SEC Warns Against Misleading Investors in Amendments to "Names Rule"
On September 20, 2023, the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to its “Names Rule”1 that are designed to prevent greenwashing and to address environmental, social, and governance (“ESG”) factors. The first Names Rule changes in 20 years, the amendments, among other things, expand the category of funds that must invest 80 percent of their assets in accordance with the investment focus that the fund’s name suggests. Once sixty days has passed after publication of the amendments in the Federal Register, fund groups with net assets exceeding $1 billion will have 24 months to comply with the amendments and groups with net assets under $1 billion will have 30 months to comply.
As investment funds provide an increasingly tailored and diverse array of fund management structures tied to ESG priorities and expanded investor preferences, the amendments are intended to protect investors from materially deceptive and misleading information by ensuring that the value of a fund’s assets is aligned with the fund’s investment focus as reflected in its name. Alongside the SEC’s proposed climate-related disclosures rule, the SEC’s Names Rule amendments reflect the SEC’s effort to update the securities laws given investors’ increased focus on ESG investments. The Names Rule amendments will expand the basis for the SEC’s continued enforcement focus on ESG-related investment practices.2
Names Rule Background
Initially adopted in 2001, the Names Rule prohibits a registered investment company from adopting as part of its name or title any words that are materially deceptive or misleading. The Names Rule considers certain types of fund names to be materially deceptive or misleading unless certain conditions are met, including when a fund’s name suggests a focus on a particular type of investment, or in investments in a particular industry or geographic focus. If so, the fund must adopt a policy to invest at least 80% of the value of its assets in the type of investment, or in investments in the industry, country, or geographic region, suggested by its name. Under the current rule, a fund generally may elect to make its 80% investment policy a fundamental policy (i.e., a policy that may not be changed without shareholder approval) or instead provide shareholders at least 60 days’ notice prior to any change in the 80% investment policy.
Amendment Features
A central feature of the amendments is expanding the scope of the 80% investment policy requirement to any fund name with terms suggesting that the fund focuses on investments with particular characteristics.3 Going forward, this will expressly include, in addition to fund names that imply investments in a specific industry, country, or geographic region, fund names with terms such as “growth” or “value,” and terms indicating that the fund’s investment decisions incorporate one or more ESG factors. “ESG” terms include “socially responsible,” “sustainable,” and “green,” if they describe a focus that investors may consider relevant when investing.4
As in the past, funds must comply with the 80 percent investment policy “under normal circumstances” and at the time a fund acquires an asset. The amendments require funds to review compliance with the 80 percent policy at least quarterly. When a fund determines that it is not in compliance with the 80 percent requirement, it generally must return to compliance within 90 days.
The amendments address the derivatives instruments5 that a fund may include in its 80 percent investment policy “basket” and the valuation of derivatives instruments for purposes of determining compliance with a fund’s 80 percent investment policy. A fund’s 80 percent basket may include a derivatives instrument that provides investment exposure suggested by the fund’s name, as well as 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. To determine if a derivative provides investment exposure to one or more relevant market risk factors, a fund “generally should consider whether the derivative provides investment exposure to any explicit input that the fund uses to value its name assets, where a change in that input would change the value of the security.” Certain derivatives must be excluded from the 80 percent investment policy calculation. Additionally, the amendments address short positions and physical short sales with the valuations provisions.
Additionally, the SEC is amending Form N-PORT so that funds must report the value of the fund’s 80 percent basket and whether an investment is included in the fund’s 80 percent basket. The amendments also include a new reporting requirement to include the definitions of terms used in the fund’s name. Funds are required to report this information for the third month of every quarter.
Other amendments adopted by the SEC:
- Generally prohibit an unlisted registered closed-end fund or business development company that is required to adopt an 80 percent investment policy from changing that policy without a shareholder vote;
- Require prospectus disclosures to provide “reasonable definitions” for terminology used in fund names that suggest an investment focus;
- Expand a 60-days’ notice to shareholders requirement associated with changes in a fund’s non-fundamental 80 percent investment policy by requiring that such a notice must describe related changes to the fund’s name; and
- Clarify that compliance with a fund’s 80 percent investment policy is not a safe harbor from the prohibitions on adopting a fund name that is otherwise materially deceptive or misleading.
1 Rule 35d-1 under the Investment Company Act of 1940.
2 Under its Enforcement Task Force Focused on Climate and ESG Issues, the SEC has brought enforcement actions against companies for making materially misleading statements about ESG investment practices and for failing to follow stated ESG policies (see e.g., SEC enforcement actions involving Deutsche Bank subsidiary DWS Investment Management Americas Inc.; Goldman Sachs Asset Management, L.P.; and BNY Mellon Investment Adviser, Inc.).
3 The SEC explained that the term “will be adequately understood to mean any feature, quality, or attribute.”
4 The amendments do not apply to certain terms that have historically been interpreted as outside the rule’s scope, such as “international,” “global,” or “intermediate term” when describing a bond.
5 “Derivatives instrument” is any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument.
ABOUT BAKER BOTTS L.L.P.
Baker Botts is an international law firm whose lawyers practice throughout a network of offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy, technology and life sciences sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.
