Rule 35d-1 Amendments: Investment Company Names
Following a 2020 request for comment, the SEC has proposed amendments to Rule 35d-1, colloquially called the “Names Rule,” which generally requires registered funds and BDCs to invest at least 80% of their assets consistent with the investment focus that the fund’s name suggests. The SEC portrays the proposal as a modest effort to prevent misleading fund names, which can have a significant impact on investors’ decisions when selecting investments. Without much pretense, it is plainly focused on “greenwashing,” and thus should be understood in the broader context of ESG regulation (also subject to rulemaking). But it also would extend rule 35d-1’s reach to more conventional naming conventions like “growth” and “value” that until now have avoided Rule 35d-1’s reach. The proposal does allow that some terms still imply only “characteristics” of the portfolio as a whole that do not trigger a requirement for an 80% policy. Thus, for example, a fund with stated duration, target date, or described as “balanced” need not adopt an 80% policy. (While somewhat helpful, it is hardly obvious why “balanced” is excepted but “value” is not. We suspect this will either get re-worked or the disclosure review staff will be making ad hoc determinations about who needs 80% policies.)
Much of the proposal is sensibly focused on ensuring adequate disclosure; it does not, for example, prescribe ESG standards. To that end, funds will have to disclose how they define the terms used in their names, including the criteria the fund uses to select the investments that the term describes. All the commissioners agree with that, in principle. Of course, the devil is in the details, and critics (including Commissioner Peirce) are concerned that there is too much subjectivity in identifying fund names that imply “particular characteristics,” which can lead to uneven (or unfair) enforcement. And the likely upshot is that fund sponsors will simply make names more generic and less informative to avoid the rule’s clutches.
The proposal would bar funds from using ESG terminology (e.g., green, sustainable, etc.) in a name if such factors carry equal weight in the manager’s investment decisions as other non-ESG factors. For these so-called “integration funds,” the ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors are not dispositive in deciding to include or exclude any particular investment in the portfolio. Commenters likely will urge better calibration on this issue because, as a practical matter, many funds would say that ESG is a “significant” factor but would not be willing to say that it is predominant or at least equal to all other non-ESG factors. Moreover, it would put ESG-focused funds in a bit of a pickle when considering the companion ESG rule (discussed below): integration of ESG factors requires more disclosure, but the funds could not name the fund to signal that integration. Thus, sponsors may choose to simply go all in or all out on ESG, which could limit the manufacture of choices in the middle.
The amendment also would impose significant new restrictions on “defensive” positioning as a means to deviate from the fund’s 80% policy. Funds will be permitted to deviate only under particular circumstances, including market fluctuations, to address large inflows or redemptions, or moving to cash to avoid losses from adverse market conditions. It also specifies that funds have 30 days (or 180 days for fund launches) to return to compliance with the 80% threshold. While advisers will balk at that change – it may force transactions that could harm shareholders – the Commission believes it will prevent funds from drifting away from their mandates and taking perpetually defensive positions. We suspect this feature of the proposal will generate a lot of discussion about shareholder protection on both sides, and perhaps actively managed funds will be given more leeway than passive funds.
The amendments also try to grapple with the increased use of derivatives. Current Rule 35d-1 does not address how to incorporate derivatives, which can magnify exposure, into the 80% calculation. The amendment thus seeks to ensure that a fund’s name accurately reflects the economic reality of the fund’s sources of returns and risk by specifying that notional exposure, rather than market value, is used for the 80% calculation. Furthermore, the rule would specify the derivatives instruments that a fund may include in its 80% basket.
For unlisted closed-end funds and BDCs, the proposal would prohibit changing the 80% policy without a shareholder vote (ie, the 80% policy must be a fundamental policy). This is designed to protect shareholders who are limited in their ability to exit the investment if they do not like the changes made.
Finally, the amendments would require recordkeeping that shows how the funds comply with the rule, and it would require new disclosure on Form N-PORT to designate whether an investment is included in the 80% bucket. Commenters will surely observe that this extra reporting operational complexity and expense without much corresponding benefit to shareholders.
In many respects, the amendments are merely refreshing a benign disclosure rule that says nothing more than a fund should make investments consistent with the strategy implied by its name. Critics will observe that we should not overstate the significance of a name because a name is hardly the sole source of information for investors to understand a fund’s strategy and risks, though the SEC recognizes that a lot of advertising punch is packed into a name. Most of the debate surely will concern the use of ESG terminology; ironically, the amendments may accomplish what many conservative commentators had hoped: discouraging the use of ESG terminology. And it is unclear what else lies inside pandora’s box. ESG is the flavor of the day, but will the SEC wade into the thicket of faith-based funds? What about thematic names? Obviously, these matters can be addressed in detailed prospectus disclosures. Indeed, that is the very point critics are making.
Comments on the proposal are due within 60 days of publication in the Federal Register, or by August 16, 2022. For more information about this proposal, please visit the SEC’s website at the link below:
ESG Disclosures
The SEC also proposes various amendments to disclosure and reporting forms to promote consistent, comparable information concerning funds’ and advisers’ incorporation of ESG criteria into investing decisions. The proposed changes apply to advisers (including private fund advisers), registered funds, and BDCs. If adopted, the amendments would impose ESG categorization and require funds and advisers to provide specific disclosures in prospectuses, annual reports, and Form ADV. Funds that focus on environmental factors would have to disclose greenhouse gas (GHG) emissions associated with their portfolio investments. “Impact” funds would have to describe the specific impact(s) they seek to achieve and summarize their progress on achieving those goals. There also would be certain proxy voting disclosure requirements. Managers also would need to craft policies and procedures to ensure compliance with their own ESG investment guidelines.
The level of disclosure required would depend on the degree to which ESG factors are part of the fund’s strategy. The proposal identifies three types of ESG funds:
- Integration Funds – These funds include ESG factors among other non-ESG factors in investment decisions and would be required to describe how ESG factors are incorporated into their investment process. This could potentially affect many advisers that consider ESG factors, but where ESG is not dispositive when selecting or excluding investments.
- ESG-Focused Funds (EFFs) – ESG is a significant or principal consideration in selecting investments or in engaging with portfolio companies, which may include ESG screens or engaging via proxy voting or direct engagement. These funds would be required to provide detailed disclosures, including data in a standardized strategy overview table.
- Impact Funds – A subset of EFFs, these seek to achieve a particular ESG impact and thus would be required to disclose how they measures progress on the particular objective both quantitatively and qualitatively with respect to a related time horizon.
Integration Funds would have streamlined disclosure requirements, requiring brief summaries of how the fund incorporates ESG factors into its selection process.” A fund that considers GHG emissions also would have to provide more detailed disclosure concerning its methodology for considering this factor. EFFs, which also include funds with a name implying ESG focus (thus coupling with the Names Rule), would face steeper disclosure burdens. Primarily, EFFs would have to complete an ESG Strategy Overview table in the fund’s prospectus, providing summary information about the strategy and how the fund incorporates ESG factors into investment decisions. The proposal is agnostic about which standards or frameworks may be used, acknowledging that two similar-sounding fund names could result is opposing views about particular investment decisions. (For instance, one company may exclude oil companies as environmentally harmful, while another approach may approve such companies for having good governance practices.) Additional disclosures around proxy voting or engagement with company management also may be required.
The proposal includes a more rigid reporting structure for environmentally-focused EFFs to report GHG emissions. This surely will be among the most controversial aspects of the proposal. The SEC proposes that such funds disclose the “carbon footprint” and “weighted average carbon intensity” of its portfolio, as well as scope 3 emissions (other indirect emissions) consistent with the widely-used “GHG Protocol.” Suffice to say this is a complicated calculation and it would spawn a whole industry of consultants. Funds that do not consider GHG emissions as part of their strategy would be excepted from this requirement. The SEC appears to be aligning itself with European regulators on this score.
Significantly, the ESG proposal is replete with nearly 200 questions for which it seeks public comment. Thus, the proposal reads more like a broad concept release than a hardened view on what the final rule will include. The SEC’s approach seems to contemplate a fair amount of leeway for advisers to choose their own methodology without prescribing any particular scoring or rating system (save for the GHG disclosures). Nevertheless, we anticipate fierce challenges to many features of the proposal, particularly with respect to GHG reporting.
As with the Names Rule, comments on this rule are due by August 16, 2022. For more information about this proposal, please visit the SEC’s website at the link below:
Request for Comment on Requiring Registration for Index Providers, Model Portfolio Providers, and Pricing Services
The SEC issued a request for comment on whether certain “information providers,” specifically index providers, model portfolio providers, and pricing services, should be subject to registration as investment advisers. The SEC posed numerous questions exploring whether these information providers satisfy the definition of “investment adviser” and the implications of requiring registration under both the Advisers Act and the Investment Company Act.
These services have grown in size and influence, and the SEC seeks to ensure oversight and investor protection. To that end, the SEC seeks to better understand when these entities are providing particularized investment advice rather than merely broad-based information. While index and model providers may perform functions that, in some respects, resemble portfolio management, some may wonder why the SEC to chose to include pricing services in the discussion. One theory is that registration would give the SEC a foothold for conducting examinations because, as a practical matter, it is becoming increasingly challenging for advisers to conduct meaningful oversight (as is required, for example, by Rule 2a-5) of the large pricing services that have become so essential to every fund’s pricing. Any new rule will require proper calibration; while aspects of their services would seem to meet the technical definition of an investment adviser, subjecting them to the gauntlet of section 15(c) approvals would be cumbersome and limit the ability to change service providers. Thus, advisers and fund managers may welcome some SEC supervision, but only if it were to lessen the burdens on managers and retain their flexibility.
As with the other new proposals, the SEC imposed a short comment period with comments due by August 16, 2022. For more information about this request for comment, please visit the SEC’s website at the following link:
