The Amendments provide for several adjustments to this compliance calculation, including as follows:

• A fund must exclude currency derivatives from its 80% Policy calculation if (i) they are entered into for hedging purposes (g., to hedge the currency risk associated with a fund’s foreign investments) and (ii) the notional amounts of the derivatives do not exceed the value of the hedged investment (or the par value thereof, for fixed-income investments) by more than 10%.
• A fund must convert interest rate derivatives to their 10-year bond equivalents and delta adjust the notional amount of options contracts.
• A fund may deduct cash and cash equivalents and U.S. Treasury securities with remaining maturities of one year or less from its assets, up to the notional amount of the fund’s derivatives instruments.
• A fund may exclude any closed-out derivatives positions when calculating assets if those positions do not result in credit or market exposure.
• 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 the investment focus suggested by the fund’s name.

The Amendments require a fund to value each short position using the value of the asset sold short.

III. Prospectus Disclosure and Form N-PORT Reporting

a. Additional Prospectus Disclosure Relating to a Fund’s Name and 80% Policy

The Amendments make changes to fund registration forms that require a fund subject to the Names Rule to include in its prospectus the definitions of the term(s) in its name and the specific criteria it uses to select the investments that the term describes, if any. A fund may reasonably define the terms used in its name, but in all cases the definitions must be consistent with the term’s plain-English meaning or established industry use.

b. Changes to Form N-PORT Reporting

The Amendments will require a fund subject to the Names Rule to report on Form N-PORT: (i) whether each investment in the fund’s portfolio is in the fund’s 80% basket; (ii) the value of the fund’s 80% basket as a percentage of the value of the fund’s assets; and (iii) 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.

IV. Other Considerations

a. Recordkeeping Obligations

The Amendments require a fund that must adopt an 80% Policy to keep certain records documenting compliance with such policy. The SEC did not prescribe what form such records must take; rather it noted that a fund should maintain “appropriate documentation that would be sufficient for a third party to verify the matter covered by each record and would be readily available to [SEC] staff.” A fund must keep, for at least six years (the first two years in an easily accessible place), the following:

• Written records documenting the value of the fund’s 80% basket as a percentage of the fund’s assets and whether, at the time of investment, an investment is included in the 80% basket and, if so, the basis for such inclusion.
• Written records of the review (quarterly or otherwise) of the fund’s 80% basket, including whether each investment is in the 80% basket and, if so, the basis for inclusion.
• If a departure from the 80% Policy due to portfolio drift (g., market movements or an influx of cash from new investors) is identified, written records documenting the date and reason for such departure.
• If a departure from the 80% Policy is identified and is due to other-than-normal circumstances, written records documenting the date and reason for such departure, including why the fund determined the circumstances were other-than-normal.
• Records of any notice sent to shareholders pursuant to the Names Rule.

Notably, in a break from the Proposed Amendments, a fund will not be required to keep records documenting why it determined it was not subject to the Names Rule, if applicable.

b. Notice Requirements

The Amendments retain the current requirement that a fund must provide 60 days’ notice to shareholders of changes to its non-fundamental 80% Policy. The Amendments require that, among other things, the notice must be provided separately from other documents and describe certain details surrounding the content of the notice. The Amendments also provide guidance on electronic delivery of such notice.

c. Closed-End Funds and BDCs

The Amendments prohibit registered closed-end funds and business development companies that are not listed on a national securities exchange from changing their 80% Policies without a shareholder vote, unless the fund conducts a tender or repurchase offer in advance of the change, subject to certain conditions.

d. ESG “Integration Funds”

The SEC declined to adopt a proposed provision regarding the use of ESG terms in the names of funds using ESG integration strategies, so called “integration funds.” The proposal was designed to target misleading fund names by indicating it would be materially misleading for a fund for which ESG factors are generally no more significant than other factors in the investment selection process to include ESG terminology in its name. However, the Release indicated that the SEC may take action on this item in the future.⁵

V. Effective and Compliance Dates

• Effective Date: The Names Rule becomes effective on December 11, 2023 (“Effective Date”).
• Compliance Dates: Larger fund groups with net assets of $1 billion or more will have 24 months from the Effective Date (December 11, 2025) to comply with the Amendments, while smaller fund groups with net assets of less than $1 billion will have 30 months from the Effective Date (June 11, 2026) to comply.

S&K Observations and Insights

While the Amendments ease some of the compliance burdens that would have resulted from adoption of the Proposed Amendments, the impact of the Amendments is nonetheless far-reaching. As a result of the expanded scope of the Rule, a number of funds (e.g., funds with terms such as “growth,” “value,” or that reference a thematic investment focus, such as ESG or sustainability) will have to adopt an 80% Policy for the first time—the Release estimates 60% of funds are currently subject to the Names Rule and that this figure is expected to reach approximately 76%. Furthermore, funds currently subject to the Rule will have increased responsibilities and costs as a result of enhanced portfolio monitoring requirements (e.g., quarterly monitoring for Names Rule compliance), disclosures (new prospectus requirements), and reporting and recordkeeping obligations (regarding compliance with names-related regulatory requirements). Some funds are expecting to automate compliance processes to facilitate compliance with the amended Rule. With the SEC seeking to ensure that a fund’s portfolio assets align with the fund’s name, it appears that the changes will also enhance transparency into the investment processes of funds subject to the Names Rule and will likely increase regulatory scrutiny. The amendments to the Form N-PORT and recordkeeping requirements will require funds to develop systems and processes for categorizing investments and monitoring those categorizations.

¹See Investment Company Names, SEC Rel. Nos. 33-11238; 34-98438; IC-3500 (Sept. 20, 2023) (“Release”), available at: https://www.sec.gov/files/rules/final/2023/33-11238.pdf.

²See Investment Company Names, SEC Rel. No. IC-24828 (Jan. 17, 2001) available at: https://www.sec.gov/rules/final/ic-24828.htm.

³See Investment Company Names, SEC Rel. No. IC-34593 (May 25, 2022), available at: https://www.sec.gov/rules/proposed/2022/ic-34593.pdf. Seward & Kissel LLP submitted a comment letter in response to the SEC’s request for comments, which is available at: https://www.sewkis.com/wp-content/uploads/081622-SK-Comment-Letter-on-Investment-Company-Names.pdf.

⁴An 80% Policy would still be required for the term “bond.”

⁵The Release states that “[b]ecause the proposed provision in the names rule mirrored the separate proposed definition of an integration fund in the ESG Disclosure Proposal, we are continuing to consider comments and are not adopting the proposed approach to integration fund names at this time.”