SEC Proposes Major Amendments to Fund Name Rule

SEC Proposes Significant Amendments to the Fund Names Rule
Kramer Levin Naftalis & Frankel LLP
George M. SilfenNicholas Tarnowski
USA May 26 2022
On May 25, 2022, the U.S. Securities and Exchange Commission (SEC) proposed significant amendments seeking to enhance Rule 35d-1 under the Investment Company Act of 1940 (the 1940 Act), the “Names Rule” governing registered fund names. A summary of various components of the sweeping proposals follows.

Expansion of Fund Names Requiring 80% Investment Policy

The proposed amendments would expand the types of names that are subject to the Names Rule’s requirements for adopting an 80% investment policy to also include names suggesting a focus in investments or issuers that have particular characteristics, in addition to fund names currently subject to an 80% investment policy. Thus, registered funds whose names suggest a focus in a particular type of investment characteristic or style (e.g., “global,” “income,” “intermediate (term),” “growth,” “value”) or that reflect use of environmental, social and governance (ESG) factors (e.g., “ESG,” “social,” “green,” “sustainable”) would be required to adopt a policy to invest at least 80% of the value of their assets in those investments. Currently, these names are not specifically covered by the Names Rule, and 80% investment policies may not be required.

The SEC clarified in the proposing release that names that reference characteristics of the fund’s portfolio as a whole or that reference elements of an investment thesis without specificity as to particular characteristics of the portfolio components (such as “balanced” and “long/short”) would continue to not be subject to an 80% investment policy.

The proposing release further clarified that, where a fund’s name suggests an investment focus with multiple elements, the 80% investment policy must address all elements in the name, whether by noting that each security in the 80% basket must represent all the elements noted in the name or by noting that the basket will be invested as a mix of investments that contain one or more of the named elements. A fund would be permitted to take a reasonableness approach in specifying how the fund’s investments will incorporate each element of a multielement name.

The proposed amendments would also add a provision that a fund’s name may still be considered materially deceptive or misleading under the 1940 Act notwithstanding the adoption of a compliant 80% investment policy. Included as examples of circumstances where a fund’s name may be materially deceptive or misleading notwithstanding an 80% investment policy are scenarios where a fund makes substantial investments in assets that are antithetical to the fund’s investment focus or a fund invests in a manner where the source of a substantial portion of the fund’s risk/return profile is different than what would reasonably be expected based on the fund name.

Temporary Departures From 80% Investment Policy

The proposed amendments further provide guidelines for when a fund is permitted to temporarily depart from the 80% investment policy. Under the proposed amended rule, temporary departures would be permitted only (i) as a result of market fluctuations or other circumstances where the temporary departure is not caused by the fund’s purchase or sale of a security or the fund’s entering into or exiting an investment, (ii) to address unusually large cash inflows or 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, (iv) to reposition or liquidate a fund’s assets in connection with a reorganization or following provision of notice of a change in the 80% investment policy to shareholders, or (v) when constructing the portfolio upon a fund’s launch. The proposing release indicates that in the event of a fund launch, the temporary departure may not exceed 180 consecutive days, and in the event of an 80% investment policy change, such departure may not exceed 60 consecutive days. For all other scenarios, the temporary departure may not last for more than 30 consecutive days (and in each case may not last longer than reasonably practicable). This proposed change would replace the “under normal circumstances” standard currently existing in the Names Rule.

Use of Derivatives in Assessing Names Rule Compliance

The proposed amendments seek to address both the valuation of derivatives instruments for purposes of determining compliance with an 80% investment policy and the derivatives that a fund may include in its 80% basket. In calculating assets for purposes of Names Rule compliance, a fund would be required to value each derivatives instrument using its notional amount (with certain adjustments) and reduce the value of its assets by excluding cash and cash equivalents up to the notional amounts of the derivatives instruments. The proposed amendments further specify that, in addition to any derivatives investment that a fund includes in its 80% basket, because such instrument provides investment exposure to the investments suggested by the fund’s name, the fund may also include in its 80% basket an instrument that provides investment exposure to one or more of the market risk factors associated with the investments suggested by the fund’s name.

Unlisted Closed-End Funds and BDCs

The proposed amendments would require that a fund’s 80% investment policy always be a fundamental investment policy if the fund is a registered closed-end investment company or BDC that does not have shares that are listed on a national securities exchange. As a result, such funds would not be permitted to change their 80% investment policy without shareholder approval and would no longer have the ability to change their 80% investment policy through the use of a 60-day advance notice to shareholders.

Materially Deceptive and Misleading Use of ESG Terminology

The proposed amendments further address what the SEC refers to as ESG “integration funds.” The proposed amendments would define the names of integration funds as materially misleading if the name includes terms suggesting that the fund’s investment decisions incorporate one or more ESG factors but such factors are generally no more significant than other factors in the investment selection process, such that the ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio. This definition would extend to any funds using names including ESG-related terms, such as “sustainable.”

Modernization of Notice

The proposed amendments would require notices to describe both a change in the fund’s 80% investment policy and any changes to fund names that accompany investment policy changes. The proposed amendments would allow such notices to be delivered electronically and would require such notices to be separate from any other document published by the fund.

Changes to Form N-PORT

The proposing release also indicates an amendment to Form N-PORT to include a new reporting item regarding a fund’s 80% investment policy, which would require such funds to report the value of the fund’s 80% basket as a percentage of the value of the fund’s assets and, if applicable, the number of days that the value of the fund’s 80% basket fell below 80% of the fund’s assets during the reporting period. A further reporting item is proposed to be added to Form N-PORT; that item would require each portfolio investment to be designated as included or excluded from the fund’s 80% basket.

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The SEC has indicated that, if the proposed amendments are adopted, they may be accompanied by withdrawal of certain no-action letters and staff statements regarding compliance with the Names Rule. It has indicated that any adoption of the proposed amendments would be accompanied by a one-year transition period to provide funds time to come into compliance with the proposed amendments.

Comments on the proposal are due within 60 days of the publication of the proposed amendments in the Federal Register.