On September 20, 2023, the SEC issued a release (the “Release”) adopting changes to the Names Rule, Rule 35d-1 under the 1940 Act (as amended, the “Final Rule”), and related form amendments. The Final Rule and the amendments substantially expand the applicability of current Rule 35d-1 and include new disclosure, compliance testing, reporting and recordkeeping requirements. Specifically, largely consistent with the related 2022 proposing release1 (the “proposing release”), the Release:
- Expands the Final Rule’s 80% investment policy requirement to apply to any fund name containing terms that suggest 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., “growth,” “value,” terms indicating that the fund’s investment decisions incorporate one or more ESG factors, and thematic terms).
- Amends funds’ prospectus disclosure requirements by requiring a fund that is required to adopt an 80% investment policy to include prospectus disclosure defining the terms used in the fund’s name, including the specific criteria the fund uses to choose the investments described by the terms.
- Retains funds’ flexibility to determine what constitutes other-than-normal circumstances in which a fund may intentionally depart from the 80% investment policy requirement and provides a 90-day period for bringing the fund back into compliance. The proposing release, in contrast, limited intentional departures to specified circumstances and generally provided only a 30-day period for bringing the fund back into compliance.
- Generally requires funds to use a derivatives instrument’s notional amount, rather than its market value, when determining the fund’s compliance with its 80% investment policy and specifically addresses the derivatives instruments that a fund may include in this 80% basket.
- Requires new compliance testing, as well as new reporting and recordkeeping requirements.
- Requires compliance with its provisions no later than 24 months after publication in the Federal Register (approximately December 2025).
These and other aspects of the Release, as well as material differences between the Release and the proposing release, are discussed below. The Appendix to this Alert shows the differences between the Final Rule and the proposing release’s Rule 35d-1.
I. New 80% Investment Policy Requirement – Names Suggesting an Investment Focus
The Amendments’ Broad Scope. The Final Rule broadens the scope of current Rule 35d-1’s 80% investment policy requirement to apply to fund names that “include terms suggesting that the fund focuses in investments that have, or whose issuers have, particular characteristics.” The Final Rule defines “investment focus” to mean “a focus 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.”
The Release notes that the Final Rule does not define the term “particular characteristics” because “this term will be adequately understood to mean any feature, quality, or attribute.” Instead, the Release highlights that the Final Rule provides, consistent with the proposing release, an illustrative parenthetical that is designed “to give non-exclusive examples of terms that suggest that the fund focuses in investments that have, or whose issuers have, particular characteristics.”
- As examples of terms that suggest an investment focus, the Final Rule’s illustrative parenthetical provides, “the terms ‘growth’ or ‘value,’ or terms indicating that the fund’s investment decisions incorporate one or more environmental, social, or governance factors.”
- The Release also notes that, based on the SEC’s “understanding of the fund industry and current practice,” the SEC expects that the “primary types of names that the expanded scope will cover will be names that include the terms ‘growth’ and ‘value,’ terms with ESG- or sustainability-related characteristics, or terms that reference a thematic investment focus.”
- Therefore, the Final Rule does not distinguish between a type of investment and an investment strategy because a fund name “might connote a particular investment focus and result in reasonable investor expectations regardless of whether the fund’s name describes a strategy as opposed to a type of investment.” As anticipated, the Final Rule requires any newly captured 80% investment policy to apply in addition to any existing 80% investment policy in current Rule 35d-1 (i.e., for any fund whose name suggests a focus in a particular type of investment, industry, country, or geographic region, or those whose name suggests certain tax treatment).
ESG Integration Funds. The proposing release was approved at the same May 2022 meeting at which the SEC approved a separate release proposing new ESG-related disclosure requirements applicable to registered funds and investment advisers (the “ESG Disclosure Proposal,” discussed in a Ropes & Gray Alert). The Release states that, “[b]ecause the proposed provision in the names rule mirrored the separate proposed definition of an integration fund in the ESG Disclosure Proposal, we are continuing to consider comments and are not adopting the proposed approach to integration fund names at this time.” This is a change from the proposing release, which:
- Addressed “integration funds,” described as funds that consider one or more ESG factors alongside other, non-ESG factors in the fund’s investment decisions but those ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio.
- Provided that the name of an integration fund is materially deceptive and misleading if the fund’s name includes terms “suggesting that the fund’s investment decisions incorporate one or more ESG factors.”
As described below, the Release notes that the Final Rule’s requirement to adopt an 80% investment policy applies when a fund’s name suggests an ESG investment focus, including names with terms indicating that the fund’s investment decisions incorporate one or more ESG factors.
Fund Names That Do Not Suggest an Investment Focus. The Release repeats the proposing release’s statement that “there would continue to be fund names that would not require the fund to adopt an 80% investment policy because the names would not connote an investment focus.” Specifically, the Release reiterates that terms in a fund’s name that reference characteristics of the fund’s portfolio as a whole – e.g., a name indicating the fund seeks to achieve a certain portfolio “duration” or that the fund is “balanced” – do not require the fund to adopt an 80% investment policy. These are examples in which a term “may indicate a fund’s objectives without communicating to investors the specific type of investments, or the particular characteristics of investments, that the fund will acquire.”
The Release provides additional examples in which a fund’s name communicates information to investors about the overall characteristics of the fund’s portfolio, instead of the particular investments in the fund (thereby avoiding a mandatory 80% investment policy under the Final Rule):
- Names that suggest a portfolio-wide result to be achieved, such as “real return,” “balanced,” or “managed risk,” names that reference a particular investment technique, such as “long/short” or “hedged,” and names that reference asset allocation determinations that evolve over time, such as a retirement target date or “sector rotation” funds.2
- Terms like “intermediate term (or similar),” in describing a “bond” fund, do not require an 80% investment policy under the Final Rule in addition to the 80% investment policy that would be required due to the fund’s use of “bond” in its name. The Release notes that these names are indistinguishable from names that describe portfolio-wide characteristics, such as names that describe portfolio duration.
- Names including the terms “global” and “international,” without an additional term that suggests an investment focus – e.g., fixed-income or growth – do not require an 80% investment policy. These terms “describe a fund’s approach to constructing a portfolio, but do not communicate the composition of the fund’s portfolio with any particularity (unlike, say, ‘Japan’ or ‘Europe’)” and, therefore, by themselves do not suggest a particular investment focus.
- Funds with terms in their name indicating a negative or exclusionary screening process for investments (e.g., “fossil fuel-free”) may not require an 80% investment policy because these types of terms indicate what is precluded from the fund’s portfolio, without communicating a fund’s particular investment focus.
The Release notes that names with terms that do not communicate the particular characteristics of investments composing the fund’s portfolio will continue to be subject to Section 35(d)’s prohibition on materially misleading or deceptive names. Funds with these names likewise will continue to be subject to the anti-fraud provisions of the Federal securities laws regarding disclosures to investors.
II. Investments Included in a Fund’s “80% Basket”
In General. The Release repeats the proposing release’s explanation that, when determining whether a fund investment asset qualifies for inclusion in a fund’s “80% basket,”3 there must be a meaningful nexus between the given investment and the investment focus suggested by the name. The Release states 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. The Release reiterates two additional points:
- There also may be instances where the percentage could be smaller, such as where a large company is a dominant firm in a given industry (e.g., the firm is an acknowledged leader in the industry).
- The use of text analytics to assign issuers to industries (based on the frequency of particular terms in an issuer’s disclosures), by itself, is not sufficient to create the requisite reasonable nexus.
According to the Release, these examples are not an exhaustive list of acceptable methods of determining eligibility for a fund’s 80% basket. The Release notes that “it is not possible to provide an enumerated list of circumstances in which a nexus exists between a security and an industry or a particular investment focus.”
- For example, the Release observes that advisers may offer funds with strategies that seek to identify issuers that are likely to generate significant amounts of revenue from certain industries or business sectors in the future. For these types of funds, it may be difficult to find a reasonable nexus between their investments and a given investment focus based on current characteristics of the issuer. These funds “may signal to investors, through the use of ‘emergent,’ ‘future,’ or some other similar term in the fund’s name, that the fund considers some future-based methodology” to determine if a reasonable nexus exists between an issuer’s securities and the investment focus suggested by the fund’s name (e.g., “XYZ Emergent 3D Printing Technology Fund”).
More generally, the “overall context is important in how an investor interprets a fund’s name.” As additional examples, the Release notes that descriptive terms, such as “aggressive,” “conservative,” or “strategic,” when paired with another term that is covered by the Final Rule’s scope, “can modify an investor’s expectations with respect to the fund’s investment focus.” To deal with these instances, the Release states, the Final Rule is:
designed to give fund managers reasonable discretion to define terms in a fund’s name, and to allocate investments reasonably into the 80% basket in accordance with the investment focus the name conveys, which can be dependent on the context of the terms in a name. In particular, the [Final Rule] requires that terms within a fund’s name must be consistent with the plain English meaning or established industry use. We are including these provisions in the [Final Rule] to provide fund managers with sufficient flexibility. (Emphasis added).
Harder Cases. The Release notes that, if a fund’s name includes terms suggesting an investment focus with more than one element, the fund’s 80% investment policy must address all of the elements in the name (as all of the elements would be reflected in the investment focus that the fund’s name suggests). A fund can take a reasonable approach in specifying how the fund’s investments will incorporate each element. For example, a fund with a name that references two or more distinct investment focuses (e.g., “XYZ Technology and Growth Fund”) could have an investment policy that provides:
- Each security included in the 80% basket must both be in the technology sector and meet the fund’s growth criteria; or
- 80% of the value of the fund’s assets will be invested in a mix of technology investments and growth investments, with some technology investments, some growth investments, and some investments in both of these categories, with no minimum or maximum investment requirements specified for either category.
Moreover, any fund that has a name that suggests at least one investment focus would be required to adopt an 80% investment policy, even if the fund’s name also contains a term that does not suggest an investment focus. Thus, the Release notes, the “XYZ Technology and Real Return Fund” would be required to adopt an 80% investment policy to invest 80% of the value of its assets in the technology sector despite the phrase “real return” also appearing in the name.
In the case of a fund of funds or other acquiring fund, the Release states that it would be reasonable for a fund to include the entire value of its investment in an appropriate acquired fund when calculating compliance with the 80% investment requirement without looking through to the acquired fund’s underlying investments.
- A fund of funds with the name “XYZ Industrials Fund” with an 80% investment policy to invest in the industrials sector could include the entire value of its investments in the “ABC Automotive Fund” when calculating compliance with the 80% investment requirement, provided that the ABC Automotive Fund has an 80% investment policy to invest in its subsection of the industrials sector.
- However, the Release states, it would not be reasonable for an acquiring fund in these circumstances to ignore situations where the acquiring fund knows that an underlying fund is not investing in a manner consistent with the acquiring fund’s investment focus. In such cases, the acquiring fund should take actions to address this departure, just as any other fund is required to resolve a temporary departure from the 80% requirement under the Final Rule. Nonetheless, an acquiring fund is not required to continuously monitor the investments of an acquired fund for purposes of compliance with the Final Rule. The XYZ Industrials Fund may rely on the ABC Automotive Fund to comply with the ABC Automotive Fund’s 80% policy.
When There Are ESG Terms in a Fund’s Name. As described above, the Release did not take action on the proposed use of ESG terms in the names of ESG integration funds. Accordingly, the Release notes that the Final Rule’s requirement to adopt an 80% investment policy applies when a fund’s name suggests an ESG investment focus, including names with terms indicating that the fund’s investment decisions incorporate one or more ESG factors.
The Release notes that, as is the case with fund names that do not include ESG terms, the general context of a name that may connote an ESG investment focus is critical in how an investor interprets such a name. For example, the “XYZ Sustainable Growth Fund” could be a fund that employs a strategy that seeks growth that is sustainable over time (i.e., growth that will be maintained at a certain level), or it could be a fund that incorporates ESG factors into its decision making. In this example, the Release states, an 80% investment policy is required in both cases. The Release notes that a fund has discretion to reasonably define the terms in its name, provided the definition is consistent with the terms’ plain English meaning or established industry use.
III. Temporary Departures from the 80% Investment Requirement
Time-of-Investment Test and Quarterly Review. Consistent with current Rule 35d-1, the Final Rule requires a fund to determine at the time it invests whether the investment should be included in the fund’s 80% basket. The proposing release would have eliminated the time-of-investment test and, in its place, required that a fund remedy departures within 30 days of the initial departure or “as soon as reasonably practicable” (whichever period is shorter). The proposing release would have required that funds engage in continual or even daily compliance testing to reassess the characteristics of investments in the fund’s 80% basket.
Instead of continual monitoring, the Final Rule requires each fund subject to the Final Rule’s 80% basket to reassess at least quarterly the assets included in the fund’s 80% basket. Specifically, portfolio investments that are included in the 80% basket at the time of investment will continue to be considered to be consistent with the fund’s 80% investment policy, unless the fund identifies (i) otherwise as part of its required quarterly reassessments, or (ii) outside of its required quarterly reassessments, that investments’ characteristics are inconsistent with the fund’s 80% investment policy.
- The monitoring approach described above does not change the requirement for funds to maintain at least 80% of the value of their assets in 80% basket assets (as determined at the time of investment), unless the fund departs temporarily from 80% in accordance with the Final Rule (as described below).
- The Release observes that the minimum quarterly review requirement is consistent with the Release’s quarterly Form N-PORT reporting requirements (described below), which require funds to report on Form N-PORT the value of the fund’s 80% basket, as well as each investment that is included in the fund’s 80% basket.
Investing Consistent with 80% Investment Policy “Under Normal Circumstances.” The Final Rule, like current Rule 35d-1, requires a fund to invest in accordance with its 80% investment policy “under normal circumstances.” A fund can depart from the fund’s investment policy in other-than-normal circumstances. The proposing release would have eliminated the requirement that a fund’s 80% investment policy apply under normal circumstances and, instead, provided specific exceptions that address circumstances where departures would be permitted (the “Specified Exceptions”).4
- In a change from the proposing release, the Final Rule retains the current “under normal circumstances” provision. Therefore, funds retain flexibility under the Final Rule to determine what constitutes other-than-normal circumstances where the fund could depart intentionally from the 80% requirement.
- While retaining the current “under normal circumstances” standard, the Final Rule includes a new limitation on how long a fund may depart from 80% under this provision (described below).
Time to Come Back into Compliance. The Final Rule requires that funds come back into compliance with the 80% investment requirement as soon as reasonably practicable in the case of drift (i.e., where the fund identifies that its investments are not consistent with this requirement, for example, as a result of inadvertent drift identified as part of the fund’s quarterly review) with an outer limit of 90 days. During that period, the fund is required to make all investments in a manner that will bring the fund into compliance with the fund’s 80% investment policy. In other-than-normal circumstances, the Final Rule requires a fund to come back into compliance within 90 days of the time that the fund initially departs from the 80% investment policy.
The proposing release would have required funds to come back into compliance with the 80% investment policy within 30 days from a departure from compliance with the 80% requirement. Thus, the extension of the time period that funds have to come back into compliance in the Final Rule is a departure from the proposing release.
Fund Launches and Reorganizations. The Final Rule permits funds to invest less than 80% of their assets in their 80% baskets temporarily for a fund launch, in order to reposition or liquidate assets in connection with a reorganization, or when notice of a change in a fund’s Names Rule policy has been provided to fund shareholders. For fund launches, the Final Rule provides funds with a temporary period to depart from the 80% investment requirement that may not exceed 180 consecutive days starting from the day the fund commences operations. For fund reorganizations, the Final Rule does not limit the period of departure.
IV. Derivatives and Names Rule Compliance
The Final Rule addresses both (i) the valuation of derivatives instruments for purposes of determining compliance with a fund’s 80% investment policy and (ii) the derivatives instruments that a fund may include in its 80% basket.
Use of Derivatives’ Notional Amounts, with Currency Hedging Exclusion. In general, the Final Rule requires a fund to use notional amounts to value derivatives in assessing whether it has invested 80% of its assets consistent with its 80% investment policy. In a change from the proposing release, the Final Rule also requires a fund to exclude from the calculation certain derivatives that hedge the currency risk associated with a fund’s foreign-currency denominated investments. These derivatives therefore will not be included in the calculation of the fund’s assets or the fund’s 80% basket when determining if the fund is complying with its 80% investment policy. Specifically, a fund must exclude a currency derivative if it (i) is entered into and maintained by the fund for hedging purposes, and (ii) the notional amounts of the 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%.
- The Release explains that excluding these derivatives from the Final Rule’s compliance calculation addresses concerns that “including certain derivatives at their notional amounts in this calculation could limit the use of derivatives for hedging purposes.” Excluding only currency derivatives is intended to ensure that any exclusion “will not result in the names rule calculation excluding instruments that create economic exposures that should be considered” in assessing whether a fund’s name is materially deceptive or misleading.
Otherwise, the Final Rule tracks the proposing release and requires a fund, in calculating its assets for purposes of compliance with the Final Rule, to value each of its derivatives instruments using its notional amount (subject to adjustments discussed below).
- When calculating notional amounts for these purposes, the Final Rule requires a fund to convert interest rate derivatives instruments to their 10-year bond equivalents and to delta adjust the notional amounts of options contracts.
- The Release states that (i) the requirement to convert interest rate derivatives instruments to 10-year bond equivalents “is designed to result in adjusted notional amounts that better represent a fund’s exposure to interest rate changes” and (ii) the requirement to delta adjust options “is designed to provide for a more tailored notional amount that better reflects the exposure that an option creates to the underlying reference asset.”
Derivatives Instruments Includes Liabilities. The Final Rule’s 80% basket is 80% of the fund’s assets. “Assets” is defined to mean “net assets, plus the amount of any borrowings for investment purposes” and subject to certain rules and exclusions described in this Section IV. The Final Rule’s requirement to use notional amounts applies to all of a fund’s derivatives instruments. The requirement applies to both the numerator and the denominator in the calculation that the fund would use to determine compliance with its 80% investment policy. Moreover, the requirement to value derivatives instruments using their notional amounts makes no distinction between derivatives instruments that are assets and derivatives instruments that are liabilities. Therefore, the Final Rule requires funds, in measuring their assets when assessing compliance with its 80% investment policy, to include the notional amount of any derivatives instrument, regardless of whether the instrument is an asset or a liability.5
Reducing the Value of a Fund’s Assets by Deducting Cash and Cash Equivalents and Certain U.S. Treasury Securities. The Final Rule permits a fund, in determining compliance with its 80% investment policy, to deduct cash and cash equivalents and U.S. Treasury securities with remaining maturities of one year or less from assets (i.e., from the denominator in the 80% calculation) up to the notional amounts of the fund’s derivatives instruments.
- This is a change from the proposing release, which would have limited the deduction to cash and cash equivalents and would have required, not permitted, this deduction from the denominator. According to the proposing release, its approach was intended to remove from the compliance calculation cash and cash equivalents because they do not themselves provide market exposure and function as low-risk collateral for the derivatives instruments whose notional amounts already are included in the denominator. Thus, “including this collateral would effectively ‘double-count’ the fund’s exposure.”
- The Release recognizes that the deduction of cash and cash equivalents from the denominator makes it easier for a fund to have an 80% basket (e.g., 80 ÷ 100 just meets the requirement, while 80 ÷ 95 (84%) exceeds the requirement). Accordingly, the Final Rule makes the deduction from the denominator permissive. In addition, permitting a fund to choose not to deduct cash and cash equivalents reflects that there are circumstances in which cash and cash equivalents provide investment exposure that is consistent with the fund’s name.
In addition, the Release acknowledges that expanding the permissible deduction to encompass all U.S. Treasury securities with remaining maturities of one year or less permits funds to exclude certain assets that effectively function as low-risk collateral for derivatives instruments, but that do not introduce unexpected investment exposure or risk to the portfolio.
Deduction of Closed-Out Derivatives Positions. In another change from the proposing release, the Final Rule permits a fund to exclude any closed-out derivatives positions when calculating assets for purposes of determining compliance with its 80% investment policy, provided those positions result in no credit or market exposure to the fund. The Release recognizes that permitting funds to exclude these closed-out derivatives positions from the calculation will not affect the fund’s risks or returns.6
Certain Derivatives Instruments Excluded from the 80% Basket. The Final Rule permits a fund to 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. The Release notes that, in addition to using derivatives as direct substitutes for cash market investments, some funds use derivatives instruments to hedge exposures or to obtain exposure to market risk factors associated with the fund’s investments (e.g., interest rate risk and credit spread risk).
- On the other hand, some derivatives are used to manage the risks of the fund’s portfolio as a whole and may “involve more complex hedging activities than transactions that provide investment exposure to one or more of the market risk factors” that are associated with investments suggested by the fund’s name. In turn, the Release notes, these activities “could create exposures that could be inconsistent with investors’ reasonable expectations of the fund’s investment activity.”
- Consequently, the derivatives instruments that a fund is permitted to include in its 80% basket must (i) function as a substitute for direct investments in the securities suggested by the fund’s name or (ii) be used to facilitate the fund’s investment in those securities by increasing or decreasing the fund’s exposure to risk factors associated with those securities.
Treatment of Short Positions. As described above, under the Final Rule, if a fund uses derivatives instruments to obtain exposure to short positions in one or more reference assets, the fund is required to use these derivatives instruments’ notional amounts for purposes of determining compliance with its 80% investment policy. This means that instruments must be valued at their notional amounts in the denominator in all cases, and at their notional amounts in the numerator where the fund includes investments that provide short exposure in the numerator.
- In a change from the proposing release, the Final Rule requires that a fund must value each “physical” short using the value of the asset sold short. As an example, the Release states that, if a fund sold short one share of a security for $100, the market value of the position would be $0 at that time because the fund has $100 in short sale proceeds, but also a liability in the form of the obligation to return a share worth $100. If the fund had instead obtained the same short exposure by employing a swap, the notional amount would be $100. To provide comparable values under the Final Rule for the physical short sale and the swap, the Final Rule requires valuing the physical short sale at $100.
- The Final Rule effects a change to the proposing release’s definition of “assets” by specifying that a fund is required to value each physical short position using the value of the asset sold short. Of course, a fund may reduce the value of its assets by excluding any cash and cash equivalents, and U.S. Treasury securities with remaining maturities of one year or less, up to the notional amount of the value of asset(s) sold short, just as a fund could exclude any cash and cash equivalents and such U.S. Treasury securities up to the notional amount of the fund’s derivatives instruments, as discussed above.
V. Unlisted Registered Closed-End Funds and BDCs
Funds that are registered closed-end investment companies or business development companies (a “BDC”), and whose shares are not listed on a national securities exchange (together, “unlisted closed-end funds and BDCs”), are subject to certain additional requirements under the Final Rule.
- Under current Rule 35d-1, an unlisted closed-end fund’s or BDC’s 80% investment policy generally must either be a fundamental policy or subject to a requirement in current Rule 35d-1 to provide shareholders 60 days’ advance notice of any change in the policy.
- The Release notes that because unlisted closed-end funds and BDCs do not issue redeemable shares or list their shares on a national securities exchange – even if they provide 60 days’ notice – shareholders in these funds generally lack the ability to redeem or quickly sell their shares if the fund were to change its investment policy and the investment focus that the fund’s name indicates.
The Final Rule prohibits unlisted closed-end funds and BDCs that are required to adopt an 80% investment policy from changing that policy unless authorized by a vote of the majority of the outstanding voting securities of the fund. In a modification from the proposing release, the Final Rule permits such funds to make changes to their 80% investment policies without this vote, provided the fund conducts a tender or repurchase offer prior to the change, the fund provides at least 60 days’ prior notice of any change in the policy in advance of the offer, the offer is not oversubscribed, and the fund purchases shares at their net asset value.
- If a tender or repurchase offer is oversubscribed, a fund would then be required to conduct a shareholder vote prior to making the change to its investment policy that the notice describes, consistent with the Final Rule.
- The Release notes that the tender/repurchase offer change also gives a fund discretion “to determine the number of shares it is willing to repurchase from shareholders after the notice of the change, in accordance with all applicable Commission rules.” In turn, this will permit fund managers “to weigh the risk of oversubscription, and the resulting need to have a special shareholder meeting to vote on the change, against the amount of liquidity they are willing to provide to shareholders.”
VI. Effect of Compliance with an 80% Investment Policy
The Final Rule includes a provision providing that a fund’s name may be materially deceptive or misleading under Section 35(d) of the 1940 Act even if the fund adopts and implements an 80% investment policy and otherwise complies with the Final Rule’s requirement to adopt and implement the policy.
The Release notes that the SEC has previously stated that Rule 35d-1’s 80% investment policy requirement is not intended to create a safe harbor from liability under Section 35(d), and the Final Rule codifies this view to make clear that a fund name may be materially deceptive or misleading even where the fund complies with its 80% investment policy.
- The Release also reiterates the proposing release’s discussion of instances where a fund may be invested 80% or more in a market index referenced in the fund’s name, but that underlying index may have components that are contradictory to the index’s name. Therefore, although the fund meets the Final Rule’s requirements by its investments in the index, the name could still be materially misleading.
- The Release states that, while index funds should generally implement written policies and procedures to ensure their compliance with Section 35(d), in response to commenters, the SEC is “confirming that the terms in a market index referenced in an index fund’s name would not be subject to an 80% investment policy test that would apply in addition to the fund’s policy to invest at least 80% of its assets in the index’s components required under the Final Rule.
VII. Prospectus Disclosure – Defining Terms Used in Fund Name
The Release includes amendments to registration forms (Form N-1A, Form N-2, Form N-8B-2 and Form S-6) that require any fund with an 80% investment policy to include prospectus disclosure defining the terms used in the fund’s name, including the specific criteria the fund uses to choose the investments described by the terms. In addition, funds are required to tag this new information using a structured data language (“Inline XBRL”).
- Under the disclosure requirements, “terms” would mean any word or phrase used in a fund’s name, other than any trade name of the fund or its adviser, related to the fund’s investment focus or strategies. Words in a fund’s name that do not describe an investment focus or strategy are not required to be defined (e.g., “fund” or “portfolio”).
- For fund names focusing on particular countries or geographic regions, the disclosure requirements replace the existing disclosure requirement with the general requirement to define terms used in the fund’s name whenever the fund’s name suggests an investment focus requiring an 80% investment policy.
- The Release states that funds have “flexibility to use reasonable definitions of the terms that their names use.” However, a fund’s use of reasonable definitions of the terms used in the fund’s name under the Final Rule “may not be inconsistent with their plain English meaning or established industry use.” Moreover, as described above, what constitutes “reasonable” in context could vary depending on the fund name but requires that the definition have a meaningful nexus between the term used in the fund’s name and the fund’s investment focus.
In a technical change to the proposing release, the Release amends the proposed disclosure requirement for open-end funds registered on Form N-1A to reflect that the principal investment strategies disclosure in the summary section of the prospectus is intended to summarize disclosure that appears later in the statutory prospectus. The summarized disclosure must appear in non-summarized form in the statutory prospectus.
- The instructions in the Release’s Form N-1A regarding principal investment strategies disclosure in the summary prospectus – Item 4(a)(1) of Form N-1A – states that disclosure provided in response to Item 4(a)(1) “must summarize the definitions of the terms used in its name, including the specific criteria the Fund uses to select the investments the term describes, if any.”
- Because Item 4(a)(1) summarizes the principal investment strategies disclosure that appears in the statutory prospectus – Item 9(b) of Form N-1A – the Release adds instructions to Form N-1A stating that disclosure provided in response to Item 9(b)(1) “must include the definitions of the terms used in its name, including the specific criteria the Fund uses to select the investments the term describes, if any.”
VIII. Modernizing the Final Rule’s Notice Requirement
Consistent with current Rule 35d-1, the Final Rule requires that, unless a fund’s 80% policy is a fundamental policy, notice must be provided to shareholders of any change in the fund’s 80% policy. The Final Rule includes the amendments to the notice requirements that appeared in the proposing release.
The Final Rule includes changes to the current notice requirement, which now requires 60 days’ notice to fund shareholders of any change in the fund’s 80% investment policy.
- The Final Rule specifically requires, if the notice is delivered in paper form, it may be provided in the same envelope as other written documents. This change is intended to clarify the current Rule’s provisions that address when and how a notice can be provided with other written documents, but not to alter these current provisions substantively.
- The Final Rule requires that the notice contain the following prominent statement (or similar clear and understandable statement) in bold-face type: “Important Notice Regarding Change in Investment Policy [and Name].” The prominent statement continues to alert shareholders that the notice contains information about a change in the fund’s investment policy and, where applicable, must also reference the fund’s name change.
- For any notice under the Final Rule that is provided in paper form, the Final Rule requires that the prominent statement must also appear on the envelope in which the notice is delivered. This is an expansion of current Rule 35d-1, which requires the statement to appear on the envelope only when the envelope includes other materials.
- For any electronic notice to shareholders, the Final Rule requires the prominent statement to appear on the subject line of the email communication that includes the notice.
- In all cases, the Final Rule requires that the notice describe, as applicable, the fund’s 80% investment policy, the nature of the change to the 80% investment policy, the fund’s old and new names, and the effective date of any investment policy and/or name changes.
- The Final Rule does not permit funds to post notices to their websites as an alternative to sending notice to shareholders.
IX. Form N-PORT Reports
The Release amends Form N-PORT to include new reporting items for registered management investment companies and ETFs that are organized as a unit investment trust (“UIT”) (other than money market funds or small business investment companies) regarding the 80% investment policy that a fund adopts in compliance with the Final Rule.
Form N-PORT includes an item that requires funds subject to the 80% investment policy requirement to report (i) with respect to each portfolio investment, whether the investment is included in the fund’s 80% basket and (ii) the value of the fund’s 80% basket, as a percentage of the value of the fund’s assets. Funds must provide this new information, along with the other information they are currently required to report. Funds are required to provide this information as of the end of the reporting period, and the information will be publicly available for the third month of each of the fund’s fiscal quarters.
In departures from the proposing release:
- Form N-PORT requires the reported information for the third month of each quarter, instead of for every month. This change reflects that the Final Rule does not require continual compliance monitoring and, instead, requires funds to review their portfolios for compliance at least quarterly.
- As a new requirement, funds also must report on Form N-PORT the definitions of the terms used in the fund’s name, including the specific criteria the fund uses to select the investments the term describes, if any.
- The Release does not adopt the proposing release’s requirement that a fund report the number of days that the value of the fund’s 80% basket fell below 80% of the value of the fund’s total assets during the reporting period.
Funds that are required by the Final Rule to adopt an 80% investment policy must maintain the following written records:
- At the time the fund invests its assets (i) documentation recording whether the investment is included in the fund’s 80% basket and, if so, the basis for including that investment in the 80% basket, and (ii) the value of the fund’s 80% basket, as a percentage of the value of the fund’s assets;
- Documentation of the fund’s review of its portfolio investments’ inclusion in the fund’s 80% basket, to be conducted at least quarterly, including whether each investment is included in the fund’s 80% basket and the basis for including each investment in the 80% basket;
- If, during the quarterly review or otherwise, the fund determines that the 80% requirement is no longer met, documentation of the determination date and the reason for any departures from the 80% investment policy;
- If there is a departure from the 80% requirement in other-than-normal circumstances, documentation of the date of the departure and the reason why the fund departed (including why the fund determined that circumstances are other-than-normal); and
- Any notice sent to the fund’s shareholders pursuant to the Final Rule.
In a change from the proposing release, the Final Rule does not require a fund that does not adopt an 80% investment policy to maintain a written record of the fund’s analysis that the investment policy is not required under the Final Rule.
XI. Unit Investment Trusts
UITs that have names that subject the UIT to the Final Rule’s requirements and whose initial deposit occurs after the compliance date of the Final Rule are required to adopt an appropriate 80% investment policy, including making the policy fundamental or providing notice to investors in the event of a change of the policy, if appropriate. However, these UITs will not be required to engage in the monitoring and other requirements associated with the Final Rule’s temporary departure requirements and will not be required to keep records under the Final Rule beyond the initial deposit. UITs will be subject to the Final Rule’s other requirements.
UITs that make their initial deposit prior to the compliance date of the Final Rule are not required to adopt a new 80% investment policy or comply with the recordkeeping requirements within the Final Rule.
XII. Compliance Dates
The compliance date for the Final Rule and related amendments is 24 months following the “effective date” for larger entities (funds that, together with other investment companies in the same “group of related investment companies” have net assets of $1 billion or more as of the end of the most recent fiscal year) and 30 months following the effective date for smaller entities.
The effective date is 60 days following publication of the Release in the Federal Register. As of the date of this Alert, the Release has not been published therein. A rough estimate of the compliance date for larger entities is December 2025.
General Thoughts. While, as detailed above, the Final Rule represents an improvement over the proposed rule in a number of respects (e.g., greater flexibility to determine “other than normal” circumstances, quarterly (rather than ongoing) assessments of whether positions continue to count toward a fund’s 80% test), it nonetheless imposes significant new implementation and ongoing operating costs for funds. As detailed above, all funds required to have 80% investment policies will be subject to new prospectus disclosure requirements, new requirements to reassess whether holdings count toward an 80% policy at least quarterly and to memorialize the basis for those decisions, and new SEC reporting requirements to help demonstrate compliance, among others. Further, the Release notes that the percentage of funds required to adopt an 80% investment policy under the Final Rule is expected to increase to approximately 76%.
A frequent criticism of the current Names Rule is that it has been applied in an uneven manner by the SEC’s disclosure staff, with similarly situated funds experiencing different levels of pressure to adopt name policies through the disclosure review process (e.g., some (but not all) funds with names suggesting consideration of ESG-related factors have been pressured to adopt names policies notwithstanding that their names did not suggest an “investment type”). While the Final Rule should improve consistency in at least some respects, it remains to be seen how the SEC staff will monitor compliance with the new rule. In particular, while the Release stresses on multiple occasions that funds will have flexibility and discretion in how they define terms, determine what is “other than normal,” etc., it is unclear whether or how much the staff will continue to challenge the “reasonableness” of these decisions.
Derivatives. The Final Rule’s approach to derivatives is something of mixed blessing. On the positive side, it reverses an informal staff position communicated to many funds over the years that most derivatives should be valued at “marked to market” rather than notional value, an approach that has made it unduly difficult for certain funds to meet their 80% tests even where they had economic exposure to the relevant asset class well in excess of 80%. On the negative side, testing compliance with the Final Rule will require funds to perform a new calculation of the “value of its assets” not required for any other purpose.
No Rest for the Weary. The next couple of years are shaping up as an exceptionally busy time for purposes of implementing new fund regulatory requirements. On the near-term horizon, funds already have July 2024 in mind as the compliance date for new Form N-PX proxy-voting reports (funds will be required to file their first reports on amended Form N-PX by August 31, 2024, covering the period July 1, 2023 to June 30, 2024). Rules requiring new tailored shareholder reports for each class of shares of each fund apply to all shareholder reports published on or after July 24, 2024. Finally, the most substantive money market fund reforms have compliance dates in 2024. In addition, the SEC’s near-term agenda still includes (i) Open-End Fund Liquidity Risk Management Programs and Swing Pricing, (ii) Enhanced ESG Practices Disclosures by Registered Investment Advisers and Investment Companies, and (iii) Cybersecurity Risk Management for Investment Advisers, Registered Investment Companies, and Business Development Companies.
Next Steps. As soon as practicable, fund advisers should identify which of their funds are newly captured by the Final Rule. In addition, for those funds that already have an 80% investment policy, advisers should identify those funds required to adopt an expanded Names Rule policy, and whether any current Names Rule policies are fundamental policies. For all funds expected to be covered by the Final Rule, it would also be advisable to begin the process of considering definitions for key terms. For example, certain funds with “value” or “growth” in their fund names may have had a general “value” or “growth” tilt or bias in the aggregate but, to date, have not had to consider definitions of “value” or “growth” that at least 80% of the value of their assets must satisfy under the Final Rule. Conducting this “inventory” in the coming months should afford more time to develop “reasonable” definitions of key terms, and may be useful in assessing whether name changes to avoid the Final Rule’s requirements should be considered. An inventory of affected funds and expected changes will also facilitate scheduling for board meetings, shareholder notices and, if necessary, shareholder meetings.
In addition, fund advisers will want to assess the Final Rule’s new compliance testing, reporting and recordkeeping requirements in order to facilitate planning and developing/modifying current practices.
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- The May 2022 proposing release was examined in a Ropes & Gray’s Alert.
- The Release notes that a target date fund’s name communicates an investment approach to investors, but does not communicate the composition of the fund’s portfolio at any particular point in time (which will change consistent with the fund’s glidepath). Similarly, the Release notes that “sector rotation” funds seek to shift their portfolio in and out of sectors over time as the economy moves through the different phases of a business cycle.
- The Final Rule defines “80% basket” as “investments that are invested in accordance with the investment focus that the fund’s name suggests.”
- The proposing release would have permitted a fund to temporarily depart from the 80% investment policy when (i) as a result of market fluctuations or other circumstances the temporary departure was 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 unusually large redemptions, (iii) to position the portfolio in cash and cash equivalents or government securities to avoid a loss in response to adverse market, economic, political or other conditions or (iv) to reposition or liquidate a fund’s assets in connection with a reorganization, to launch the fund or, following notice of a change in the fund’s 80% investment policy, to fund shareholders at least 60 days before the change pursuant to the Final Rule.
- See Release at n. 234.
- The Release also recognizes that this position differs from the treatment of closed-out positions under the Derivatives Rule (Rule 18f-4), which does not permit funds to exclude offsetting positions across different counterparties in calculating derivatives exposure in determining if a fund qualifies as a limited derivatives user.
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