SEC Proposes Amendments to Rule 35d-1 Under the 1940 Act
On May 25, 2022, the Securities and Exchange Commission (“SEC”) proposed amendments to Rule 35d-1 (the “Names Rule”) under the Investment Company Act of 1940, as amended (“1940 Act”), as well as amendments to fund registration forms, Form N-PORT and recordkeeping requirements, which together would:
- Expand the scope of the Names Rule to apply to any fund name with terms suggesting that the fund focuses on investments that have, or investments whose issuers have, particular characteristics (including fund names with terms that suggest investment decisions incorporate one or more ESG factors).
- Specify under what circumstances a fund may depart from its 80% investment policy and the time frames in which it must get back into compliance.
- Require that the notional value of derivatives, rather than market value, be used in determining a fund’s compliance with the 80% investment policy, as well as address what types of derivatives can be included in a fund’s 80% basket.
- Require all unlisted registered closed-end funds and business development companies (“BDCs”) that have an 80% investment policy to make such policy fundamental so they may not be changed without a shareholder vote.
- Enhance prospectus disclosure requirements to include definitions of terms used in a fund’s name and criteria used to select the investments that the term describes.
- Require terms in a fund name to be in plain English or consistent with established industry use.
- Codify that the use of ESG or similar terminology in a fund’s name would be materially deceptive and misleading if the identified ESG factors do not play a central role in the fund’s strategy.
- Codify that any fund name could be materially deceptive and misleading even if the fund complies with the Names Rule.
- Amend the Names Rule’s notice requirement.
- Amend Form N-PORT to add items related to Names Rule compliance.
- Expand recordkeeping requirements for all funds, whether or not they must comply with the Names Rule.
The various aspects of the Proposing Release are discussed in more detail below.
80% Investment Policy Requirement
Names Suggesting an Investment Focus
The amendments to the Names Rule would expand the Rule to require that any fund whose name includes terms suggesting that the fund focuses on investments that have, or whose issuers have, particular characteristics, have an 80% investment policy. Therefore, the Names Rule would apply to any fund whose name:
- Suggests a guarantee or approval by the United States government, including any name that uses the words “guaranteed” or “insured” or similar terms in conjunction with the words “United States” or “U.S. government”.
- Suggests that the fund’s distributions are exempt from federal income tax or from both federal and state income tax.
- Suggests an investment focus by including terms suggesting that the fund focuses its investments in: a particular type of investment or investments; a particular industry or group of industries; particular countries or geographic regions; or investments that have, or whose issuers have, particular characteristics (e.g., a name with terms such as “growth” or “value,” or terms indicating that the fund’s investment decisions incorporate one or more ESG factors). For purposes of the Names Rule, “ESG” would also include terms such as “socially responsible investing”, “sustainable”, “green”, “ethical”, “impact” or “good governance”.
As mentioned in the Proposing Release, in addition to fund names that currently require an 80% investment policy, the amendments would also expand the Names Rule to apply to funds whose name have not previously required such a policy. For example, a fund name that contains terms such as: “global”, “international”, “income” or “intermediate term” would all be subject to the Names Rule under the amendments. There would also continue to be fund names that would not require a fund to have an 80% investment policy, such as “balanced”, “real return” or a name indicating that a fund seeks to achieve a certain portfolio duration.
If a fund’s name includes multiple terms that would suggest an investment focus, the 80% investment policy must address each such term, but the Proposing Release notes that a fund can take a reasonable approach to specify how it will incorporate each such element. As an example, the Proposing Release notes that the “ABC Wind and Solar Power Fund” could have an investment policy that each investment in the 80% basket must be in both the wind and solar power industries, or it could have an investment policy that at least 80% of its assets will be invested in a mix of securities that are either in the wind industry or the solar power industry.
The Proposing Release also addresses how funds can determine if an investment qualifies to be included in the 80% basket. With respect to determining if a security is in a specific industry, the Proposing Release notes that there must be “a meaningful nexus between the given investment and the focus suggested by the name”. An example provided in the Proposing Release is that a fund could define a security to be issued by a company in a particular industry if such company derives more than 50% of its revenue or income from, or owns significant assets in, the industry. Conversely, the Proposing Release notes that using text analytics to assign issuers to an industry based on the frequency of certain terms in their disclosure documents would not be a reasonable method to use on its own.
Temporary Departures from the 80% Investment Requirement
The proposed amendments would only allow a fund to deviate from its 80% investment policy if:
- the deviation is due to market fluctuations or other circumstances not caused by the fund’s purchase or sale of a security or the fund’s entering into or existing an investment.
- to address unusually large cash inflows or unusually large redemptions.
- 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.
- to reposition or liquidate a fund’s assets in connection with a reorganization, to launch the fund, or when notice of a change in the fund’s 80% investment policy has been provided to fund shareholders at least 60 days before the change pursuant to the Names Rule.
For all of the above circumstances, except fund launches, reorganizations, or a change in a fund’s 80% investment policy after the 60 days’ notice to shareholders, the fund must come back into compliance with its 80% investment policy as soon as practicable but no longer than 30 consecutive days. For a fund launch, the fund would have 180 consecutive days to be in compliance with its 80% investment policy. There is no express limit for deviations caused due to reorganizations or changes in a fund’s 80% investment policy as the Proposing Release indicates that shareholders would have already received disclosures informing them of these changes.
The existing rule of testing for compliance with the 80% investment policy at time of investment would no longer apply, but the Proposing Release indicates that the SEC does not believe this will result in significant operational challenges for most open-end funds.
Considerations Regarding Derivatives in Assessing Compliance with the Names Rule
The amendments to the Names Rule would require that a fund, when calculating its assets for purposes of compliance with the 80% investment policy, would have to value derivatives using their 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 derivative instruments. Additionally, the amendments would allow a fund to include in its 80% basket derivatives that provide investment exposure to one or more of the market risk factors associated with the investments suggested by the fund’s name, in addition to derivatives that provide investment exposure to the investments suggested by the fund’s name.
Unlisted Closed-End Funds and BDCs
With respect to unlisted closed-end funds and BDCs, the amendments to the Names Rule would require that the 80% investment policy be a fundamental policy of the fund which can only be changed with shareholder approval. The Proposing Release notes that the SEC believes this is appropriate because of the inability for shareholders to be able to quickly redeem out of these investments if they do not want to remain invested in a fund that has changed its investment policy.
Effect of Compliance with an 80% Investment Policy
The amendments to the Names Rule would include a new provision providing that a fund’s name could be materially deceptive or misleading under section 35(d) even if the fund has adopted an 80% investment policy. In the Proposing Release, the SEC notes that depending on how a fund invests the other 20% of its assets, the fund name could be misleading; for example, if the fund invests in a way such that the source of a substantial portion of the fund’s risk or return is different from what an investor would reasonably expect based on the fund’s name.
Prospectus Disclosure Defining Terms Used in Fund Name
The Proposing Release also includes amendments to fund registration forms that would require each fund that must have an 80% investment policy to include disclosure 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. For this purpose, “term” would mean any word or phrase in a fund’s name, other than any trade name of the fund or adviser, related to the fund’s investment focus or strategies.
Plain English/Established Industry Use Requirement
The Proposing Release includes a requirement that any fund subject to the Names Rule would be required to have terms in the fund’s name be consistent with their plain English meaning or established industry use. The Proposing Release notes that the SEC’s view is that disclosure in the prospectus cannot cure a misleading name.
Materially Deceptive and Misleading Use of ESG Terminology in Certain Fund Names
The Proposing Release states that the use of ESG or similar terminology in fund names would deceive and mislead investors if the identified ESG factors do not play a principal role in the fund’s strategy. The amendments would address what the Proposing Release calls “integration funds” and would find that such funds’ names are materially deceptive and misleading if they include terms suggesting the fund’s investment decisions incorporate one or more ESG factors. An “integration fund” is a fund that 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 selection process and may not be determinative in deciding to include or exclude a particular investment in the fund’s portfolio.
Modernizing the Names Rule’s Notice Requirement
The current notice requirements under the Names Rule would generally remain with an amendment to address electronic delivery of the notice of a change in a fund’s 80% investment policy.
Additionally, there is specificity on what must be included in the notice:
- The fund’s 80% investment policy
- The nature of the change to the 80% investment policy
- The fund’s old and new names
- The effective date of any investment policy and/or name changes.
The Proposing Release states that this is designed to codify best practices that the SEC has observed and increase consistency in the content that is provided to shareholders.
Form N-PORT Amendments
The Proposing Release includes amendments to Form N-PORT to require funds that must comply with the Names Rule to report additional information that would assist the SEC in overseeing a fund’s compliance with its 80% investment policy. Such information would include reporting on the number of days that a fund was not in compliance with its 80% investment policy and indicating with respect to each portfolio investment, whether or not that investment was part of the 80% basket.
Funds that are require to comply with the Names Rule would have to maintain certain records documenting their compliance with the Rule. With respect to funds that are not required to comply with the Names Rule, such funds would have to maintain a written record of their analysis that an 80% investment policy is not required.
If the amendments in the Proposing Release are adopted, the SEC staff expects that much of its guidance on Rule 35d-1, as well as no-action letters and other statements will be withdrawn. Funds would have a one-year transition period to come into compliance with the amendments.
Comments on the Proposing Release should be submitted on or before 60 days after the Proposing Release is published in the Federal Register.