# Conformed to Federal Register Version > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Asec%3A5c9389ee6ee787ce ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text Conformed to Federal Register Version SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 230, 232, 239, 270 and 274 [Release No. 33-11067; 34-94981; IC-34593; File No. S7-16-22] RIN: 3235-AM72 Investment Company Names AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. SUMMARY: The Securities and Exchange Commission (the “Commission”) is proposing to amend the rule under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”) that addresses certain broad categories of investment company names that are likely to mislead investors about an investment company’s investments and risks. The proposed amendments to this rule are designed to increase investor protection by improving and clarifying the requirement for certain funds to adopt a policy to invest at least 80% of their assets in accordance with the investment focus that the fund’s name suggests, updating the rule’s notice requirements, and establishing recordkeeping requirements. The Commission also is proposing enhanced prospectus disclosure requirements for terminology used in fund names, and additional requirements for funds to report information on Form N-PORT regarding compliance with the proposed names-related regulatory requirements. DATES: Comments should be received on or before August 16, 2022. ADDRESSES: Comments may be submitted by any of the following methods: Electronic Comments: 1 • Use the Commission’s Internet comment form (https://www.sec.gov/rules/submitcomments.htm); or • Send an email to rule-comments@sec.gov. Please include File Number S7-16-22 on the subject line; Paper Comments: • Send paper comments to Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090. All submissions should refer to File Number S7-16-22. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s website (http://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and printing in the Commission’s Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Operating conditions may limit access to the Commission’s public reference room. All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly. Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission’s website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at www.sec.gov to receive notifications by email. 2 FOR FURTHER INFORMATION CONTACT: Pamela Ellis, Mykaila DeLesDernier, Bradley Gude, Senior Counsels; Amanda Hollander Wagner, Branch Chief; or Brian McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation Office, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-8549. SUPPLEMENTARY INFORMATION: The Commission is proposing for public comment: amendments to 17 CFR 270.35d-1 (“rule 35d-1”) under the Investment Company Act; amendments to Form N-1A [referenced in 17 CFR 239.15A and 17 CFR 274.11A], Form N-2 [referenced in 17 CFR 239.13 and 17 CFR 274.11a-1], Form N-8B-2 [referenced in 17 CFR 274.12], and Form S-6 [referenced in 17 CFR 239.16] under the Investment Company Act and the Securities Act of 1933 (“Securities Act”) [15 U.S.C. 77a et seq.]; amendments to Form NPORT [referenced in 17 CFR 274.150] under the Investment Company Act; amendments to 17 CFR 232.11 (“rule 11 of Regulation S-T”) and 17 CFR 232.405 (“rule 405 of Regulation S-T”) under the Securities Exchange Act of 1934 (“Exchange Act”) [15 U.S.C. 78a et seq.]; amendments to 17 CFR 230.485 (“rule 485”) under the Securities Act; and amendments to 17 CFR 230.497 (“rule 497”) under the Securities Act. TABLE OF CONTENTS INTRODUCTION AND BACKGROUND........................................................................ 5 A. Overview of Section 35(d) of the Act and the Names Rule .................................................. 8 B. Challenges Regarding Application of the Names Rule and Need for Modernization ......... 11 C. Overview of Rule Proposal .................................................................................................. 16 II. DISCUSSION ..................................................................................................................... 19 A. 80% Investment Policy Requirement................................................................................... 19 1. Names Suggesting an Investment Focus ......................................................................... 19 I. 2. Temporary Departures from the 80% Investment Requirement ..................................... 33 3. Considerations Regarding Derivatives in Assessing Names Rule Compliance .............. 48 4. Unlisted Closed-End Funds and BDCs ........................................................................... 65 5. Effect of Compliance with an 80% Investment Policy ................................................... 69 3 B. Prospectus Disclosure Defining Terms Used in Fund Name............................................... 72 C. Plain English/Established Industry Use Requirement ......................................................... 78 D. Materially Deceptive and Misleading Use of ESG Terminology in Certain Fund Names .. 81 E. Modernizing the Rule’s Notice Requirement ...................................................................... 86 F. N-PORT Reports .................................................................................................................. 95 1. Investment Company Act Names Rule Investment Policy ............................................. 95 2. Investments to Be Included in a Fund’s 80% Basket .................................................... 100 G. Recordkeeping ................................................................................................................... 102 1. Funds Required to Adopt an 80% Investment Policy ................................................... 103 2. Funds That Do Not Adopt an 80% Investment Policy .................................................. 106 H. Unit Investment Trusts ....................................................................................................... 108 I. Transition Period and Compliance Date ............................................................................ 111 III. ECONOMIC ANALYSIS ............................................................................................... 113 A. Introduction ........................................................................................................................ 113 B. Broad Economic Considerations........................................................................................ 114 C. Economic Baseline............................................................................................................. 117 1. Fund Industry Overview ................................................................................................ 117 D. Benefits, Costs, and Effects on Efficiency, Competition and Capital Formation.............. 121 1. Benefits .......................................................................................................................... 122 2. Costs .............................................................................................................................. 133 E. Reasonable Alternatives Considered ................................................................................. 147 1. Returns-Based Requirement .......................................................................................... 147 2. Permit the Use of Derivatives’ Notional Values for Purposes of Names Rule Compliance 148 3. Modify Requirements for Tagging Prospectus Disclosure ........................................... 149 4. Board Approval or Notification of Temporary Departures ........................................... 150 5. Require a Higher Percentage of Assets Invested in Accordance with the Investment Focus ............................................................................................................................. 151 6. Unlisted Closed-End Funds and BDCs ......................................................................... 152 F. General Request for Comment........................................................................................... 153 IV. PAPERWORK REDUCTION ACT ANALYSIS ......................................................... 155 A. Introduction ........................................................................................................................ 155 B. Rule 35d-1 .......................................................................................................................... 156 C. Prospectus Disclosure ........................................................................................................ 159 1. Form N-1A .................................................................................................................... 160 2. Form N-2 ....................................................................................................................... 161 3. Form N-8B-2 ................................................................................................................. 161 4. Form S-6 ........................................................................................................................ 162 D. N-PORT Reporting Requirements ..................................................................................... 163 4 E. Investment Company Interactive Data............................................................................... 164 F. Request for Comments ....................................................................................................... 167 V. INITIAL REGULATORY FLEXIBILITY ANALYSIS.............................................. 168 A. Reasons for and Objectives of the Proposed Actions ........................................................ 169 B. Legal Basis ......................................................................................................................... 169 C. Small Entities Subject to Proposed Rule Amendments ..................................................... 170 D. Projected Reporting, Recordkeeping, and Other Compliance Requirements .................... 170 1. 80% Investment Policy Requirements – Proposed Scope Expansion and Other Proposed Amendments .................................................................................................................. 172 2. Effect of Compliance with an 80% Investment Policy ................................................. 173 3. Recordkeeping Requirements........................................................................................ 174 4. Disclosure and Reporting Requirements ....................................................................... 175 5. Materially Deceptive and Misleading Use of ESG Terminology in Certain Fund Names 177 6. Exceptions for Certain UITs.......................................................................................... 179 E. Duplicative, Overlapping, or Conflicting Federal Rules ................................................... 179 F. Significant Alternatives ..................................................................................................... 180 G. Request for Comment ........................................................................................................ 183 VI. CONSIDERATION OF IMPACT ON THE ECONOMY ........................................... 183 VII. STATUTORY AUTHORITY ......................................................................................... 184 I. INTRODUCTION AND BACKGROUND The name of a registered investment company or business development company (“BDC”) is a means of communicating information about the fund to investors and is also an important marketing tool for the fund. 1 While the Commission has often cautioned against investors relying on a fund’s name as the sole source of information about the fund’s investments and risks, it has also recognized that the name of a fund may communicate a great deal to an investor. 2 A fund’s name is often the first piece of fund information investors see and, while 1 This release refers to registered investment companies and BDCs collectively as “funds.” 2 See Investment Company Names, Investment Company Act Release No. 24828 (Jan. 17, 2001) [66 FR 8509 (Feb. 1, 2001)] (“Names Rule Adopting Release”); see also Request for Comments on Fund Names, Investment Company Act Release No. 33809 (Mar. 2, 2020) [85 FR 13221 5 investors should go beyond the name itself and look closely at a fund’s underlying disclosures, a fund’s name can have a significant impact on their investment decisions. These considerations provided the policy basis underlying the Commission’s adoption of rule 35d-1 under the Act, the “names rule,” in 2001. 3 Congress provided the Commission with rulemaking authority to address materially deceptive or misleading fund names, recognizing the concern that investors may rely inordinately on a fund’s name to determine its investments and risks. 4 The names rule, in turn, helps ensure that a fund’s name does not misrepresent the fund’s investments and risks. Consequently, the rule helps to ensure that investors’ assets in funds are invested in accordance with their reasonable expectations based on the fund’s name. 5 The role of this rule remains important and distinct from other disclosure requirements, in that fund names are subject to the unique practical constraint of being concise by necessity, but still convey significant information (Mar. 6, 2020)] (“2020 Request for Comment”), at n.11 and accompanying text. The comment letters on the 2020 Request for Comment (File No. S7-04-20) are available at https://www.sec.gov/comments/s7-04-20/s70420.htm. All references to comment letters in this release are available in this comment file. 3 Names Rule Adopting Release, supra footnote 2. 4 See id. at n.3 and accompanying text (“In amending section 35(d), Congress reaffirmed its concern that investors may focus on an investment company’s name to determine the company’s investments and risks, and recognized that investor protection would be improved by giving the Commission rulemaking authority to address potentially misleading investment company names.”). 5 See id. at text preceding n.48; see also, e.g., Comment Letter of the CFA Institute (May 5, 2020) (“CFA Institute Comment Letter”); Comment Letter of Chris Barnard (Mar. 9, 2020) (“Barnard Comment Letter”); Comment Letter of the University of Miami School of Law Investor Rights Clinic (Apr. 27, 2020) (“IRC Comment Letter”). But see ICI Comment Letter I (emphasizing that the Commission noted when it adopted the names rule that investors should not rely on a fund’s name as the sole source of information about that fund). 6 to an investor. However, as the fund industry has developed, and practices regarding names rule compliance have continued to evolve over the past two decades, we believe that improvements to the names rule are appropriate for the rule to continue to meet this purpose. 6 For example, interpretive issues as to when a fund is subject to the names rule have raised questions about the rule’s application with respect to particular fund names that could mislead investors about the fund’s investment focus, such as when a fund’s name suggests investment in companies that meet certain environmental, social, or governance (“ESG”) criteria. Competitive market pressures create incentives for asset managers to include terminology in their funds’ names designed to attract investor assets. We believe it is critical that fund names that suggest certain information about a fund’s investments and attendant risks do so accurately. Under certain circumstances, the current structure of the rule also may permit funds to depart from the investment focus suggested by their name over time, which can deprive investors of the protections of the rule. The rule also is not currently well-suited to address ways in which the fund industry has evolved since its adoption, both in terms of funds’ increasing use of derivatives to further their investment strategies and investors’ increasing election for the electronic delivery of fund 6 See Comment Letter of Allianz Global Investors U.S. Holdings LLC (May 27, 2020) (“AllianzGI Comment Letter”); see also Comment Letter of the Consumer Federation of America (May 12, 2020) (“CFA Comment Letter”) (arguing that funds “clearly understand both how important fund names can be in communicating and advertising to investors and that fund names can influence investor decisions,” and, as a result, funds “are very careful to choose names that are appealing to investors”). 7 documents, such as prospectuses and shareholder reports. We are proposing to amend the names rule to address these and other concerns. A. Overview of Section 35(d) of the Act and the Names Rule Section 35(d) of the Act prohibits a registered investment company from adopting as part of its name or title any word or words that the Commission finds are materially deceptive or misleading. 7 This section of the Act further authorizes the Commission to define such names or titles as are materially deceptive or misleading. Congress adopted this provision due to concerns that investors may focus on an investment company’s name to determine the company’s investment objectives and level of risk, and recognized that investor protection would be improved by giving the Commission rulemaking authority to address potentially misleading fund names. 8 The names rule generally requires that if a fund’s name suggests a focus in a particular type of investment (e.g., ABC Stock Fund, the XYZ Bond Fund, or the QRS U.S. Government Fund), or in investments in a particular industry (e.g., the ABC Utilities Fund or the XYZ Health Care Fund), or geographic focus (e.g., the ABC Japan Fund or XYZ Latin America Fund), 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 7 15 U.S.C. 80a-34(d). BDCs, which are not registered investment companies, are subject to the requirements of section 35(d) pursuant to section 59 of the Act [15 U.S.C. 80a-58]. 8 See S. Rep. No. 293, 104th Cong., 2d Sess. 8-9 (1996). 8 name. 9 The names rule imposes a similar 80% investment policy requirement for funds that have names suggesting that a fund’s distributions are exempt from federal income tax or from both federal and state income tax (“tax-exempt funds”). 10 Under the rule, a fund may generally 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 notice at least 60 days prior to any change in the 80% investment policy. 11 However, an 80% investment policy relating to a taxexempt fund name must be a fundamental policy. Further, unit investment trusts (“UITs”) that have made their initial deposit prior to July 31, 2002 are not required to comply with the rule’s requirements to adopt an 80% investment policy. 12 Under the rule, a fund is required to invest in accordance with its 80% investment policy “under normal circumstances.” In addition, the rule provides that a fund must apply its 80% investment policy at the time the fund invests its assets. If, subsequent to an investment, the 9 “Assets” is currently defined in the names rule as net assets, plus the amount of any borrowings for investment purposes; see also section 2(a)(41) of the Act [15 U.S.C 80a-2(a)(41)] (defining “value”). 10 Such a fund must adopt a fundamental policy: (1) to invest at least 80% of the value of its assets in investments whose income is exempt from federal income tax or from both federal and state income tax, or (2) to invest its assets so that at least 80% of the income that it distributes will be exempt from federal income tax or from both federal and state income tax. 11 Under the Act, a fund may not depart from a fundamental policy unless it has been authorized by the vote of a majority of its outstanding shareholders. 15 U.S.C. 80a-13(a)(3). In this release, we refer to a policy that a fund must currently adopt under the names rule as an “80% investment policy” and the fund’s investments invested in accordance with this policy, the fund’s “80% basket.” We are proposing a parallel definition of “80% basket” in the proposed amendments to the names rule, and when referring to the proposed rule, references to a fund’s “80% basket” refer to the proposed definition of this term. See proposed rule 35d-1(g)(1). 12 July 31, 2002 was the compliance date of the rule. See Names Rule Adopting Release, supra footnote 2. Based upon a review of Morningstar data as of October 2021, 222 currently-active UIT series were formed before this date. 9 fund’s assets are no longer invested in accordance with the policy, the fund’s future investments must be made in a manner that will bring it into compliance. The rule also includes certain requirements for the notices that funds must send prior to a change in an 80% investment policy that is not a fundamental policy. These notices are required to be provided in plain English in a separate written document. A fund must also include a prominent statement reading “Important Notice Regarding Change in Investment Policy,” or a similar clear and understandable statement, in bold-face type. In adopting the names rule, the Commission made clear that it is not intended to be a safe harbor for materially deceptive or misleading names. 13 The prohibitions of section 35(d) and, indeed, the anti-fraud provisions of the federal securities laws regarding disclosures to investors, continue to apply to funds notwithstanding their compliance with the names rule. 14 A name that would lead a reasonable investor to conclude that the fund invests in a manner that is inconsistent with the fund’s actual or intended investments or the risks of those investments would be 13 See Names Rule Adopting Release, supra footnote 2, at n.16 and accompanying text. 14 See, e.g., 15 U.S.C. 77q(a) and 17 CFR 240.10b-5(b) (prohibiting making untrue statements of material fact or making material omissions to obtain money or property in the offer or sale of securities or in connection with the purchase or sale of a security); 17 CFR 230.156 (prohibiting sales literature that is materially misleading in connection with the offer or sale of securities issued by an investment company); and 17 CFR 275.206(4)-8 (prohibiting investment advisers to pooled investment vehicles from making untrue statements of material fact or making material omissions to an investor or prospective investor in the pooled investment vehicle); see also In re Ambassador Capital Management, LLC, and Derek H. Oglesby, Initial Decision Rel. No. 672 (Sep. 19, 2014) (made final in Investment Company Act Release No. 31371 (Dec. 11, 2014)) (determining an adviser caused violations by a fund of sections 34(b) and 35(d) of the Act by causing violations of 17 CFR 270.2a-7 while still holding the fund out as a money market fund); Names Rule Adopting Release, supra footnote 2, at n.44 and accompanying text. 10 deceptive or misleading even if the fund is in compliance with its 80% investment policy. 15 In addition, a fund must adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the federal securities laws generally, which would include section 35(d) and the names rule. 16 Fund compliance officers are required to include a discussion of any material compliance matter involving the names rule in their required annual reports to the board addressing the operation of funds’ compliance policies and procedures. 17 B. Challenges Regarding Application of the Names Rule and Need for Modernization The names rule has not been amended following its adoption in 2001, and since that time, the staff, members of the fund industry, and investor advocacy groups have identified a number of challenges regarding the application of the names rule that could have investor protection implications. The Commission published a Request for Comment on Fund Names in March 2020, which sought public comment on the framework for addressing funds’ names, particularly in light of market and other developments since the rule’s adoption. 18 15 Names Rule Adopting Release, supra footnote 2, at nn.16 and 44 and accompanying text; see also In the Matter of the Private Investment Fund for Governmental Personnel, Inc., Investment Company Act Release No. 2474 (Jan. 18, 1957) (“[The Commission] must take into account the effect which the name may have not only on the sophisticated and informed investor, but also on the unwary and the ignorant.... Actual deception of investors need not be shown; it is sufficient that the name of the company or its securities be found to have a tendency or capacity to deceive or mislead. Nor is it necessary that we sample public opinion to determine what the name in question may mean to investors...”). 16 See 17 CFR 270.38a-1 (“rule 38a-1”). 17 See rule 38a-1(a)(4)(iii). 18 2020 Request for Comment, supra footnote 2. 11 Commenters generally agreed that a fund’s name is an important piece of information that investors use to select a fund, and that asset managers give considerable thought to the fund names that they choose in light of their goals in communicating to investors. 19 They also agreed that the names rule provides important investor protections and stated that it has been largely effective in regulating misleading and deceptive fund names, but some commenters suggested further improvements. 20 Some provided context as to just how much the investment management industry has changed in the twenty years since the names rule was adopted and suggested updates may be appropriate. For example, commenters stated that registered investment companies manage considerably more assets than they did in 2001 ($22.8 trillion total net assets as of March 2020 compared to $7.2 trillion in 2001) and that the variety of fund types and fund strategies has increased since 2001, with exchange-traded funds (“ETFs”) and funds of funds having grown since then and funds such as emerging market, international, and alternative strategy funds having attracted substantial amounts of investment. 21 The Commission staff have 19 See, e.g., Comment Letter of Aaron Cantrell, Head of Economic Research, Record Currency Management and Isabel Estevez, PhD Candidate, University of Cambridge (May 5, 2020) (“Cantrell and Estevez Comment Letter”); CFA Comment Letter; ICI Comment Letter I; AllianzGI Comment Letter. 20 See, e.g., Comment Letter of Invesco Ltd. (May 5, 2020) (“Invesco Comment Letter”); Comment Letter of the Public Investors Advocate Bar Association (Apr. 15, 2020) (“PIABA Comment Letter”); CFA Institute Comment Letter. 21 See ICI Comment Letter I; see also SIFMA AMG Comment Letter (stating that there have been significant evolution and innovation in the asset management industry since 2001); Comment Letter of T. Rowe Price (May 21, 2020) (“T. Rowe Price Comment Letter”) (stating that since the adoption of the names rule, funds have “expanded their strategies, increased the use of derivatives and new types of financial instruments, and expanded the diversity of products available to investors”); and Comment Letter of State Street Global Advisors (May 5, 2020) (“SSGA Comment Letter”) (“[t]he investment management industry has changed considerably since the Names Rule was adopted in 2001”). 12 also observed an increase in filings by funds with investment focuses in ESG or “thematic” areas such as cybersecurity, blockchain, and artificial intelligence. Further, as highlighted in the 2020 Request for Comment, since the Commission adopted the names rule there has been significant growth in “passive management” funds that seek to replicate the return on a particular index. 22 The current scope of the rule has created interpretive issues. The Commission has previously taken the position that fund names that incorporate terms such as “growth” and “value” connote an investment objective, strategy, or policy (i.e., “investment strategies”) and are therefore not within the scope of the 80% investment policy requirement. 23 This has resulted in some fund names being excluded from this requirement because the name contains a term suggesting an investment strategy, even if the name also suggests an investment focus to investors. Certain funds with names that may raise the same types of concerns as those that the rule’s current scope directly addresses may therefore not have adopted an 80% investment policy. The potential investor protection issues that these interpretive scoping considerations raise are particularly evident in the treatment of funds with names that suggest an investment focus in companies that meet certain ESG standards. Investors may reasonably expect funds with 22 2020 Request for Comment, supra footnote 2, at n.22; see also Investment Company Institute, 2021 Fact Book: A Review of Trends and Activities in the Investment Company Industry, at 4849, available at https://www.ici.org/system/files/2021-05/2021_factbook.pdf (“2021 ICI Fact Book”) (stating that at the end of 2020, index mutual funds and index ETFs together had $9.9 trillion in total net assets and accounted for 40% of assets in long-term funds, as compared to 19% at the end of 2010). 23 Names Rule Adopting Release, supra footnote 2, at n.43 and accompanying text. (“In addition, the rule does not apply to fund names that incorporate terms such as “growth” and “value” that connote types of investment strategies as opposed to types of investments.”) 13 these names to invest in companies with policies, practices, or characteristics that are consistent with these standards, particularly when the fund’s name contains the term “ESG” or similar terminology (such as “sustainable,” “green,” or “socially responsible”). 24 As discussed in more detail below, this type of terminology may be particularly powerful in fund names, as funds can attract significant interest and stand out to investors by using these terms in their names. 25 The proposed amendments to the names rule would address fund names with ESG and similar terminology by providing that funds whose names include these terms are subject to the rule’s 80% investment policy requirement, and by defining certain uses of ESG terminology in fund names as materially deceptive and misleading. This would help to prevent potential “greenwashing” in fund names by requiring a fund’s investment activity to support the investment focus its name communicates so that investors will not be deceived or misled by the fund’s name. Interpretive positions taken by funds that these kinds of names are not subject to the rule have resulted in investors in these funds not receiving these protections. The 2020 Request for Comment also asked questions exploring whether the names rule is as effective as it could be at addressing changes to funds’ portfolios over time, for example by asking whether compliance with the rule’s 80% investment policy requirements should continue to be determined as of the time of investment, as opposed to a fund maintaining the required level of investment at all times. A fund in some circumstances can drift away over time from the 24 See Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, Investment Company Act Release No. 34594 (May 25, 2022) (“ESG Proposing Release”), published elsewhere in this issue of the Federal Register. 25 See infra footnote 124 and accompanying text. 14 type of investment focus that the fund’s name suggests. 26 The current names rule may not be as effective as it could be at addressing changes in funds over time, both due to possible “drift” and the current rule’s allowing a fund to comply with its 80% investment policy only under “normal circumstances.” The 2020 Request for Comment also raised the issue that, in the years following the names rule’s adoption in 2001, funds have increasingly used derivatives and other financial instruments to execute their strategies. 27 The Commission has interpreted the names rule to permit funds to include synthetic instruments, such as derivatives, in the fund’s 80% basket if the instrument has economic characteristics similar to the securities included in the 80% basket. 28 However, the Commission has not specifically addressed how to include a derivatives instrument in that calculation. This, in turn, may have implications for whether a fund’s name accurately reflects the economic reality of the fund’s sources of returns and risk. Lastly, the rule’s requirements for delivering notices of changes to a fund’s investment policy are worded in a way that could suggest that funds must deliver these notices in paper. For 26 This drift, however, currently may be limited in that any future investment must be made in a manner that will bring the fund into compliance with the 80% investment requirement. See rule 35d-1(b). 27 See 2020 Request for Comment, supra footnote 2, at 7-8; see also, e.g., Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Release No. 33704 (Nov. 25, 2019) [85 FR 446 (Jan. 24, 2020)] and Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 34084 (Nov. 2, 2020) [85 FR 83162 (Dec. 21, 2020)] (“Derivatives Rule Adopting Release”). 28 Names Rule Adopting Release, supra footnote 2, at section II.A.1. 15 example, the rule includes requirements on the envelope in which the notice is delivered. A number of commenters raised this issue given many investors have elected to receive fund materials electronically, stating that the rule should provide funds with more flexibility on delivery method. 29 We believe that we could provide greater specificity about the application of the notice requirement to investors who have elected electronic delivery. 30 C. Overview of Rule Proposal After consideration of these issues, we are proposing amendments to the names rule to modernize and enhance the investor protections that it currently provides. • Expansion of Scope. We are proposing to expand the rule’s 80% investment policy requirement beyond its current scope, to apply to any fund name with terms suggesting that the fund focuses in investments that have, or investments whose issuers have, particular characteristics. This would include, for example, fund names with terms indicating that the fund’s investment decisions incorporate one or more ESG factors. • Changes Over Time and Temporary Departures from a Fund’s 80% Investment Policy. To address concerns as to whether the rule effectively addresses changes to fund names and portfolios over time and about when a fund must be in compliance with its 80% investment policy, we are proposing amendments to the current requirement that a fund’s policy apply at the time of investment, and “under normal circumstances.” Instead, the proposed amendments specify the particular 29 See, e.g., Fidelity Comment Letter; Invesco Comment Letter; ICI Comment Letter I. 30 See infra footnote 136. 16 circumstances under which a fund may depart from its 80% investment policy, including specific time frames for getting back into compliance. • Derivatives. To address the rule’s application to derivatives investments, we are proposing to amend it to require funds to use a derivatives instrument’s notional amount, rather than its market value, for the purpose of determining the fund’s compliance with its 80% investment policy. Also, we are proposing to amend the names rule to address the derivatives instruments that a fund may include in its 80% basket. • Unlisted Closed-End Funds and BDCs. We are proposing to require that a registered closed-end fund or BDC, whose shares are not listed on a national securities exchange and that is required to adopt an 80% investment policy, must make its 80% investment policy a fundamental policy in all cases. As a result, these funds would not be permitted to change their 80% investment policies without a shareholder vote. This proposed amendment is meant to address investor protection concerns regarding funds that can change their 80% investment policies without shareholders having the ability to vote on the change or readily exit the fund. • Enhanced Prospectus Disclosure. We also are proposing amendments to funds’ prospectus disclosure requirements that would require a fund to define the terms used in its name, including the criteria the fund uses to select the investments that the term describes. • Plain English Requirements for Terms Used in Fund Names. We are proposing effectively to require that any terms used in the fund’s name that suggest either an 17 investment focus, or that the fund is a tax-exempt fund, must be consistent with those terms’ plain English meaning or established industry use. • Materially Deceptive and Misleading Use of ESG Terminology. The use of ESG or similar terminology in a fund’s name would deceive and mislead investors where the identified ESG factors do not play a central role in the fund’s strategy. Accordingly, we would define the names of “integration funds” as materially deceptive or misleading if the name indicates that the fund’s investment decisions incorporate one or more ESG factors. For purposes of this release, an integration fund is a fund that considers one or more ESG factors alongside other, non-ESG factors in its investment decisions, but such 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. • Modernization of Notice Requirement. We are further proposing to update the names rule’s notice requirement to expressly address funds that use electronic delivery methods to provide information to their shareholders. The proposed amendments also would require notices to describe not only a change in the fund’s 80% investment policy, but also a change to the fund’s name that accompanies the investment policy change. • Form N-PORT Reporting Requirements. We are proposing amendments to Form NPORT to require greater transparency on how fund investment selection methods match the investment focus that the fund’s name suggests. These proposed amendments would include a new reporting item regarding a fund’s names rule compliance. They also would include a new reporting item requiring a fund subject to 18 the 80% investment policy requirement to indicate, with respect to each portfolio investment, whether the investment is included in the fund’s 80% basket. • Recordkeeping. The proposed amendments would require funds that must adopt an 80% investment policy to adhere to recordkeeping requirements that are designed to provide the Commission and staff, as well as the fund’s compliance personnel, the ability to evaluate the fund’s compliance with the rule’s requirements. Funds that do not adopt an 80% investment policy would be required to maintain a written record of their analysis that such a policy is not required under the names rule. II. DISCUSSION A. 80% Investment Policy Requirement 1. Names Suggesting an Investment Focus We are proposing to broaden the scope of the names rule’s current 80% investment policy requirement also to apply to fund names that include terms suggesting that the fund focuses in investments that have, or whose issuers have, particular characteristics. 31 The proposed amendments provide as examples fund names with terms such as “growth” or “value,” or terms indicating that the fund’s investment decisions incorporate one or more ESG factors. 32 This would be in addition to fund names that currently require an 80% investment policy, which 31 We are also proposing to add BDCs to the definition of “fund” in the rule. See proposed rule 35d1(g)(5) (defining “fund”). 32 Proposed rule 35d-1(a)(2). The term “ESG” encompasses terms such as “socially responsible investing,” “sustainable,” “green,” “ethical,” “impact,” or “good governance” to the extent they describe environmental, social, and/or governance factors that may be considered when making an investment decision. 19 are funds whose names suggest a focus in a particular type of investments or industry, or in particular countries or geographic regions, or those that suggest certain tax treatment. This scope expansion is designed to help ensure that fund names that communicate to investors that the fund focuses its investments in a particular way are addressed by the rule. The names rule is designed to ensure that a fund’s investment activity supports the investment focus its name communicates and, thus, the investor expectations the name creates. 33 The proposed scope expansion recognizes that even where a fund’s name could be construed as referring to an investment strategy, it nevertheless can also connote an investment focus, and we believe this connotation is likely to be materially deceptive and misleading unless supported by an 80% investment policy. 34 That is, 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. 35 Further, as we note below, academic research indicates that a 33 As used in this release, consistent with proposed rule 35d-1(a)(2), “investment focus” means 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. As discussed in more detail below, under the proposed amendments, where a fund’s name suggests an investment focus that has multiple elements, the fund’s 80% investment policy must address each element. 34 See supra paragraph accompanying footnote 23. 35 Distinguishing whether a term connotes a “strategy” versus a “type of investment” can be a subjective determination, prone to second guessing, and the categories of “strategy” versus “type of investments” are not mutually exclusive. Interpretive questions caused by these issues draw Commission resources to address. For example, the Division of Investment Management’s Disclosure Review and Accounting Office staff spends a significant amount of time and attention on names rule compliance issues. We also believe that the proposal would address concerns raised by commenters regarding inconsistent treatment across funds in interpreting “strategy” by expanding the rule’s coverage, rendering moot the need to determine whether a fund name describes a type of investment versus an investment strategy. See, e.g., SIFMA AMG Comment Letter; T. Rowe Price Comment Letter. 20 significant number of funds follow an investment strategy that does not align with the investment strategy identified in the fund’s name and, thus, we believe that the proposed scope expansion would better define and help prevent materially deceptive and misleading fund names in light of the investor protection concerns that this practice raises. 36 Investors’ expectations as to the composition of a fund’s portfolio can result even when investment-focus-suggesting terms used in a fund’s name may have more than one reasonable definition. For example, terms like “green” or “sustainable” may be more subjective than a term like “large cap equity” and thus not always viewed as referring to a “type” of investment. But these terms still communicate to investors that the fund will concentrate in investments that the fund considers “green” or “sustainable.” Current fund practices are mixed on how funds understand the scope of the names rule, in that some funds consider certain terminology in their names to require an 80% investment policy under the rule, while others do not. 37 Some commenters responding to the 2020 Request for Comment supported an approach similar to our proposal. 38 Some of these commenters asserted that many investors often rely on fund names, rather than disclosures such as those concerning the fund’s objective, strategies, and risks, when making an investment decision and that fund managers purposefully adopt names designed to draw interest in their fund. 39 Some also stated that funds with certain names not currently required to adopt an 80% investment policy can often connote an investment focus to 36 See infra footnote 165 and accompanying text. 37 See ICI Comment Letter I. 38 See, e.g., Crowley Comment Letter; Silver Comment Letter; CFA Comment Letter. 39 See IRC Comment Letter; Silver Comment Letter; CFA Comment Letter. 21 investors and, therefore, can have the effect of misleading or deceiving investors. 40 Commenters similarly said the inclusion of “buzzwords” in funds’ names can “give the illusion of safety or preservation of capital as objectives.” 41 One commenter also stated that investors do not make a distinction between “strategies” and “types of investments” when making an investment decision and, instead, will assume that the fund will invest in the ways suggested by the name. 42 Other commenters objected to any expansion of the rule to require an 80% investment policy for fund names that suggest an investment strategy. 43 These commenters’ concerns generally centered around perceived complexity and subjectivity in determining what assets are appropriate for the 80% basket. Specifically, these commenters argued that investment strategies are too subjective to be quantifiably measured in an asset-based test like the 80% investment policy requirement and that there can often be many investment methods to achieve the same strategy. 44 A number of commenters raised these points specifically in discussing an approach 40 See PIABA Comment Letter (“PIABA contends that the Names Rule should apply to the investment strategy of a fund, particularly where the investment strategy entails a high degree of risk. The terms “growth” and “value” should not [be] used to mislead investors as to aggressive, high risk funds.”); CFA Comment Letter; see also CFA Institute Comment Letter (stating that the rule is limited in its effectiveness but that it should not be expanded to cover strategies). 41 See Silver Comment Letter; see also PIABA Comment Letter (discussing funds—registered funds as well as hedge funds—that have been marketed using language such as “high-grade” although the funds employ risky (including leveraged) investment strategies); CFA Comment Letter. 42 See CFA Institute Comment Letter. 43 See, e.g., SIFMA AMG Comment Letter; Comment Letter of Capital Research and Management Company (May 5, 2020) (“Capital Group Comment Letter”); ICI Comment Letter I. But see, e.g., CFA Comment Letter; Practus Comment Letter; PIABA Comment Letter; MSCI Comment Letter (arguing that names suggesting strategies should be subject to the 80% investment policy requirement). 44 See, e.g., Nia Impact Capital Comment Letter (stating that the terms “sustainable” and “ESG” are “still quite subjective in nature”); SIFMA AMG Comment Letter; T. Rowe Price Comment 22 that would require funds with ESG terminology in their names to adopt an 80% investment policy. 45 Some commenters also stated that application of the 80% investment policy requirement to a strategy could lead to standardization in funds’ investment portfolios that is not market-driven and limit fund flexibility to change strategies in response to market changes or events. 46 For these reasons, a number of commenters suggested that fund disclosure would be a more appropriate tool for investors to educate themselves about the strategy better, rather than requiring funds whose names describe a strategy to adopt an 80% investment policy. 47 As discussed above, we believe that fund names included in the proposed expanded scope—such as names with terms like “growth,” “value,” or “sustainable” where a fund may not have adopted an 80% investment policy under the current rule—communicate to investors that the fund will concentrate in investments that the fund believes have those particular characteristics. The proposed amendment also would apply to other fund names that historically may have not required an 80% investment policy (depending on the context), such as names that Letter; see also CFA Comment Letter (arguing that while the rule should apply to strategies, a different approach than an 80% investment policy should be taken). 45 See, e.g., Cantrell & Estevez Comment Letter; Credit Suisse Comment Letter; Invesco Comment Letter. Some commenters also recommended avoiding prescriptive definitions of terms like “ESG” and sustainable.” See, e.g., BlackRock Comment Letter; Cantrell & Estevez Comment Letter; Ceres Comment Letter. But see, e.g., Beirbaum Comment Letter; Global Affairs Associates Comment Letter; Janain Comment Letter (each maintaining that funds that include ESG terms or similar terminology in their names should be subject to the requirement to adopt an 80% investment policy). 46 See Capital Group Comment Letter; ICI Comment Letter I; Invesco Comment Letter; SIFMA AMG Comment Letter. 47 See SIFMA AMG Comment Letter; Capital Group Comment Letter; T. Rowe Price Comment Letter. 23 include terms like “global,” “international,” “income,” or “intermediate term (or similar) bond.” 48 Conversely, 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 under the proposal. For example, these would include names that reference characteristics of a fund’s portfolio as a whole, or that reference elements of an investment thesis without specificity as to the particular characteristics of the component portfolio investments. We do not believe that such names suggest that the fund focuses its investments in any of the ways covered under the proposed expanded scope, though such names would continue to be subject to section 35(d)’s prohibition on materially misleading or deceptive names, and funds with these names would continue to be subject to the anti-fraud provisions of the federal securities laws regarding disclosures to investors. These names would include, for instance, names that suggest characteristics of the fund’s overall portfolio, such as a name indicating the fund seeks to achieve a certain portfolio “duration” or that the fund is “balanced.” 49 They also include names that 48 See Names Rule Adopting Release, supra footnote 2, at n.42 and Division of Investment Management, Frequently Asked Questions about Rule 35d-1(Investment Company Names) (available at https://www.sec.gov/divisions/investment/guidance/rule35d-1faq.htm) at Questions 8, 9, and 11. These FAQs represent the views of the staff of the Division of Investment Management. They are not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved the FAQs’ content. The FAQs, like all staff statements, have no legal force or effect: they do not alter or amend applicable law, and they create no new or additional obligations for any person. 49 To the extent that a term used in a fund name could reasonably be understood to describe the characteristics of the portfolio as well as, or alternatively, the characteristics of the component portfolio investments—for example, the term “global”—we believe such a name would suggest an investment focus under the proposed amendments. Nevertheless, as discussed in more detail 24 reference a particular investment technique, such as “long/short.” We also believe that names that suggest a possible result to be achieved, such as “real return,” or a name that references a retirement target date, similarly do not suggest a focus in a particular type of investment or investments that have particular characteristics. In these cases the name indicates the fund’s objectives but without specifying the fund’s investments or intended investments. Regardless of whether a fund is required to adopt an 80% investment policy under the rule, a fund must, consistent with rule 38a-1, adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws, which include section 35(d) and the names rule. 50 Where a fund’s name suggests an investment focus that has multiple elements, the fund’s 80% investment policy must address all of the elements in the name. Take, for example, the fund name “ABC Wind and Solar Power Fund.” The fund’s investment policy could provide that each security included in the 80% basket must be in both the wind and solar industries, or instead that 80% of the value of the fund’s assets will be invested in a mix of investments, with some solar investments, some wind investments, and some investments in both industries. Similarly, the “XYZ Preferred Securities and Income Fund” could adopt a policy to invest at least 80% of the value of its assets in preferred securities and securities that meet the fund’s standards for being income-producing. A fund’s 80% investment policy must address each element in the fund name that suggests an investment focus, but permits the fund to take a reasonable approach in below, a “global” fund could use any reasonable definition of “global” as we are not proposing to mandate any particular test for what this term means. 50 See supra footnote 16 and accompanying text. 25 specifying how the fund’s investments will incorporate each such element in the name. For example, the “XYZ Environmental, Social, and Governance Fund” must adopt an 80% investment policy to address all three of those elements, and we recognize that there are multiple reasonable ways the policy could address these elements. Any fund that has a name that suggests an 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. For example, 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 some cases, what would be appropriate to include in the fund’s 80% basket would be context-specific. For example, we understand that funds currently do not include the value of short positions, including short-exposure derivatives, related to the investment focus suggested by a fund’s name in their 80% baskets, absent some terminology in the fund’s name such as “inverse,” “hedged,” or “long/short” that suggests to investors that short activity is or may be part of the fund’s investment approach (e.g., the “XYZ Long/Short Equity Fund”). 51 We request comment below on funds’ current practices regarding including or excluding short positions in their 80% baskets and whether any changes in this area would be appropriate. Consistent with the current names rule, funds would be able to define terms used in their names in a reasonable way, but, in a change from the current rule, would be subject to the 51 This hypothetical fund would be subject to the 80% investment requirement because of the inclusion of the term “equity,” which suggests a type of investment, and not because of the term “long/short,” which does not suggest an investment focus. 26 proposed requirement that any terms used in the fund’s name that suggest an investment focus must be consistent with those terms’ plain English meaning or established industry use. 52 What constitutes “reasonable” in this context could vary depending on the fund name, but requires a meaningful nexus between the given investment and the focus suggested by the name. For instance, when the investment focus relates to an industry, there are different approaches a fund could take to determine if a given security is tied to the economic fortunes and risks associated with the named industry. For example, we believe it would be reasonable for a fund to define securities in a given industry as securities issued by companies that derive more than 50% of their revenue or income from, or own significant assets in, the industry. In such cases, there 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). A fund’s compliance policies and procedures could address its processes to allocate portfolio companies in its 80% basket, for example, by reference to a specific test based on the source of the companies’ revenue. We understand that some funds also use text analytics to assign issuers to industries based on the frequency of particular terms in an issuer’s disclosures. For example, if an issuer’s public disclosure documents repeatedly use a term like “blockchain,” some funds would assign the issuer to the blockchain or fintech industry without further analysis. Although text analysis may be a helpful component of a fund’s analysis, we do not believe it is reasonable to conclude 52 Cf. Names Rule Adopting Release, supra footnote 2, at n.43 (“As a general matter, an investment company may use any reasonable definition of the terms used in its name and should define the terms used in its name in discussing its investment objectives and strategies in the prospectus.”). 27 that an issuer is in a given industry solely because the issuer’s disclosure documents frequently include words associated with the industry. Further, we believe it would generally be reasonable for a fund of funds or other acquiring 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. For example, a fund of funds with the name “XYZ Industrials Fund” with an 80% investment policy to invest in the industrials sector could count 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. We request comment on the proposed requirement for funds with names that suggest an investment focus to adopt and implement an 80% investment policy. 1. Should we expand the requirement for certain funds to adopt an 80% investment policy, as proposed, to cover names that include terms suggesting an investment focus in investments or issuers that have particular characteristics? Is it clear what types of names would subject a fund to the expanded scope of this requirement under the proposed rule? Should we only require certain fund names that suggest an investment focus, such as those that “reasonably suggest” an investment focus, to adopt an 80% investment policy? Would the proposed amendments address all types of names that connote an investment focus to investors, or otherwise create investor expectations regarding the composition of the fund’s portfolio? Conversely, are there certain names that would be included under the expanded scope for which investors would not have these types of expectations? 28 2. Is it appropriate to retain, as proposed, the requirement for fund names that suggest a focus in a particular type of investment or investments, investments in a particular industry or group of industries, or particular countries or geographic regions to adopt an 80% investment policy? Should we eliminate or add to these types of names in the rule text, given the proposed expanded scope of the requirement (i.e., including within the scope names that include terms suggesting a focus in investments or issuers that have particular characteristics)? 3. Should we, as proposed, adopt a scoping requirement that does not distinguish between types of investments and investment strategies? Do investors make a distinction between investment strategies and types of investments when assessing fund names in making an investment decision? 4. Should the names rule’s 80% investment policy requirement apply, as proposed, to fund names with terms such as “ESG” and “sustainable” that reflect certain qualitative characteristics of an investment? Why or why not? Are investors relying on these terms as indications of the kinds of companies in which the fund invests or does not invest? Would this be the case even to the extent that funds with ESG and similar terminology in their names may use disparate means to select their portfolio investments? Should there be any additional requirements for funds that use ESG or similar terminology in their names? 5. As an alternative to basing the calculation of the 80% basket on the fund’s assets, should we instead use a different method of calculation? As discussed in more detail below, we considered, as a reasonable alternative to the proposal, whether to require funds’ historical returns to exhibit minimum exposures to certain risk 29 factors in lieu of the percentage of assets test. Should we instead adopt this sort of method of calculation that assesses the returns that a fund’s investments contribute to the fund’s overall performance, or that requires a fund with a name suggesting a particular investment focus to exhibit minimum exposures to certain risk factors that correlate with the investment focus its name suggests? 6. Will funds be able to reasonably determine what investments qualify for their 80% baskets under the proposed rule? What steps and tools will funds use to make these determinations? If not, what steps should we take to clarify this, particularly given the proposed expanded scope of the 80% investment policy requirement? Is it likely that funds with similar names will come to different reasonable determinations as to what investments qualify for inclusion in their 80% baskets? If so, will investors be confused by these names? 7. Should funds with names with multiple elements be required to address all of those elements? Should this be required at all times or, if not, what limits, if any, should there be regarding fund names with multiple elements in light of the prohibition against materially deceptive or misleading names under the Act? Should a fund whose name includes multiple elements be required to invest some specific minimum percentage (e.g., 5%, 10%, 25%) in each element? 8. Is there any particular topic or issue that funds encounter in complying with the 80% investment policy currently, or that they would encounter in complying with the proposed amendments to the 80% investment policy requirement, that should be addressed by Commission guidance? For example, would funds benefit from 30 guidance about what procedures might be reasonable for a fund whose name indicates a focus in a particular industry to select its 80% basket investments? 9. As discussed above, we understand that, absent a term in a fund’s name such as “inverse,” funds do not currently include short positions in the fund’s 80% basket. Should the Commission address by guidance or a provision in the names rule the inclusion of short positions in a fund’s 80% basket related to the fund’s investment focus, and if so, what practices with respect to the inclusion or exclusion of short positions would be appropriate in light of section 35(d) and the policy goals of the names rule’s 80% investment policy requirement? For example, assume a fund with “equity” in its name and nothing in the name suggesting that the fund also engages in short sales, such as the phrase “long/short.” If the fund had $100 and invested it all in equity securities, then were to sell short equity securities with a value of $50, how should that short sale affect the fund’s compliance with its 80% investment policy? Should the short sale reduce the value of the equity investments included in the 80% basket, and are there specific circumstances where a short sale should not reduce the value of the fund’s 80% basket securities? How should we address short sales where the returns of the assets sold short are correlated with returns of securities (or the asset class) in the fund’s 80% basket, but the assets sold short are not identical to any of the securities in the 80% basket (or are not in the same asset class as the securities in the 80% basket)? If the short sale should reduce the value of the equity investment in the 80% basket in the example above, what reduction would 31 be appropriate—e.g., should the reduction be $50, the value of the equity securities sold short? 53 10. Should we provide a specific provision in the rule requiring funds with ESG (or similar terminology) in their names only to attribute a particular type of investment towards their 80% basket, or guidance that addresses this? Why or why not? Are there other types of guidance regarding ESG investing and the names rule that we should provide? 11. Should we adopt any specific requirements with regards to the portion of the fund’s assets not included in the 80% basket? For fund names that suggest an investment focus that has multiple elements, should we adopt any specific requirements, such as a specific minimum percentage (e.g., 20%, 25%, etc.) of assets invested, with regards to how each element must be accounted for in the fund’s 80% investment policy? 12. Are there any other particular types of fund names we have not specifically addressed above, for which we should require a specific treatment under the names rule as we propose to amend it? Should those particular names be subject to the requirement to adopt an 80% investment policy or not? 13. Should we codify any of the guidance provided above? For example, should we add an exception to the rule that permits funds of funds, and other acquiring funds, to include the entire value of their investment in an appropriate acquired 53 See infra section II.A.3 (addressing the valuation of derivatives instruments for the purpose of determining a fund’s compliance with its 80% investment policy). 32 fund in calculating their 80% basket without looking through to the acquired fund’s underlying investments? 14. With respect to certain name terms that could connote both an investment focus and the characteristics of the fund’s overall portfolio (e.g., “global”), should we, as proposed, require funds with names including these terms to adopt an 80% investment policy? If not, how should we differentiate when these terms are being used to suggest an investment focus and when they are not? 15. Consistent with the current names rule, the proposed amendments would generally apply to money market funds. 17 CFR 270.2a-7 (“rule 2a-7”) also requires funds that use the term “money market” in their names to comply with the requirements of that rule. Are the requirements of rule 2a-7 sufficient to prevent materially misleading or deceptive money market funds names, or should we continue to apply the names rule to those funds? 2. Temporary Departures from the 80% Investment Requirement The proposed amendments would permit a fund to depart temporarily from the requirement to invest at least 80% of the value of its assets in accordance with the investment focus or tax treatment its name suggests (“80% investment requirement”) only under certain specified circumstances. 54 These temporary departures would be permitted only: (1) as a result of market fluctuations, or other circumstances where the temporary departure is not caused by the fund’s purchase or sale of a security or the fund’s entering into or exiting an investment; (2) to 54 The proposed temporary departure provision would be applicable not only to funds whose names suggest a particular investment focus, but also to tax-exempt funds that are required to invest their assets in accordance with the provisions of proposed rule 35d-1(a)(3)(i). 33 address unusually large cash inflows or unusually large redemptions; (3) to take a position in cash and cash equivalents or government securities to avoid a loss in response to adverse market, economic, political, or other conditions; or (4) to reposition or liquidate a fund’s assets in connection with a reorganization, to launch the fund, or when notice of a change in the fund’s 80% investment policy has been provided to fund shareholders at least 60 days before the change pursuant to the rule. 55 Under each of these circumstances except fund launches (where accompanying temporary departures could not exceed a period of 180 consecutive days), reorganizations (for which the proposed rule does not specify a required time frame for accompanying temporary departures), or where the 60-day notice has been provided to shareholders, a fund would have to bring its investments back into compliance with the 80% investment requirement within 30 consecutive days. 56 In all cases, a fund would have to come back into compliance as soon as reasonably practicable. 57 In contrast, the names rule currently provides that a fund’s 80% investment policy applies “under normal circumstances,” leaving it to funds to determine what constitutes something other than a normal circumstance. This aspect of the current rule was designed to provide funds 55 “Reorganization” is defined in section 2(a)(33) of the Act and includes actions such as voluntary liquidations. 56 Proposed rule 35d-1(b)(1) and (g)(7) (defining “launch” as a period, not to exceed 180 consecutive days, starting from the date the fund commences operations). 57 “As soon as reasonably practicable” would not strictly mean “as soon as possible” in all cases and is intended to allow for consideration by the adviser of how to return to compliance in a manner that best serves the interest of the fund and its shareholders (but in no case longer than the proposed 30-day limit where applicable). For example, a fund need not return to compliance within 2 days, even if doing so is technically possible, if such an approach would harm the fund or its shareholders by, for instance, causing the fund to purchase illiquid assets at a premium. 34 flexibility to manage their portfolios while requiring that they normally invest 80% of their assets consistent with their 80% investment policy. 58 In addition, under the current rule, compliance with the 80% investment requirement is determined at the time a fund invests its assets. This provision was designed to avoid requiring a fund to rebalance its investments if the fund’s portfolio were no longer invested in accordance with the fund’s 80% investment policy as a result of, for example, market movements or an influx of cash from new investors. 59 The rule currently requires that if, subsequent to an investment, the 80% investment requirements of the rule are no longer met, the fund’s future investments must be made in a manner that will bring the fund into compliance with those requirements. The new approach we are proposing is designed to permit appropriate flexibility to depart temporarily from the 80% investment requirement in particular, time-limited circumstances when doing so would be beneficial to the fund and its shareholders, while providing additional parameters designed to prevent a fund from investing inconsistently with its 80% investment policy for an extended period of time. The new approach continues to address, for instance, certain circumstances in a fund’s life cycle in which it might not be invested fully in its 80% basket, as well as circumstances in which external events could cause the portfolio to “drift” in a way that causes the fund to depart temporarily from the 80% investment requirement. For example, a new fund may need a reasonable amount of time after commencing operations to 58 See Names Rule Adopting Release, supra footnote 2, at nn.37-40 and accompanying text. 59 See Investment Company Names, Investment Company Act Release No. 22530 (Feb. 27, 1997) [62 FR 10955 (Mar. 10, 1997)] at n.28 and accompanying text. 35 comply with the 80% investment requirement, or a fund with “small cap” in its name may see certain of its investments grow such that they are no longer “small cap” and need to re-invest in relative short order. 60 An investor choosing to invest in a fund with a name conveying a particular investment focus may expect that the fund will not stray from this investment focus for a protracted period of time in these and similar examples. While the current rule includes a requirement that a fund must make future investments in a manner to bring the fund into compliance with the 80% investment requirement, this provision does not address situations where the fund is not investing its assets in a given period of time. Moreover, the parameters we are including in the proposal reflect our belief that investors’ expectations for funds’ investment focuses may not depend on whether market events negatively affect the investment in the fund’s portfolio. For example, investors increasingly seek out funds that are structured as passive investment vehicles, such as index-based mutual funds and ETFs, in order to obtain specific types of investment exposure for their portfolios. 61 These investors are specifically seeking a return tied to the investment focus suggested in the fund’s name. 62 These investors may expect the fund to invest in a manner that is consistent with its stated investment focus with the understanding that investors may rebalance their own portfolios 60 See also Names Rule Adopting Release, supra footnote 2, at n.39 and accompanying text. 61 Based on data obtained from Morningstar Direct, in 2001 there were approximately 432 mutual fund and ETF index funds. As of the end of 2019, there were approximately 2,311 index funds. 2020 Request for Comment, supra footnote 2, at n.22. At the end of 2020, index mutual funds and index ETFs together had $9.9 trillion in total net assets and accounted for 40% of assets in long-term funds, as compared to 19% at the end of 2010. See 2021 ICI Fact Book. 62 See CFA Comment Letter (stating that when funds deviate from their 80% investment policy for extended periods of time, this can affect asset allocation programs some investors use to determine which funds to buy or sell by changing the nature of the investment). 36 if desired rather than expecting the fund to do so. As another example, consistency in investment companies’ investments with their names and investors’ reasonable expectations may be particularly important to retirement plan and other investors who place great emphasis on allocating their investment company holdings in well-defined types of investments, such as stocks, bonds, and money market instruments. 63 As a result, consistency with the investment focus suggested by the fund’s name would seem to be a primary concern for these investors. To address these concerns, the proposed rule amendments specify that a fund departing from the 80% investment requirement must bring its investments back into compliance as soon as reasonably practicable, and that the maximum amount of time for the departure would be 30 consecutive days, other than in the case of a fund launch (which would be limited to 180 consecutive days starting from the day the fund commences operations) or a reorganization (for which the proposed rule does not specify a required time frame for accompanying temporary departures). We are proposing this “as soon as reasonably practicable” standard because we anticipate that most temporary departures would last substantially less than 30 days, though this could depend on the specific facts and circumstances. We recognize that some investors may prefer for a fund to be permitted to depart from its investment focus for longer than 30 days to avoid any losses that the fund may incur to come back into compliance within that time period. We believe, however, that, at some point, departures may begin to change the nature of the fund 63 See id.; see also Names Rule Adopting Release, supra footnote 2, at n.8 and accompanying text. 37 fundamentally, which would undermine investor expectations created by the fund’s name. 64 The proposed time limits are designed to prevent such a fundamental change. A shorter required time period to come back into compliance, for example seven days, would ensure a fund rapidly rebalances its portfolio, but could result in forced sales at depressed prices or in a tax-disadvantaged manner, to the detriment of investors. 65 As another example, purchasing less liquid securities in a compressed timeframe in order to comply with the fund’s 80% investment policy could drive up the price for those securities, also potentially adversely affecting investors. While there is still the possibility that these adverse effects could occur with the proposed, longer periods, we believe that it is a lessened concern in those time frames given the increased flexibility that a longer period of time would provide to rebalance the portfolio and for any market-wide issue to resolve. We are proposing to give fund launches a longer period, 180 consecutive days, in recognition of the likelihood that it can take longer for funds to find investments during their start-up, particularly for funds that invest in securities whose supply is limited. 66 We acknowledge that establishing a set time frame to return to the 80% investment requirement may result in operational changes for some funds, in order to assess the new time limits on temporary departures relative to the current rule’s requirement to assess compliance with the 80% 64 See Janain Comment Letter (recommending limiting the amount of time funds can engage in temporary defensive positions as they believe that some funds have taken liberties and that “[a]t some point, temporary becomes normal”); see also CFA Comment Letter (highlighting concerns about “drift”); Crowley Comment Letter (expressing concerns about extended departures from the 80% investment requirement). 65 Some commenters highlighted these sorts of challenges while expressing concerns regarding changing the rule to include a maintenance test for the 80% investment requirement. See, e.g., BlackRock Comment Letter; Capital Group Comment Letter; ICI Comment Letter I. 66 See also Names Rule Adopting Release, supra footnote 2, at n.39 and accompanying text. 38 investment requirement at the time of investment. However, we anticipate many funds, particularly open-end funds, already assess their names rule compliance daily or intra-daily (for example, those that trade portfolio assets daily). Therefore we anticipate that for many funds, the proposed new approach, which would require compliance with the 80% investment requirement except under the rule’s specified limited circumstances, would not result in significant operational changes although we acknowledge that may not be the case for all funds. While we continue to believe that there are circumstances where a fund’s temporary departure from the 80% investment requirement would be appropriate, we believe that specifying these circumstances in the rule, as opposed to a more principles-based approach, would help ensure that these departures are temporary in nature and limited in scope. 67 Thus, in place of the rule’s current standard that a fund’s 80% investment policy applies “under normal circumstances,” we are proposing four specific exceptions that address circumstances where such departures would be limited in time, have investor protection benefits, and/or involve circumstances where an investor is unlikely to be materially misled or deceived. First, the proposed rule would permit temporary departures that occur as a result of market fluctuations, or other circumstances where the temporary departure is not caused by the fund’s purchase or sale of a security or the fund’s entering into or exiting an investment. This recognizes that a fund may not be in compliance with the 80% investment requirement for a short period of time while the fund addresses such an event. For example, the investments in a fund’s 80% basket may decline in value such that they fall below 80% of the fund’s assets. 67 See, e.g., SIFMA AMG Comment Letter; BlackRock Comment Letter; T. Rowe Price Comment Letter. 39 Further, the underlying index of an index fund could rebalance, which may cause the fund to have less than 80% of its assets invested in the reconstituted index until the fund has the opportunity to realign its investments. The proposed rule also would permit funds experiencing unusually large cash inflows or outflows in response to redemption requests to depart temporarily from the 80% investment requirement. This would provide a fund the opportunity to depart temporarily from the fund’s 80% investment requirement in order to invest the incoming cash, or sell investments to meet the outflow, in an orderly way. Similarly, the proposed rule would permit temporary departures for funds to take temporary defensive positions in cash, cash equivalents, or government securities to react to adverse conditions. 68 These generally reflect prior Commission statements regarding some circumstances in which departures from the 80% investment requirement would be appropriate under the current rule. 69 We are also proposing to permit funds temporarily to invest less than 80% of their assets in the 80% basket to reposition or liquidate assets in connection with a reorganization or to launch the fund. For fund launches, the temporary period would not be permitted to exceed 180 consecutive days starting from the day the fund commences operations. Both reorganizations and 68 See, e.g., Registration Form Used by Open-End Management Investment Companies, Investment Company Act Release No. 23064 (Mar. 13, 1998) [63 FR 13916 (Mar. 23, 1998)]. The proposed provision permitting temporary departures to avoid losses in response to adverse market, economic, political, or other conditions in the names rule reflects the formulation of temporary defensive positions from Form N-1A. See Form N-1A, Instruction 6 to Item 9(b)(1). As a result, funds should understand this provision as consistent with this disclosure requirement and any related disclosure the fund provides. Further, we believe that context dictates that “other conditions” is not all-encompassing, but rather would be other conditions similar to an adverse market, economic, or political condition. 69 See Names Rule Adopting Release, supra footnote 2, at section II.A.4 (describing ways in which funds might use the “under normal circumstances” standard to engage in temporary departures). 40 launches may result in a fund holding assets in a way that is inconsistent with its 80% investment policy in order to complete the action. For example, at start-up it may take time for a new fund to find and purchase available investments consistent with the fund’s investment focus and hold cash in the interim. In the case of a merger, a target fund may need to rebalance its portfolio to more closely mirror the investments held by the acquiring fund. Unlike the other circumstances in which the proposed rule amendments would permit temporary departures, the proposed rule amendments would not limit the time of departures associated with fund reorganizations or where the fund has provided notice it intends to change its 80% investment policy, and additionally the time for departures associated with fund launches could last for 180 consecutive days from the date the fund commences operations. Planned reorganizations may take longer to complete than 30 days or even 180 days. Moreover, the planned action will be disclosed and the reorganization is likely to be a permanent change to the nature of the investor’s investment. 70 Similarly, a change to a fund’s 80% investment policy is a permanent change to the fund’s investments, about which funds notify investors pursuant to the provisions of the rule. Thus, we do not believe that changes in the fund’s investment portfolio to support the upcoming reorganization would generally be inconsistent with investors’ reasonable expectations. As a result, we do not believe that an express time limit is necessary for departures from the 80% investment requirement made in connection with these actions. Such departures, like all of the proposed departures, would still be required to be resolved as soon as reasonably practicable. 70 For example, when the board of an open-end fund determines to approve a reorganization, the fund would supplement its prospectus. 41 In the case of the launch of a new fund, it may be better for investors if the fund takes additional time to invest in a manner consistent with the fund’s 80% investment policy in order to avoid the potential for adverse impacts on the price of a targeted investment, to scale up an investment, or to find a better investment that corresponds to the investment focus relative to what is currently available. Nonetheless, we believe that, consistent with current guidance, such a period should not exceed 180 consecutive days. 71 The proposed amendments therefore would not permit any fund to exceed 180 consecutive days to invest its assets consistent with the 80% investment requirements when launching a fund. 72 Further, in effect, the proposed amendments would generally require open-end funds to be fully invested within a much shorter time than 180 days, consistent with the proposed requirement to do so “as soon as reasonably practicable.” These funds should be able to fully invest in their investment focus relatively quickly because they invest in relatively liquid assets and because they receive cash from share purchases on an ongoing basis. Accordingly, if a new open-end fund were to acquire assets at the time of launch that largely mirrored the assets in another pre-existing fund in the fund family, but with a different name that reflects a different set of investment parameters that would be applied to that portfolio in the future, the manager should generally adjust the new fund’s portfolio to the new parameters in a much shorter time than 180 days in accordance with an 80% investment policy based on the investment focus the fund’s name suggests. 71 See Names Rule Adopting Release, supra footnote 2, at n.39 and accompanying text. 72 Cf. id. at n.40 (stating that, in very limited circumstances, it may be appropriate for a closed-end fund that invests in securities whose supply is limited to take longer than six months to invest offering proceeds). 42 We request comment on the proposed treatment of temporary departures from the 80% investment requirement. 16. To what extent do funds currently “drift” away from the investment focus suggested by their name? If they do, to what extent is this attributable to the provisions of the current names rule, such as the time of investment test? In general, how effective is this provision, and the “under normal circumstances” provision, at addressing materially deceptive or misleading names over time? 17. Should we limit the exceptions for market fluctuations, unusually large cash flows, and temporary defensive positions to 30 days as proposed or some other amount of time? Does the proposed 30-day limit raise any interpretive questions or potential compliance concerns the Commission should address in the rule text or as guidance? Are we correct in our belief that it will be unusual for funds to need to engage in these activities past that period? At what point can it be reasonably said that the nature of the fund has changed in these circumstances? 18. Should funds be limited, as proposed, to taking positions in cash and cash equivalents or government securities outside of their 80% investment policies in the case of a temporary defensive position? Are there other investments that funds use to protect the fund in the case of adverse market, economic, political, or other conditions? For example, should the rule allow funds to invest in securities that are similar to these investments? What kinds of investments do funds hold currently when taking defensive positions? 43 19. Is the requirement to bring a fund back into compliance with the 80% investment requirement as soon as reasonably practicable appropriate? Is it sufficient to protect against concerns about portfolio drift? 20. Is “as soon as reasonably practicable” readily understood? Would funds benefit from additional guidance on what would (or would not) satisfy this standard? How long would it typically take for a fund to come back into compliance with its 80% investment policy where a fund asset has increased or decreased in value? 21. Under the proposed amendments, the 30-day period runs from the time the fund invests less than 80% of the value of its assets in accordance with its 80% investment policy. Should the rule instead specify that it run from the beginning of one of the precipitating sets of circumstances that the rule describes? 22. Under what circumstances do funds currently depart from the 80% investment requirement? Are there any circumstances not covered by the proposed rule amendments that an investor would expect? For example, should we also exempt departures relating to a name or investment policy change? If so, how long do these actions typically take? Should we limit such departures to 30 days? To what extent do these actions typically fall within the definition of “reorganization” under the Act, for example, by resulting in the sale of 75% or more in value of the assets of a fund? 23. Instead of specifying the circumstances in which a fund may depart from the 80% investment requirement, should we retain the current provision that an 80% investment policy applies under normal circumstances but specify that, in any 44 event, departures may not persist for more than 30 days? Would investor expectations be met under these circumstances? 24. Instead of limiting temporary departures (except in the context of fund reorganizations or launches) to 30 days, should the rule instead provide that, if a temporary departure persists past 30 days, the fund’s board must approve, or be informed in writing about, the temporary departure? If we were to require board approval, should we require that a majority of the independent directors also approve of the departure? Should the approval or written report be required to be given by, or provided to, the board immediately, or no later than its next regularly scheduled board meeting? To the extent that the rule were to include board reporting, should we also require the report to include a recommendation from the fund’s adviser about whether to rebalance the fund’s holdings over a longer period of time, or to initiate a name change? Should we include a recordkeeping requirement for the report? Should we also require reporting to the Commission on a non-public basis regarding a departure that lasts longer than 30 days, the reasons for the departure, and the adviser’s plan to resolve the departure, with a follow-up report to the Commission once the departure has been resolved? Should we require a fund to notify the board about temporary departures even if they do not persist beyond 30 days? For example, while funds would be required to include a discussion of material compliance matters involving the names rule in their annual reports required under rule 38a-1, should we further require that these reports, or board reports in connection with regularly scheduled board meetings, 45 identify the number of and reason for temporary departures during the period covered by the report? 73 25. Does the proposed 30-day limitation create any compliance issues with other provisions of the federal securities laws? For example, how would a fund address a situation where, in order to meet the 30-day limit, it had to invest more than 15% of its net assets in illiquid investments, contrary to 17 CFR 270.22e-4 (“rule 22e-4,” or the “liquidity rule”)? Should we permit temporary departures to exceed the 30- or 180-day limits where meeting the 80% investment requirement would conflict with the requirements of the liquidity rule, and if so, how should we address any attendant investor protection concerns? Are there any circumstances when the investments suggested by a fund’s name become illiquid for more than 30 days? 26. Should we provide a specific time limit on temporary departures relating to fund reorganizations? If so, how long should it be? 27. Similarly, should we provide a specific time limit on the temporary departure where the fund has provided notice to shareholders under the rule? If so, should it be 60 days consistent with the rule’s notice requirements or some other time? Should we extend a similar provision to funds with redeemable securities that have suspended redemptions under section 22(e) of the Act, or under analogous 73 See supra footnote 17. 46 circumstances, such as market closures, for funds that do not issue redeemable securities? 28. Is 180 consecutive days the appropriate time to permit temporary departures relating to fund launches? If not, what would be a more appropriate time? Should we generally provide different time frames depending on the type of fund? For example, should we require a shorter period than 180 days for launches of openend funds, which typically invest in relatively liquid assets and which receive cash from share purchases on an ongoing basis, to avoid harm to early investors in those funds? Is the proposed definition of “launch” appropriate, or would a different definition (e.g., the date that a fund’s registration statement becomes effective) be more appropriate? 29. To what extent do portfolio managers keep funds close to the 80% investment requirement currently, or do they typically retain some buffer above that amount? 30. How often do different types of funds currently assess compliance with an 80% investment policy? Are we correct in our assessment that many funds already review their names rule compliance daily or on an intraday basis? How does this compliance assessment take into account whether characteristics of an investment may have changed (e.g., changes in market capitalization of equity holdings, or changes with respect to whether a particular holding continues to be an investment in a particular industry)? To the extent that certain funds generally assess compliance at least daily, does the proposed alternative approach to the current time of investment test increase investor protection, both for these funds specifically and across the fund industry? 47 31. Should we make any changes to the proposed temporary departure provisions to more specifically address tax-exempt funds? For example, should the provisions’ 30-day limit specifically address tax-exempt funds that adopt a policy to invest their assets so that at least 80% of the income they distribute is tax-exempt, given that income distributions can be less frequent than monthly? How often do such funds engage in temporary departures under the current rule? 3. Considerations Regarding Derivatives in Assessing Names Rule Compliance We are proposing to address both the valuation of derivatives instruments for purposes of determining compliance with its 80% investment policy, as well the derivatives that a fund may include in its 80% basket. Specifically, the proposed amendments would require that, in calculating its assets for purposes of names rule compliance, a fund must value each derivatives instrument using its notional amount, with certain adjustments discussed below, and reduce the value of its assets by excluding cash and cash equivalents up to the notional amounts of the derivatives instrument(s). 74 The proposed amendments also would specify that, in addition to any derivatives instrument that a fund includes in its 80% basket because the derivatives instrument provides investment exposure to the investments suggested by the fund’s name, the fund may include in its 80% basket a derivatives instrument that provides investment exposure to one or more of the market risk factors associated with the investments suggested by the fund’s name. 75 Accordingly, when a fund determines its compliance with its 80% investment policy, all derivatives instruments would be included in the denominator in the calculation, as well as any 74 See proposed rule 35d-1(g)(2). 75 See proposed rule 35d-1(b)(2). 48 derivatives in the fund’s 80% basket, i.e., the numerator in the calculation. We designed these proposed amendments to reflect the investment exposure derivatives investments create better and to increase comparability, as some funds currently value derivatives instruments using their notional amounts for purposes of determining their compliance with the 80% test while other funds use market values. 76 The amendments are designed both to allow funds to use names that may more effectively communicate their investments and risks to investors and reduce the risk that a fund may use derivatives to invest in a manner inconsistent with the investment focus suggested by the fund’s name. Funds currently are permitted to include synthetic instruments, such as derivatives instruments, in the fund’s 80% basket if the synthetic instrument has economic characteristics similar to the securities included in the 80% basket. 77 A fund, therefore, currently could include derivatives with these characteristics along with cash market investments in assessing whether 80% of the value of its assets is invested in accordance with the investment focus that the fund’s name suggests. A derivatives instrument’s “value,” as defined in the Act, however, may bear no relation to the investment exposure created by the derivatives instrument. 78 For example, a total 76 See, e.g., Capital Markets Comment Letter (stating that “[i]n practice, however, funds have been inconsistent in how derivative investments apply towards the 80% investment requirement: while some funds assert that a derivative’s notional value is more appropriate than its market value for purposes of complying with the 80% investment policy, many funds employ a derivative’s market value for the asset-based test”). 77 Names Rule Adopting Release, supra footnote 2, at 8511, n.13 (stating that the rule’s reference to “investments,” rather than “securities” as proposed, would permit a fund in appropriate circumstances to include a synthetic instrument in the 80% basket if it has economic characteristics similar to the securities included in that basket). 78 15 U.S.C §2(a)(41)(B) (defining “value,” in part, as the market value of securities for which market quotations are readily available and, for all other investments, as fair value as determined in good faith by the board of directors). 49 return swap on a market index generally will have a zero market value at inception, and will change in market value based on any appreciation or depreciation in the index, not on the fund’s investment exposure. A fund entering into a swap or other derivative referencing a market index with a notional amount of $1 million would achieve the same economic exposure as investing $1 million in the underlying securities directly, but the swap’s market value therefore generally would be far smaller than $1 million and would not reflect the swap’s investment exposure. Further, using a derivatives instrument’s market value for purposes of assessing names rule compliance could prevent a fund from using a name that effectively communicates its investments. Take, for example, a fund with the term “emerging market debt” in its name. While the fund could directly own emerging market debt securities, this could be inefficient due to transaction and custody costs, foreign regulatory requirements, and reduced liquidity. It may be most efficient for the fund to enter into a total return swap that provides economic exposure to the emerging market debt securities. However, the swap’s market value may be a small percentage of the fund’s net assets such that the fund’s emerging market debt investments would not be sufficient to comply with the fund’s 80% investment policy. Moreover, using derivatives instruments’ market values for purposes of assessing names rule compliance could result in a fund being in compliance with the fund’s 80% investment policy despite the fund having significant exposure to investments that are not suggested by the fund’s name. For example, a fund with emerging market debt in its name could invest 80% of its assets in emerging market debt, but also could use derivatives to obtain substantial investment exposure to U.S. equities. The fund might satisfy its 80% investment policy using the derivatives’ market values for this purpose because the market value of a fund’s derivatives investment can be small and unrelated to its investment exposure, as discussed above. But this 50 fund’s name could be deceptive and misleading if the performance of U.S. equities and not emerging market debt were the primary driver of the fund’s risk and returns. Use of derivatives’ notional amounts The names rule is designed to ensure that a fund’s investment activity supports the investment focus its name communicates, and for funds that use derivatives instruments, the investment exposure of those derivatives instruments is generally better reflected by a derivatives instrument’s notional amount than by its market value. For most types of derivatives instruments, the notional amount generally serves as a measure of a fund’s investment exposure to the underlying reference asset or metric. A total return swap, for example, can provide a return that is the economic equivalent of a direct investment in the derivative’s reference asset. Accordingly, we are proposing that for purposes of determining a fund’s compliance with its 80% investment policy, the fund must value a derivatives instrument using its notional amount with certain adjustments. 79 In calculating notional amounts for these purposes, a fund would be required to convert interest rate derivatives to their 10-year bond equivalents and to delta adjust the notional amounts of options contracts. The proposed requirement to convert interest rate derivatives to 10-year bond equivalents is designed to result in adjusted notional amounts that better represent a fund’s exposure to interest rate changes. 80 We believe that, absent this adjustment, short-term interest 79 A fund’s use of notional amounts when determining the value of the fund’s assets in the 80% basket would not affect the fund’s valuation practices under rule 2a-5 under the Act [17 CFR 270.2a-5]. 80 See Derivatives Rule Adopting Release, supra footnote 27, at section II.E.1. 51 rate derivatives can produce large unadjusted notional amounts that may not correspond to large exposures to interest rate changes. 81 Further, the proposed 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. 82 We believe that requiring these tailoring adjustments is appropriate for purposes of the names rule in order for a fund’s 80% investment policy to best reflect the fund’s investment exposure, which in turn would help ensure that the investment focus a fund’s name communicates is not materially deceptive or misleading. Requiring these adjustments would prevent a fund, for example, from including a deep out-of-the money option in its 80% basket to comply with its 80% investment policy. In that case, the option’s unadjusted notional amount would not represent the exposure that the option creates to the underlying reference asset at that time. Scope of the proposed approach Our proposed approach would apply to all of a fund’s derivatives instruments. That is, when assessing compliance with a fund’s 80% investment policy, the fund would be required to value all of its derivatives positions using notional amounts. The proposed approach would apply to both the numerator and the denominator in the calculation that the fund would use to determine compliance with its 80% investment policy. 83 81 Id. 82 Id. 83 Our proposed approach to value derivatives instruments using their notional amounts does not distinguish between derivatives instruments that are assets versus derivatives that are liabilities of the fund. For example, assume a fund enters into a total return swap based on an index with a notional amount of $100 million, and that index declines a very small amount. The total return swap would be a liability of the fund until the fund extinguishes that liability through the payment 52 Deduction from assets of cash and cash equivalents up to notional amounts Funds that use derivatives instruments to gain exposure to the markets in which they invest may maintain portions of their assets in cash and cash equivalents. For purposes of determining such a fund’s compliance with its 80% investment policy, our proposed approach would require the deduction of cash and cash equivalents from assets (i.e., the denominator in the 80% calculation) up to the notional amounts of the fund’s derivatives instruments. 84 This aspect of the proposed approach is designed to remove from the calculation cash and cash equivalents, which do not themselves provide market exposure, where they effectively function as low-risk collateral for the derivatives instruments whose notional amounts already are included in the denominator and thus including this collateral would effectively “double-count” the fund’s exposure. 85 That is, where a fund holds derivatives and cash and cash equivalents, the fund is obtaining its investment exposure through the derivatives, not the cash and cash equivalents, and including both the derivatives measured at their notional amounts and the value of the cash and cash equivalents would overstate the scale of the fund’s market exposure obtained through the derivatives instruments. If a fund held derivatives and cash market securities, like investments in equity securities or bonds, both the notional amounts of the derivatives and the value of the of variation margin. The notional amount of the swap would still reflect the magnitude of the fund’s investment exposure notwithstanding the fund’s then-current loss on the investment. For this reason, the proposal would require funds, in measuring their assets for purposes of names rule compliance, to include the notional amount of any derivatives instrument, regardless of whether it is an asset or liability of the fund. 84 See proposed rule 35d-1(g)(2). 85 Cf. Invesco Comment Letter (recommending that a fund electing to include derivatives in its 80% investment policy be required to deduct the value of cash and cash equivalents when determining the denominator for its 80% test). 53 securities would be required to be included because the fund would be obtaining market exposure through both kinds of investments. Using an example, assume an equity fund enters into an equity swap with a notional amount of $80 and holds $80 in U.S. Treasury bills and $20 in other securities. 86 Assume the swap has a market value of $0. If the equity fund were to include the notional amount of the swap in numerator and in the denominator when determining the fund’s compliance with its 80% investment policy without excluding the U.S. Treasury bills, the fund would not be in compliance with the 80% investment requirement ($80 swap notional amount /$180 = 44%). This would be the case even though, economically, the fund is achieving an investment exposure akin to investing $80 in equity securities directly (i.e., the swap could be viewed as a synthetic position in equity securities). If the equity fund were to deduct the $80 in U.S. Treasury bills from the denominator when determining the fund’s compliance with its 80% investment policy, the fund would satisfy that requirement ($80 swap notional amount / $100 = 80%). By way of contrast, however, assume that the fund invests the $80 in corporate debt instead. Now, the fund would fail the 80% investment requirement: $80 swap notional amount / $180, composed of $80 swap notional + $80 corporate debt + $20 other investments = 44%. The equity fund would not predominately have the equity exposure that its name would suggest. 86 See, e.g., Derivatives Rule Adopting Release, supra footnote 27, at text accompanying n.749 (stating that “[t]he Commission has also stated that items commonly considered to be cash equivalents include Treasury bills, agency securities, bank deposits, commercial paper, and shares of money market funds”). 54 Derivatives instruments included in the 80% basket We recognize 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 (for example, interest rate risk, credit spread risk, and foreign currency risk). Those instruments may have very high notional amounts. For example, a foreign equity or bond fund may hold substantial currency forwards or swaps to hedge foreign currency risk. If the rule did not allow funds to treat the notional amounts of those derivatives instruments as investments that reflect the fund’s investment focus, the notional amounts of those derivatives instruments could cause a fund to fall out of compliance with its 80% investment policy. For example, if ABC Foreign Equity Fund invested $100 in foreign equity securities, $100 in currency forwards, and held no other assets, the fund would not satisfy its 80% investment policy if the currency forwards were not included in the fund’s 80% basket ($100 in foreign equity securities / $100 in foreign equity securities + $100 currency forwards = 50%). Thus, in addition to any derivatives instrument that the fund includes in its 80% basket because it provides investment exposure to the investments suggested by the fund’s name, our proposed approach would permit 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 investments suggested by the fund’s name. As a result, the derivatives instruments included in a fund’s 80% basket would either be functioning as a substitute for direct investments in the securities suggested by the fund’s name or 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. We believe that our proposed approach would help ensure that the fund’s use of 55 derivatives would not be inconsistent with investors’ reasonable expectations of the fund’s investment activity. As illustrated in the example above regarding ABC Foreign Equity Fund, a foreign equity fund may hedge currency risks by entering in currency forwards with high notional amounts. If these notional amounts were not included in the fund’s 80% basket, the fund might not be able to comply with its 80% investment policy even though the currency forwards relate to the foreign equity securities suggested by the fund’s name. Accordingly, we believe it would be reasonable for a fund to include a derivatives instrument in its 80% basket where the derivatives instrument provides investment exposure to one or more of the market risk factors associated with the investments suggested by the fund’s name. As another example, the XYZ Corporate Bond Fund, whose portfolio includes corporate bonds as well as interest rate swaps to manage the portfolio’s overall duration, could include the interest rate derivatives in its 80% basket. Comments received Several commenters responding to the 2020 Request for Comment addressed the valuation of derivatives in measuring a fund’s compliance with its 80% investment policy. Many commenters urged the Commission to permit funds to use notional amounts to value derivatives instruments because a derivatives instrument’s market value may bear little relation to the fund’s investment exposure to the kinds of investments suggested by the fund’s name. 87 Further, one commenter suggested amendments to the names rule that generally would require a fund that 87 See, e.g., BlackRock Comment Letter; Capital Group Comment Letter; ICI Comment Letter I; T. Rowe Price Comment Letter. 56 includes derivatives in its 80% basket to use the notional value of derivatives instruments, adjusted as this proposal reflects, when measuring its compliance with its 80% investment policy. 88 We agree with commenters that notional amounts better reflect the fund’s investment exposure. For the reasons discussed above, our proposed approach would require a fund to use the notional amounts of its derivatives instruments when measuring the fund’s compliance with its 80% investment policy. In contrast, other commenters suggested that a fund’s derivatives investments generally should be valued at market value for these purposes. 89 Some commenters stated that this approach better indicates price sensitivity, the risks to a fund’s portfolio, and comparability across funds. 90 A derivative’s market value reflects profits and losses that the fund has incurred on any given date, and we agree that the concerns that commenters discuss are important for funds to consider as part of their valuation and risk management processes. However, we believe these topics are less relevant to the names rule’s policy goal of ensuring that a fund’s investments, and the sources of the fund’s returns, are in line with the investment focus that the 88 See Invesco Comment Letter (suggesting that a fund should generally value a derivatives instrument included in its 80% basket using the derivatives instrument’s notional value, “gross up” the denominator in the 80% test to include these derivatives’ notional amounts, and suggesting adjustments for interest rate derivatives and involving the “delta adjustments” of the notional value of options positions; also suggesting that the fund deduct the value of cash and cash equivalents when determining the denominator for its compliance with the 80% investment policy requirement); see also BlackRock Comment Letter (requesting clarification that the market value of cash and cash equivalents should be deemed an eligible asset that is included in a fund’s 80% basket and considered part of the derivatives exposure in determining compliance with a fund’s 80% investment policy). 89 See, e.g., Council of Institutional Investors Comment Letter; Nuckolls Comment Letter. 90 Id. 57 fund’s name reflects. This is because, as discussed above, a fund’s gains and losses on a derivatives investment do not reflect the investment exposure the derivatives create. We also believe that transparency regarding a fund’s compliance with its 80% investment policy and the investments a fund includes in its 80% basket are important. Our proposal would provide transparency, which in turn would permit additional comparability, in the proposed Form NPORT reporting requirements that would require funds to identify each investment that is included their 80% baskets. 91 Current Form N-PORT reporting requirements would continue to provide transparency regarding the market value of each of these investments. Another commenter addressed the use of derivatives instruments more generally. This commenter suggested that the Commission “limit” an approach that would permit funds to use notional values for purposes of names rule compliance, stating that derivatives instruments have risks that differentiate them from cash market holdings. 92 That commenter also stated that it would be misleading or deceptive for a fund to gain significant exposure through a derivative to a particular asset class but use a name that reflects exposure to a different asset class. 93 Alternatively, a commenter suggested that a fund’s name should reflect the use of derivatives when a fund uses derivatives frequently or when the fund uses derivatives for frequent, nontactical uses and creates exposures equal to or greater than one-third of the total exposures for all investment vehicles in the fund’s portfolio. 94 91 See infra section II.F; see also proposed Item C.2.e of Form N-PORT. 92 Consumer Federation of America Comment Letter. 93 Id. 94 CFA Institute Comment Letter. 58 We agree that funds’ use of derivatives presents unique risks. After the compliance date of rule 18f-4 (17 CFR 270.18f-4), funds that enter into derivatives under that rule will be required to satisfy that rule’s conditions. 95 We do not believe that a fund’s name generally would provide such specific information about fund risks—such as differences in risks between derivatives and cash-market investments—which instead must be disclosed in a fund’s prospectus. Particularly where a fund name refers to asset classes like “equity” or “credit,” investors might not form specific expectations about how the fund would obtain that investment exposure—in contrast to fund names that refer to categories of instruments like “stock” that may result in these types of investor expectations. However, we do agree that it could be misleading or deceptive for a fund to gain significant exposure through a derivatives instrument to a particular asset class but use a name that reflects exposure to a different asset class. Our proposed approach is designed to address this concern, in requiring a fund to value all of its derivatives instruments using their notional amounts for purposes of determining names rule compliance as this would better reflect the investment exposure of all of the fund’s derivatives investments. We request comment on our proposed approach with regard to the valuation of derivatives instruments when assessing the fund’s compliance with its 80% investment policy, as well as the derivatives that a fund may include in its 80% basket: 32. Is it appropriate to require a fund to use a derivatives instrument’s notional amount, with certain adjustments, and to reduce the value of its assets for this purpose by excluding any cash and cash equivalents up to the notional amount of 95 See Derivatives Rule Adopting Release, supra footnote 27. 59 the derivatives instrument, as proposed? Ar [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Asec%3A5c9389ee6ee787ce. Public record. Not legal advice.