On September 20, 2023, the US Securities and Exchange Commission (SEC) voted by a 4-1 margin to adopt amendments to Rule 35d-1, commonly known as the “names rule” (Rule), under the Investment Company Act of 1940, as amended (1940 Act). The amendments greatly expand the scope of the Rule, but relax some of the compliance requirements that were originally proposed.
The Rule as originally adopted in 2001 requires funds with names suggesting (i) a focus in certain industries or types of investments, (ii) a focus in certain countries or geographic regions, or (iii) that the fund’s distributions are tax exempt, to adopt a policy to invest, under normal circumstances, at least 80% of the fund’s net assets (plus borrowings for investment purposes) in industries, investment types, or geographic regions suggested by the fund’s name (80% Policy). The final amendments to the Rule expand the 80% Policy requirement to include funds that have names suggesting a focus in investments that have, or issuers that have, “particular characteristics.” The term “particular characteristics” is not defined, but as described in more detail below, the amendments and the adopting release provide some guidance regarding what terms would trigger the expanded 80% Policy requirement.
In addition to expanding the scope of the 80% Policy requirement, the final Rule amendments address (i) temporary departures from a fund’s 80% Policy, (ii) enhanced prospectus disclosures and plain English requirements; (iii) treatment of 80% Policies for unlisted closed-end funds and business development companies (BDCs), (iv) treatment of derivatives, (v) Form N-PORT requirements, and (vi) recordkeeping requirements.
Expanding the scope
The final amendments expand the scope of the Rule to require an 80% Policy for funds with names that suggest the fund focuses on investments that have, or issuers that have, “particular characteristics.” The term “particular characteristics” is not defined, but, according to the SEC it should be adequately understood to mean any “feature, quality, or attribute.”1 Despite not having a formal definition of “particular characteristics” the text of the amended Rule does provide examples of certain terms that would be covered. Such terms include growth, value, and terms indicating that the fund incorporates one or more environmental, social, and/or governance (ESG) factors in its investment decisions.
The adopting release specifically states that terms referencing a thematic investment focus are covered under the Rule’s expanded scope. Certain thematic terms were already clearly within the scope of the Rule as originally adopted, because they generally described an industry or investment type, such as terms suggesting focus in cybersecurity or health and wellness. Other thematic terms that were not as clearly within the scope of the original Rule, such as metadata, big data and meme stocks, may now require an 80% Policy because these terms may suggest a particular investment focus in investments or issuers with particular characteristics. The adopting release describes terms that reference well-known organizations, affinity groups, or demographic populations (such as millennial and gen-z) as thematic terms, but also states that such terms may not communicate particular characteristics of investments composing a fund’s portfolio, and therefore may not require the adoption of an 80% Policy.
The adopting release provides additional guidance to assist in analyzing fund names by specifically describing terms that may not suggest an investment focus. These terms are summarized in the table below:
When assessing whether a term implicates the expanded 80% Policy requirement the analysis generally rests on whether the term describes particular investments or issuers, or describes the portfolio as a whole. For example, when providing additional guidance regarding the terms growth and value, the SEC noted that it “understand[s], based on staff review of fund disclosure, that it is not typical in current practice for growth and value funds to implement their strategies on a portfolio-wide basis, as opposed to a selection process based on the growth or value characteristics of the fund’s component portfolio investments.”2 While for certain terms, this distinction between characteristics of individual investment and portfolio-wide strategies may be clear, for others it is not. For example, the term income was identified in the proposing release, along with the terms global, international, and intermediate term bond, as a term that may require an 80% Policy, even though it historically has not. While the adopting release clarified that the terms global, international and intermediate term would not (in most cases) by themselves require an 80% Policy, it was silent regarding the term income. The term income can reasonably be interpreted to describe the types of investments that a fund makes, but can also be a portfolio-wide strategy. For such terms, the adopting release was clear in stating “[i]f terms in a fund’s name can reasonably be understood to reference either the characteristics of a fund’s individual investments or the intended result of a fund’s portfolio investments in the aggregate, the fund will be required to adopt an 80% investment policy, consistent with the proposal.”3
The SEC reiterated in the adopting release that even if a fund complies with the Rule, or is not required to have an 80% Policy, it is still required to comply with Section 35(d) of the 1940 Act, which prohibits materially deceptive or misleading names. For example, while a fund with the term fossil fuel-free in its name may not be required to have an 80% Policy, its name would be considered materially deceptive and misleading if that fund invested in the securities of a fossil fuel company. Similarly, if a fund had an 80% Policy and complied with it, its name could still be materially deceptive and misleading if, for example, the fund invested assets in its 20% basket in investments that are materially inconsistent with the investment focus indicated by the fund’s name.
In a departure from the proposal, the SEC did not adopt the amendments to the Rule defining the names of ESG “integration funds” as materially deceptive and misleading if the names included ESG terms. In the proposal, an integration fund was described as a fund that considered one or more ESG factors alongside other non-ESG factors in investment decisions, but those ESG factors were no more significant than other factors in the investment process (i.e., the ESG terms were not determinative). While the “integration fund” rules were not adopted, the final Rule amendments clearly include ESG terms as terms that suggest a focus in investments or issuers with “particular characteristics” and would require the adoption of an 80% Policy.
Departures from the 80% investment policy
The amendments as proposed prescribed certain circumstances under which funds could depart from their 80% Policies, allowed funds 30 days to come back into compliance, and essentially required continuous daily monitoring of a fund’s investment portfolio. After considering the concerns of several commenters on the proposal, the SEC did not adopt the more prescriptive elements of the proposed amendments. The final amendments maintain the Rule’s original requirement that a fund must comply with its 80% Policy at the time of investment, and “under normal circumstances,” but added a quarterly review requirement in lieu of the continuous monitoring requirement that was proposed. Under the quarterly review requirement, funds must review each portfolio investment on a quarterly basis to determine if the fund is in compliance with its 80% Policy. The final amendments also allow funds 90 days to come back into compliance with their 80% Policies. The 90 day period begins upon the identification of non-compliance, which could occur at any time, including (i) during normal circumstances at the time of investment, (ii) in connection with a quarterly review (even if the non-compliance is due to market forces or other events outside of the fund’s control), or (iii) during non-normal circumstances at the time the fund intentionally makes a non-compliant investment.
In connection with a reorganization or launch of a fund, the fund may temporarily be non-compliant with its 80% Policy. For the launch of a new fund, this temporary period may last up to 180 days from the fund’s commencement of operations. The final amendments do not prescribe a time period for temporary departures in connection with reorganizations.
While the final amendments, as adopted, are less prescriptive and onerous than the proposed amendments, certain funds may still face difficulties. For example, one Commissioner expressed concern during the open meeting at which the final amendments were considered that there was no mechanism under the Rule for a fund’s board to approve an extended compliance time. This type of flexibility would have been helpful, for example, for closed-end funds that primarily invest in privately negotiated investments that are not readily available in the marketplace and may require extensive diligence.
Prospectus disclosure and plain English requirements
Under the amended Rule, if a fund is required to adopt an 80% Policy, it must include disclosure in its prospectus that defines the terms used in its name, including the specific criteria the fund uses to select investments that the term describes, if any. Funds have flexibility to use reasonable definitions of the terms used in their name, provided that the definitions are not inconsistent with the terms’ plain English meanings or established industry use. The SEC acknowledged that different funds may have different definitions of the same term under this framework.
While certain descriptor terms may not require an 80% Policy on their own, these terms may provide context to other terms in the fund’s name. The final amendments provide flexibility to define terms in a fund’s name based on context. For example, two funds could have the term “growth” in their names, which would require each fund to have an 80% Policy, but one fund might be called the conservative growth fund, while the other is called the aggressive growth fund. The context in which the term “growth” is found in each fund’s name modifies an investor’s expectations with respect to those funds. As such, the types of investments included in each fund’s 80% basket, and how each fund describes its 80% Policy may differ. Similarly, terms such as “global” or “international,” while not requiring 80% Policies on their own, would modify investor expectations when used together with terms that do require an 80% Policy.
Consistent with the proposal, if a fund’s name contains two or more terms that would require an 80% Policy, the fund’s 80% Policy must address all of those terms. The SEC did not prescribe a specific approach to address multiple terms, other than requiring fund managers to take a reasonable approach in specifying how the fund’s investments will incorporate each element.
With respect to ESG terms, the final amendments have the potential to bring consistency to how ESG terms are treated under the Rule. Under the Rule as originally adopted in 2001, ESG terms were not explicitly addressed, and, as a result, ESG funds have been treated inconsistently and have received different levels of scrutiny from the Staff. Under the new amendments to the Rule, ESG terms will be treated the same as any other terms that suggest an investment focus in investments or issuers with “particular characteristics.” In fact, the SEC specifically stated that “there is not a principled basis to treat ESG terms differently than other terms that have the potential to be materially deceptive and misleading.”4
Unlisted closed-end funds and BDCs5
Under the Rule as originally adopted in 2001, a fund (other than a tax-exempt fund) was able to determine whether it would 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 vote of the majority of the fund’s outstanding voting securities). As proposed, the amendments to the Rule would have required an 80% Policy adopted by an unlisted closed-end fund or BDC to be 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.
Several commenters expressed concerns regarding the proposal, including the high costs associated with holding shareholder meetings, the lack of benefit to shareholders, and the fact that BDCs are generally exempt from the 1940 Act provisions that require funds to disclose and have shareholder votes on changes to fundamental policies. In response to such comments, the SEC relaxed the requirements for unlisted closed-end funds and BDCs. The amendments as adopted do not use the term “fundamental policy” and instead state that an unlisted closed-end fund or BDC may not change its 80% Policy without a vote of the majority of the fund’s outstanding voting securities, unless (i) the fund conducts a tender/repurchase offer in advance of the change, (ii) the fund provides at least 60 days’ notice of the proposed change prior to the tender offer, (iii) the tender/repurchase offer is not oversubscribed, and (iv) the fund purchases its shares at net asset value.
The Rule as originally adopted in 2001 did not specify how derivatives were to be valued for purposes of compliance with a fund’s 80% Policy. This lack of guidance led to inconsistencies, because some funds value derivatives instruments at their notional value whereas others use market value. To clarify the treatment of derivatives, the SEC adopted 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 the investment focus suggested by the fund’s name (such as interest rate risk or credit spread risk).
- Amendments to the definition of “assets”
- 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 must value each physical short position by using the value of the asset sold short.
- A fund may reduce the value of its assets by excluding any cash and cash equivalents, and US Treasury securities with remaining maturities of one year or less, up to the notional amount of the derivatives instrument(s) and the value of asset(s) sold short, and also exclude any closed-out derivatives positions if those positions result in no credit or market exposure to the fund.
- A fund must exclude from its calculation of its assets derivatives instruments used to hedge currency risks associated with one or more specific foreign-currency-denominated equity or fixed-income investments held by the fund, provided that such currency derivatives are entered into and maintained by the fund for hedging purposes and that the notional amounts of such derivatives do not exceed the value of the hedged investments (or the par value thereof, in the case of fixed-income investments) by more than 10%.
Consistent with the proposal, 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. In a departure from the proposal, the SEC specifically excluded certain derivatives instruments used to hedge currency risks from the fund’s calculation of assets or its 80% basket. The SEC acknowledged in the adopting release that requiring a fund to include such instruments used to hedge currency risks in its asset calculations could have adverse effects on funds and their shareholders.6 Further, the SEC noted that it has “previously distinguished currency derivatives, when directly matched to particular investments held by the fund, as instruments that ‘predictably and mechanically provide the anticipated hedging exposure.’”7 As such, according to the SEC, the specific currency hedging instruments excluded by the final amendments to the Rule “would not generally create economic exposures that could cause a fund’s name to be materially deceptive or misleading.”8
In addition to the Rule amendments, the SEC established new requirements for Form N-PORT. Funds that are required to adopt 80% Policies will be required to disclose the following on Form N-PORT: (i) the definitions of the terms used in the fund’s name, including any specific criteria the fund uses to select investments the terms describe (even though the same disclosure is also required in the fund’s prospectus); (ii) the value of the fund’s 80% basket, as a percentage of the value of the fund’s assets; and (iii) for each individual portfolio investment, whether that investment is included in the fund’s 80% basket. BDCs and money market funds are not required to file Form N-PORT or any other forms requiring similar reporting related to their 80% Policies.
In order to include a particular investment in a fund’s 80% bucket, there must be a “meaningful nexus” between the given investment and the investment focus suggested by the fund’s name. The SEC stated in the adopting release for the final amendments that “it would generally be reasonable for a fund to determine that a sufficient nexus exists between certain securities and a given industry if the securities are issued by companies that derive more than 50% of their revenue or income from, or own significant assets in, the industry…. [however] the use of text analytics to assign issuers to industries based on the frequency of particular terms in an issuer’s disclosures is not, in and of itself, sufficient to create a reasonable nexus.”9
Notice requirements and recordkeeping
Under the final amendments, if a fund (that has not adopted an 80% Policy as a fundamental policy) desires to change its 80% Policy, it must provide written notice to shareholders at least 60 days prior to implementation of the change. The notice may be delivered by mail, or electronically. The notice must be provided in plain English, separately from other documents (provided that if the notice is delivered in paper form, it may be provided in the same envelope as other written documents). The notice must contain the following statement: Important Notice Regarding Change in Investment Policy [and Name], and describe 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. While the notice provisions of the amended rule do not specifically address the notice to be provided by unlisted closed-end funds and BDCs, it may be implied that these notice procedures would apply to such funds in addition to the tender offer process that would also be required.
The final amendments require funds to maintain written records documenting their compliance with the Rule. A fund must maintain written records documenting the following:
- At the time of investment, whether the investment the fund makes is included in the fund’s 80% basket and, if so, the basis for including such investment in the fund’s 80% basket, and the value of the fund’s 80% basket, as a percentage of the value of the fund’s assets;
- The fund’s quarterly review of its portfolio investments’ inclusion in the fund’s 80% basket, including whether each investment is included in the fund’s 80% basket and the basis for including such investment in the 80% basket;
- Under normal circumstances, the date any departure from the fund’s 80% Policy was identified, and the reason for the departure;
- Under not-normal circumstances, the date of the departure from the fund’s 80% Policy, the reason for the departure, and the reason why the fund determined that circumstances were other than normal; and
- Notices sent to shareholders under the Rule.
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.
In a departure from the proposal, the final amendments do not require a fund that does not adopt an 80% Policy to maintain a written record of the fund’s analysis that such a policy is not required.
The amendments to the Rule and the accompanying form amendments will become effective within 60 days after publication in the Federal Register (Effective Date).
The compliance date for larger entities (funds that, together with other investment companies in the same “group of related investment companies” as that term is 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) is 24 months after the Effective Date, and the compliance date for smaller entities (fund groups with less than $1 billion in assets) is 30 months after the Effective Date.
While the compliance dates may seem far off, we believe that there are several aspects of the Rule that merit prompt attention from funds and advisers. For example:
- Funds that do not currently have an 80% Policy may wish to begin to assess whether or not they will need to adopt one.
- Funds that currently have an 80% Policy will need to consider whether their policies will need to change, and what steps need to be taken in order to make such changes.
- Some funds may need to consider whether or not a name or strategy change is necessary.
- In all cases, funds that are required to have 80% Policies will need to consider how they will comply with the new compliance, reporting and recordkeeping requirements.
1 Final Rule, Investment Company Names, Release No. 33-11238, pg. 30 (September 20, 2023) (hereinafter Adopting Release).
4 Adopting Release at 53.
5 Unlisted BDCs include non-traded BDCs and private BDCs.
6 The SEC provided the following example in the adopting release: “[A] US equity fund may invest up to 20% of its assets in stocks of companies domiciled outside of the United States, consistent with the names rule. The fund in this example would not include the foreign stocks in its 80% basket, and therefore these foreign stocks would be in the denominator in the calculation that the fund would use to determine compliance with its 80% investment policy. Any related currency derivative that the fund holds for hedging purposes, therefore, also would be in the denominator. This currency derivative could have a high notional amount, even though it would be reducing, not increasing, the fund’s exposure to risks associated with the fund’s foreign securities. Holding the currency derivative therefore could significantly limit the extent to which the fund could invest outside of its 80% basket…A fund also could decide to leave its foreign-currency-denominated investments unhedged in lieu of breaching its 80% investment policy, increasing risks to the fund and its shareholders.” Adopting Release at 85.