On September 20, 2023, the US Securities and Exchange Commission (the “SEC”) voted, by a 4-1 vote, to adopt certain amendments (the “final rule” or the “amendments”) to Rule 35d-1 (the “Names Rule”) under the Investment Company Act of 1940 (the “1940 Act”) and to certain SEC forms addressing fund names that the SEC believes are likely to mislead investors about a fund’s investments and risks.¹ The amendments consist of changes that will require (i) more funds to adopt an 80% investment policy, (ii) ongoing monitoring of funds’ alignment with the 80% investment policy, (iii) enhanced prospectus disclosure for terminology used in fund names, and (iv) additional reporting and recordkeeping regarding compliance. This Client Alert summarizes key aspects of the final rule.

Amendments to the 80% Investment Policy Requirement

Names Suggesting an Investment Focus

The SEC adopted the Names Rule in 2001 to address certain fund names that the SEC believed would be likely to mislead an investor about a fund’s investments and risks. The Names Rule currently requires funds whose names suggest a focus in a particular type of investment, industry, country, or geographical region to adopt a policy to invest at least 80% of the value of its net assets in holdings aligned with the fund’s name (referred to herein as an “80% policy”).

As amended, the final rule expands the 80% policy requirement beyond its current scope to apply to any fund with terms in its name that suggest that the fund focuses on investments that have, or investments whose issuers have, particular characteristics. The final rule cites as examples the terms “growth,” “value,” or terms indicating that the fund’s investment decisions incorporate one or more environmental, social, or governance (“ESG”) factors as the types of terms that suggest that a fund focuses on investments that have, or whose issuers have, particular characteristics. In the adopting release, the SEC noted its anticipation that the primary types of names that the expanded scope of the Names Rule will cover will be fund names that include the terms “growth” and “value,” terms with ESG- or sustainability-related characteristics, or terms that reference a thematic investment focus. The SEC reiterated in the adopting release that there are certain terms that do not communicate to investors the particular characteristics of investments that will make up the fund’s portfolio and for which an 80% policy will not be required. It highlighted such names that suggest a portfolio-wide result to be achieved, such as “real return,” “balanced,” or “managed risk”; names that reference a particular investment technique, such as “long/short” or “hedged”; and names that reference asset allocation determinations that evolve over time, such as a retirement target date or “sector rotation” funds.

Temporary Departures from the 80% Investment Requirement

Currently, a fund is required to invest in accordance with its 80% policy “under normal circumstances,” and a fund must apply its policy at the time of investment. If, subsequent to an investment, the fund’s assets are no longer invested in accordance with the policy (for example, as a result of inadvertent drift), the fund’s future investments must be made in a manner that will bring it into compliance with its 80% policy.

The final rule maintains the current “under normal circumstances” provision, as well as the “time of investment” test. Under the final rule, a fund is now also required to review its portfolio investments’ inclusion in the fund’s 80% basket at least quarterly.

In addition, for instances in which a fund identifies that its investments are not consistent with its 80% policy, the fund must make all future investments in a manner that will bring the fund back into compliance with the 80% policy. The fund must come back into compliance “as soon as reasonably practicable” and, in all circumstances, within 90 consecutive days of the fund’s identification that the requirement is no longer met.

The final rule also permits a fund to invest less than 80% of its assets in the 80% basket temporarily to reposition or liquidate assets in connection with a reorganization or to launch the fund. For fund launches, the final rule provides a fund 180 days from when the fund commenced operations, during which the fund may depart from the 80% investment requirement. The final rule does not limit the time of departures associated with fund reorganizations.

Considerations Regarding Derivatives in Assessing Names Rule Compliance

The final rule includes changes that address the valuation of derivatives instruments for the purposes of determining compliance with a fund’s 80% policy and the derivatives that a fund may include in its 80% basket. The SEC noted in the adopting release that the amendments are designed both to allow funds to use names that may more effectively communicate their investments and risks to investors, and to reduce the risk that a fund may use derivatives to invest in a manner inconsistent with the investment focus suggested by the fund’s name.

Valuation of Derivatives Instruments

The final rule generally requires a fund to use notional amounts to value derivatives in assessing whether the fund has invested 80% of the value of its assets in accordance with the investment focus that the fund’s name suggests. The final rule also requires a fund to exclude from the calculation certain derivatives that hedge the currency risk associated with the fund’s foreign-currency denominated investments. In calculating notional amounts, the final rule requires a fund to convert interest rate derivatives to their 10-year bond equivalents and to delta adjust the notional amounts of options contracts.

Compliance with 80% Policy

The final rule permits a fund, in determining compliance with its 80% policy, to deduct cash and cash equivalents, and US 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 instruments. The final rule also permits funds to exclude closed-out derivatives positions from the Names Rule calculation if those positions result in no market exposure to the fund because these closed-out positions will  not affect the fund’s risks or returns. In addition, the final rule permits a fund to 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.

Under the final rule, if a fund uses derivatives instruments to obtain exposure to short positions in one or more reference assets, the fund will have to use these derivatives instruments’ notional amounts for purposes of determining compliance with its 80% policy.

Unlisted Registered Closed-End Funds and BDCs

The final rule prohibits a registered closed-end fund or BDC whose shares are not listed on a national securities exchange and that is required to adopt an 80% policy from changing that policy unless authorized by a vote of the majority of the outstanding voting securities of the fund. However, such funds are permitted to amend their 80% policies without 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 policy in advance of that offer, the offer is not oversubscribed, and the fund purchases shares at their net asset value.

Effect of Compliance With an 80% Policy

The final rule includes a new provision providing that a fund’s name may be materially deceptive or misleading under Section 35(d) of the 1940 Act even if the fund adopts and implements an 80% policy and otherwise complies with the Names Rule’s requirement to adopt and implement the policy. This provision codifies the SEC’s prior position that the Names Rule’s 80% policy requirement is not intended to create a safe harbor from liability under Section 35(d) for materially deceptive or misleading fund names. The SEC noted that the provision makes clear that a fund name may be materially deceptive or misleading even when, for example, the fund complies with its 80% investment policy but invests in a way such that the source of a substantial portion of the fund’s risks or returns is materially different from what an investor would reasonably expect based on the fund’s name. Should a fund use its 20% basket to invest in assets that are materially inconsistent with the investment focus or risk profile reflected by the fund’s name, the fund’s name would be materially deceptive or misleading under Section 35(d).

The adopting release provides two examples:

• A “green energy and fossil fuel-free” fund making a substantial investment in an issuer with fossil fuel reserves
• A “conservative income bond” fund using the 20% basket to invest in highly volatile equity securities that introduce significant volatility into a fund that investors would expect to have the lower levels of volatility associated with lower-yielding bonds

The adopting release also notes that this new provision would apply to situations in which a fund may have invested 80% or more in a market index referenced in the fund’s name but the underlying index may have components that are contradictory to the index’s name. In such circumstances, even though the fund meets the Names Rule requirements by its investments in the index, the fund’s name could still be materially misleading or deceptive in that the index’s name would suggest an investment focus that the fund does not follow.

Modernization of Notice Requirement

The final rule continues to require that, unless a fund’s 80% policy is a fundamental policy, notice must be provided to shareholders of any change in the 80% policy. The final rule includes certain new requirements designed to incorporate greater specificity on the content and format of the notices, as well as certain requirements designed to address the needs of investors who elect to receive notices electronically.

Enhanced Prospectus Disclosure, Form N-PORT Reporting, and Recordkeeping

Prospectus Disclosure

The amendments include new prospectus reporting requirements that require each fund that must adopt and implement an 80% policy to include disclosure in its prospectus 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. A fund’s use of reasonable definitions of the terms used in its name under the final rule, however, may not be inconsistent with their plain English meaning or established industry use. Funds must tag most of the new information that is included under the amendments by using a structured data language (i.e., Inline XBRL).

Form N-PORT Reporting

The amendments require new N-PORT reporting items for registered management investment companies and exchange-traded funds organized as a unit investment trust, other than money market funds or small business investment companies, (collectively, “N-PORT funds”) regarding the 80% policy. The amendments require N-PORT funds that are required to adopt an 80% policy to report the following on Form N-PORT: (1) whether each investment in the fund’s portfolio is in the fund’s 80% basket and (2) the value of the fund’s 80% basket as a percentage of the value of the fund’s assets. The amendments also require that Form N-PORT funds subject to the 80% policy requirement report the definitions of the terms used in the fund’s name, including the specific criteria the fund uses to select the investments that the term describes, if any.

Recordkeeping

The final rule requires funds that are subject to the 80% policy requirement to maintain certain records documenting compliance with the Names Rule. Specifically, these funds will be required to maintain the following:

• Written records, at the time the fund invests its assets, documenting (1) whether the investment is included in the fund’s 80% basket and, if so, the basis for including that investment in the 80% basket and (2) the value of the fund’s 80% basket as a percentage of the value of the fund’s assets
• Written records documenting the fund’s review of its portfolio investments’ inclusion in the fund’s 80% basket, to be conducted at least quarterly, including whether each investment is included in the fund’s 80% basket and the basis for including each investment in the 80% basket;
• If during this review or otherwise the fund identifies that the 80% requirement is no longer met due to drift, written records documenting the date this was identified and the reason for any departures from the 80% policy;
• If there was a departure from the 80% requirement in other-than-normal circumstances, written records documenting the date of any such departure and reason why the fund departed (including why the fund determined that circumstances are other-than-normal); and
• Any notice sent to the fund’s shareholders pursuant to the Names Rule

The SEC did not prescribe the particular form of documentation required to be maintained, but  noted that funds 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.

All of these records must be maintained for at least six years following the creation of each required record (or, in the case of notices, following the date the notice was sent) and in an easily accessible place for the first two years.

Unadopted ESG Provisions

The SEC did not adopt elements of the proposed rulemaking that targeted the use of ESG terms in the names of ESG “integration funds.” Under the proposed rules, the names of ESG “integration funds” (funds that consider one or more ESG factors alongside other, non-ESG factors in the fund’s investment decisions, but those ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio) would have been defined as materially deceptive and misleading if the name include terms indicating that the fund’s investment decisions incorporate one or more ESG factors. The SEC noted in the adopting release that it continues to consider comments regarding those elements of the proposed rulemaking because the proposed provision mirrored the separate proposed definition of an integration fund in the SEC’s ESG Disclosure Proposal.

Compliance Deadlines

Effective Dates

The final rule becomes effective 60 days after publication in the Federal Register.

Compliance Dates

The SEC adopted a tiered transition period for funds to comply with the final rule depending on their size. Compliance dates for the final rule are as follows:

• 24 months after the effective date for larger entities (funds that, together with other funds in the same “group of related investment companies,” as defined in rule 0-10 under the 1940 Act, have net assets of $1 billion or more as of the end of the most recent fiscal year)
• 30 months after the effective date for smaller entities (funds that together with other funds in the same “group of related investment companies” have net assets of less than $1 billion as of the end of the most recent fiscal year)

SEC staff in the Division of Investment Management are reviewing no-action letters and other statements addressing compliance with the Names Rule to determine which letters and other staff statements, or portions thereof, should be withdrawn in connection with the final rule.

^[1] As is the approach in the adopting release, this Client Alert refers to registered investment companies and business development companies (“BDCs”) collectively as “funds.”

[View source.]