“What’s in a name? That which we call an ESG fund, by any other name would be as green.”
That altered version of Juliet’s famous line in the William Shakespeare play, Romeo and Juliet, highlights a global regulatory trend to further expand investor protection. There is renewed focus on fund names, catalyzed by the spread of ESG investing and marketing practices. For example:
-
Hong Kong’s Securities and Futures Commission stated in a June 2021 circular to management companies: “The reference to ESG or similar terms in the fund’s name and marketing materials should accurately and proportionately reflect the ESG features against other features of the fund and should not overstate or over-emphasize the ESG features.”
-
The Canadian Securities Administrators Staff Notice 81-334, published January 2022, extensively discusses the expectation for ESG indicators in fund names to align with investment objectives and related disclosures.
-
The U.S. Securities and Exchange Commission published rule proposals under the rubric “Investment Company Names,” which goes further than many ESG-driven “reminders” by industry regulators in other jurisdictions. They build on the existing Names Rule (i.e., Rule 35d-1 under the Investment Company Act of 1940), which per the SEC, “helps ensure that a fund’s name accurately reflects the fund’s investments and risks.”
Backdrop to the Names Rule Amendment Proposals
In 2001, the SEC first adopted the Names Rule, applicable to registered investment companies and business development companies, in order to address materially deceptive or misleading fund names. In the ensuing decades, fund AUM has increased substantially, as have the variety of fund types and fund strategies, the adoption of widely varying ESG strategies, the use of derivatives, and electronic delivery of fund documents. In light of such industry changes, certain challenges of Names Rule interpretation, compliance and enforcement have grown more acute. The SEC is seeking to add clarity and accountability to the Names Rule through the new proposals.
Key Elements of the Proposed Names Rule Amendments
-
Scope expansion: The existing 80% investment policy requirement will apply to any fund name with terms suggesting the fund focuses on investments that have, or whose issuers have, particular characteristics, including ESG.
-
80% investment policy departures: In contrast to the current Names Rule in which a fund’s policy applies at the time of investment and “under normal circumstances,” the proposed amendments specify circumstances under which a fund may depart from its 80% investment policy, with time frames for returning to compliance.
-
Derivatives: The proposal amends the Names Rule to require funds to use a derivatives instrument’s notional amount, rather than its market value, with an additional amendment to address the derivatives instruments that a fund may include in its 80% basket.
-
Unlisted closed-end funds and business development companies: The proposal requires that a registered closed-end fund or BDC, whose shares are not listed on a national securities exchange, must make its 80% investment policy a fundamental policy with consequent shareholder approval requirements.
-
Prospectus disclosure: The proposal includes prospectus disclosure requirements for a fund to define the terms used in its name, including the criteria the fund uses to select the relevant investments.
-
Plain-English requirements: Any terms used in the fund’s name that suggest either an investment focus, or that the fund is a tax-exempt fund, must be consistent with those terms’ meaning in plain English or established industry use.
-
Use of ESG terminology: The use of ESG or similar terminology in a fund’s name would deceive and mislead investors in the case of “integration” funds.
-
Notice requirements: The proposal updates the notice requirement to address funds that use shareholder electronic delivery methods. This includes a requirement for notices to describe not only a change in a fund’s 80% investment policy, but also the accompanying change to the fund’s name.
-
Form N-PORT: The proposed amendments include new reporting items for Names Rule compliance and requiring a fund to indicate, on an investment-by-investment basis, whether the investment is in the fund’s 80% basket.
-
Recordkeeping: The amendments include standard rule-related recordkeeping requirements, including documentation that an 80% policy is not required.
Practical Compliance Considerations
While the summary above paraphrases key components of the proposed Names Rule amendments, the amendments become more involved and complex when examined in detail. In this case, decades of compliance experience with the existing Names Rule means that fund personnel are accustomed and attuned to the basic concepts. However, taken together, the set of proposed amendments will significantly raise the stakes and operational requirements for Names Rule compliance.
At a high level, compliance teams will need to consider current and planned fund names—in light of the expanded scope and enumerated examples under the proposed revisions—for potential inclusion within the rule’s requirements, followed by an “amend” or “comply” decision, which will not be made in a vacuum.
The updated compliance framework will have to start from the top, with definition of terms and statements of policy, filtering down to the day-in-day-out procedures that will have to be put in place to abide by the upgraded reporting requirements.
While it might be tempting to treat the new Form N-PORT reporting items as an afterthought, consideration of how to achieve daily flagging of positions and compliant calculation of weights should be prioritized. Funds should consider the top-level investment policy and definition of terms in light of the ability to effectively implement the policy and definitions via a combination of versatile portfolio analytics and portfolio compliance systems—fed by the data items that enable ongoing, daily enforcement of the investment policy.
Conclusion
Fund names are attracting increased scrutiny by industry regulators around the world, driven by the spread of ESG investing interest and a wide dispersion of fund ESG investing strategies and marketing practices.
In the U.S., the SEC framed its proposed Names Rule amendments as remedial and responsive to industry changes. Despite industry familiarity with the Names Rule, the amendments—if adopted as proposed—will significantly raise the stakes and operational requirements for Names Rule compliance.
Post Comment
