SEC Adopts Amendments to Crack Down on Misleading Fund Names and Greenwashing

On September 20, 2023, the SEC adopted final amendments to Rule 35d-1 of the Investment Company Act of 1940 (the “Names Rule”). Under the Names Rule, originally adopted in 2001, funds registered under the Investment Company Act may not use names that are deceptive or inconsistent with their investments. The new amendments expand these requirements to cover more than three-quarters of U.S. registered investment funds. Thus, under the final amendments, funds with names suggesting that they focus on particular characteristics (e.g., names that use terms like “growth” or “value”) or that include terms that reference a thematic investment focus (e.g., terms touting the incorporation of one or more environmental, social, or governance (“ESG”) factors into investment decisions, such as “sustainable,” “green,” or “socially responsible”) will be subject to increased regulation. The amendments to the Names Rule also update notice requirements, establish certain recordkeeping requirements, and require increased disclosure in prospectuses and on Form N-Port.

The goal of the amendments is to enhance truth in advertising, with a particular eye towards combatting “greenwashing,” the practice of claiming that one’s practices, products, or services are more environmentally friendly or sustainable than they really are. The adopting release specifically cautions that the breadth of ESG-related terms in the investment fund space, as well as evolving investor expectations around terms such as “sustainable” or “socially responsible,” have increased the likelihood of investor confusion and compounded the potential for greenwashing in fund names. Commissioner Lizárraga’s statement noted that the amendments aim to provide investors clarity and an enhanced investing experience at a time when increasing popularity of ESG investment products has been accompanied by a “concerning” trend in disclosures that “fail to accurately support the underlying investment mix” (AKA greenwashing). That being said, the final amendments do not include the strict limits on ESG fund names previously proposed: the proposed amendments would have prohibited funds from using ESG terms in their names if they consider non-ESG factors alongside ESG factors when making investment decisions. However, the SEC did state that it would reconsider this issue in later rulemaking that is more narrowly focused on ESG.

The Names Rule amendments are effective for all registered funds, including existing funds, 60 days after publication of the final rule in the Federal Register. All funds falling within the newly expanded scope of the Names Rule, i.e., at least 75% of all U.S. registered investment funds, will need to be in compliance (which could entail changing their names, adopting an 80% policy, etc.) by the following dates depending on their size:¹

• Larger Entities (i.e., funds that have net assets of $1 billion or more as of the most recent fiscal year): 24 months following the amendments’ effective date
• Smaller Entities (i.e., funds that have net assets of less than $1 billion as of the most recent fiscal year): 30 months following the amendments’ effective date

The principal elements of the amendments include:

1. Expansion of Scope

The amendments expand the coverage of the 80% investment policy requirement (“80% rule”) to include fund names with terms suggesting that the fund focuses on investments that have, or investments whose issuers have, particular characteristics, including a name with terms such as “growth,” “value,” or terms that reference a thematic investment focus such as indicating that the fund’s investment decisions incorporate one or more ESG factors. The SEC expressly declined to define the term “particular characteristics” in the adopting release to ensure that the rule remains “evergreen.” That being said, the SEC does provide that it anticipates 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. The 80% rule requires any fund with certain names to adopt a policy to invest at least 80% of the value of the fund’s assets in investments that match the fund’s name. As discussed in our previous V&E Insight on the proposed rules, the 80% rule already applies to names suggesting “guarantee or approval by the United States government,” “investment in certain investments or industries,” “investment in certain countries or geographic regions,” or “[t]ax-exempt” status.

2. Quarterly Review Requirement and Procedures for Temporary Departures from the 80% Rule

The final amendments require a fund subject to the 80% rule to review their portfolio assets’ inclusion in the “80% basket” (investments that are invested in accordance with the fund’s name) at least quarterly. This is a departure from the proposed rule, though the final rule, like the proposed rule, allows for specific time frames (90 days, as opposed to 30 days under the proposed rule) wherein funds may get back into compliance if they depart from the 80% rule as a result of drift or “other-than-normal” circumstances. Finally, while the proposed rule would have allowed funds to depart from their 80% investment policies only under certain specified circumstances, the final amendments stick with the existing Name Rule’s requirements that funds invest in accordance with their policies “under normal circumstances” and for the 80% rule to apply at the time a fund invests its assets.

3. Increased Prospectus Disclosure and Plain English Requirements

The amendments require funds subject to the 80% rule to disclose in their prospectuses the definitions of the terms used in their names, including the criteria that the funds use to select the investments that the term describes. Such funds will also be required to ensure that any terms used in their names that suggest an investment focus or that the funds’ distributions are tax-exempt are consistent with the plain English meaning or established industry use of such terms.

4. Increased Form N-PORT Reporting Requirements

Pursuant to the amendments, funds subject to the 80% rule (excluding money-market funds and business development companies (“BDCs”)) will be required to disclose on their quarterly Form N-Port the definitions of terms used in their names, the value of their 80% baskets, and each investment that is included in the 80% basket. Note that the proposed rule would have required monthly reporting of such definitions.

5. New Recordkeeping Requirements

The final amendments also require funds to maintain written records documenting their compliance with the 80% rule for at least six years following the creation of each record, with the first two years of recordkeeping being in an easily accessible place. The final amendments set out certain detailed requirements for the contents of such records.

6. Modernization of Notice Requirements

The final amendments continue to require that funds provide 60 days’ notice to shareholders of any change in their 80% policies (unless the policy is a “fundamental policy” as defined under the Names Rule). The amendments additionally update the Names Rule’s notice requirement to expressly address funds that use electronic delivery methods to deliver information to shareholders, as well as include new specificity about the delivery and content of such notice.

7. Special Considerations for Funds with Derivative Holdings, Closed-End Funds and BDCs

Pursuant to the amendments, funds with derivatives in their holdings must use the derivatives’ nominal amount, rather than their market value, for the purpose of determining their compliance with the 80% rule (with certain adjustments). Additionally, under the final amendments an unregistered closed-end fund or BDC that is required to adopt an 80% investment policy pursuant to the 80% rule cannot change its policy without a shareholder vote unless (1) the fund conducts a tender or repurchase offer with at least 60 days’ prior notice of the policy change, (2) that offer is not oversubscribed, and (3) the fund purchases shares at their net asset value.

Greenwashing Considerations and Next Steps

While the new amendments speak beyond just ESG and sustainability-related fund names (names including terms such as “growth” or “value” are also explicitly captured by the new requirements), these developments evidence the SEC’s continued focus on ESG-related disclosure and greenwashing. The SEC recognizes the significant demand for ESG-positioned investment products, but acknowledges the substantial risks for misleading customers given the relatively opaque nature of fund portfolio composition to most individuals. Beyond adopting these amendments, the SEC has continued making notable moves in this area. For instance, the Division of Enforcement’s Climate and ESG Task Force settled a number of high profile actions against financial institutions for ESG-related concerns in 2022 and it has been reported that the SEC’s Enforcement Division has sent numerous document requests, including subpoenas, to multiple asset managers regarding ESG marketing disclosure this year. This is in line with the SEC’s 2023 Examination Priorities, which provided that ESG investing is a notable new and significant focus area, and that the division would “continue its focus on ESG-related advisory services and fund offerings, including whether funds are operating in the manner set forth in their disclosures.” And, of course, the SEC has signaled that its long-awaited rules on climate-related disclosure will be finalized this fall.

In light of these developments, funds should closely review their names and the new amendments to determine whether compliance will be required. Funds and other SEC-regulated entities should also ensure that their sustainability-related disclosure is specific and accurate given the SEC’s continued focus on, as well as other emerging risks concerning greenwashing. Please contact the V&E Team to discuss these developments and their potential effects on your business.

¹ For purposes of determining whether a fund is a Larger Entity or a Smaller Entity, the assets of the fund are pooled with other investment companies in the same “group of related investment companies” as defined by Rule 0-10 of the Investment Company Act.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.