SEC Looks to Modernize the Fund Names Rule

Justice Martin

Associate Editor

Loyola University Chicago School of Law, JD 2024

On May 25th, 2022, the Securities and Exchange Commission (SEC) issued a proposal to the Investment Company Act of 1940 Rule 35d-1 which expands on a rule that mostly regulates fund names.  The SEC has decided to take these measures to combat “greenwashing”; a marketing ploy used by fund investors to draw in socially conscious investors for investments that are anything but sustainable. The SEC believes investors lack comparable, consistent, reliable information on ESG products.  This article will discuss these new proposals and what they mean for important stakeholders.

The Emergence of ESG

Nowadays, when listening to the media discuss investing, one term is becoming more and more relevant: ESG.  ESG stands for Environmental, Social, and Governance, and more investment firms are creating funds that pertain to this area. For example, the 1919 Socially Responsive Balanced Fund does not invest in any company that earns more than 5% revenue from tobacco production or sales.  Furthermore, the fund avoids companies that manufacture nuclear weapons.

With the increase of ESG-centered funds, the SEC decided that many investors may not know what that means and could be led astray by fund managers.  In response, the SEC published proposals to the Names Rule to protect these investors and provide more information on the relatively new area of focus.

History of the Names Rule

Prior to the proposed amendments, the current version of the Names Rule has been in effect since 2001.  It was initially enacted to ensure that a fund’s name does not misrepresent the fund’s investments and risks.  The rule generally required that if a fund name suggested that a fund has an investment focus that is specialized to an industry, geography, or type of investment, or that a fund is tax-exempt, the fund must invest 80% of the net value of its assets consistent with the fund name.  Further, the fund can either designate the 80% investment policy as non-fundamental or fundamental.  “Fundamental” means that the policy cannot be changed without shareholder approval, or the investment manager must provide investors with 60 days’ notice of any change in the investment policy.

What are some of the proposed amendments?

Some, but not all of the general highlights of the proposed amendments are as follows:  The SEC will allow temporary departures from the 80% investment policy stated above but only under specifically enumerated circumstances. The SEC wants to expand the scope of the rule to apply to any fund name that includes terms that suggest that the fund focuses on investments with particular characteristics, including the ESG Factors.

Furthermore, the commission is aiming for more clear information to be added to prospectuses for investors.  Amendments such as a “plain English provision will require that the prospectus include terms consistent with plain English or well-known industry use.  Accompanying the requirement of plain English is the requirement of defined terms within the prospectus that include the criteria for the selection of investments that are used in the fund’s name.  This is to ensure that investors have adequate information that is not ambiguous or misleading.

Lastly, a “no safe harbor” provision will hold fund managers accountable for using the remaining 20% of their net assets to invest in anything antithetical to the fund’s investment focus.  If the SEC determines that a fund manager is investing 20% of its net assets in something that does not align with the fund’s stated focus, then the fund will be out of compliance with the new rule.

Challenges/feedback with proposed amendments?

After these proposals are made there is usually some time for public comment before the rules are published in the Federal Registrar.  Specifically, the SEC has allowed 60 days for public comment on this proposal.  Some important critiques that have been brought to the forefront of this proposal within legal departments nationally, these critiques include the emphasis on subjectivity with these new proposals.  For example, it is up to the commission’s discretion to decide when a fund is not meeting the 80% policy or if a fund is using the remaining 20% of net assets on investments that are antithetical to the fund’s investment focus.  This may give the commission too much power and lead to unfair treatment and in turn, an increase in legal disputes between investment managers and the commission.  Ultimately, only time will tell how these new regulations impact important stakeholders, however, it is without question that some sort of effort to update the Investment Company Act of 1940 is well overdue.