Environmental, Social, and Governance Funds: SEC Proposed Names Rule Reform

Environmental, Social, and Governance Funds: SEC Proposed Names Rule Reform

October 6, 2022
Environmental, Social, and Governance Funds: SEC Proposed
Names Rule Reform
On May 25, 2022, the Securities and Exchange
offerings but may be inconsistent with the Names Rule.
Commission (SEC) commissioners voted 3-1 to officially
Various observers think that this scenario has encouraged
propose amendments to its “Names Rule” governing certain
fund “greenwashing,” when a fund overstates the ESG
investment fund names. The proposed rulemaking is in
attributes of its investments.
response to concerns that the relationship between
environmental, social, and governance (ESG) funds names
May 2022 Proposed Rule
and their actual investment strategies was potentially
As mentioned above, the agency proposed amendments to
confusing or misleading. This In Focus covers background
the Names Rule in May 2022 meant to modernize the
on this policy issue, features of the proposed rule, and
prevailing fund naming convention. (On the same day, the
arguments made for and against the changes.
SEC also voted to propose a complementary rulemaking
that would require enhanced fund disclosures for ESG-
Background
oriented funds, which, it is hoped, will enable the ESG
ESG funds are portfolios of equities and/or bonds, typically
funds to be more transparent, potentially reducing the
in the form of mutual funds, for which ESG factors have
incidence of greenwashing.) If adopted as proposed, the
been considered in the investment process. Investor interest
reform would require SEC-registered funds to reassess their
in such funds has grown considerably over the years. For
fund names, investment policies mandated under the Names
example, according to Morningstar, which tracks fund data,
Rule, and related fund prospectus disclosures. In proposing
domestic ESG funds had $357 billion in assets at the end of
the reform, the agency argued, “Under certain
2021, greater than four times the total amount held three
circumstances, the current structure of the rule also may
years earlier.
permit funds to depart from the investment focus suggested
by their name over time, which can deprive investors of the
For years, various outside observers and officials at the
protections of the rule…. The rule also is not currently
SEC, which regulates funds primarily through the
well-suited to address ways in which the fund industry has
Investment Company Act of 1940 and the Investment
evolved since its adoption.” Major parts of the proposal
Advisers Act of 1940 (P.L 76-768; both are found in
include:
different titles in the same act), have raised concerns over
their perceptions of confusing relationships between some
Modernization of the 80% investment policy
fund names, especially environmentally oriented ones, and
requirement. At present, the Names Rule directs funds
the fund’s investments strategies.
with certain names to invest 80% of their assets in the
investments suggested by their names. The proposal would
Fund naming is largely governed by the “Names Rule”
expand this requirement to any fund name that suggests a
(Rule 35d-1 pursuant to the Investment Company Act)
focuses on investments that have, or investments whose
adopted by the SEC in 2001, which requires that at least
issuers have, particular characteristics. An example would
80% of the assets of an SEC-registered investment
be fund names with terms such as growth or value and
company or a business development company (BDC, a type
those indicating that the fund’s investment decisions
of fund that invests in small and medium-sized companies
incorporate one or more ESG factors. The proposal would
and distressed firms) with a name that suggests that it
also require a fund that holds derivatives to use their
focuses on particular types of investment (e.g., industries,
notional values, not their market values, in determining
nations, regions) must be invested in that type of asset.
fund compliance with the Name Rule.
Reportedly, the SEC staff have often taken an approach in
which terms such as ESG or sustainable in a fund name
Temporary departures from a fund’s 80% investment
trigger the rule’s requirement.
policy. The proposal denotes the unique circumstances
under which a fund may depart from the 80% investment
In March 2020, the SEC staff issued a request for comment
policy, including sudden changes in market value of its
on whether the existing requirements are effective,
underlying investments. Specific time frames for when such
including for funds that contain terms such as ESG or
funds must return to the 80% investment policy regime
sustainable, and help ensure that investors are not misled by
would also be delineated.
fund names. It noted that a major concern is whether an
ESG label refers to a “strategy,” where the Names Rule is
Unlisted closed-end funds and BDCs. The proposal would
not applicable, or a “specific type of investment,” where the
prohibit a registered closed-end fund (a type of mutual fund
Names Rule does apply. It also described a competitive
whose shares can be purchased and sold on a stock
market environment that may incentivize fund asset
exchange) or a BDC whose shares are not listed on a
managers to use fund names to differentiate new fund
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Environmental, Social, and Governance Funds: SEC Proposed Names Rule Reform
national securities exchange from changing its 80%
of derivatives instruments, the notional value generally
investment policy unless fund shareholders vote to do so.
serves as a measure of a fund’s investment exposure to
such underlying reference assets.
Enhanced prospectus disclosure, reporting, and
recordkeeping. The proposal would include a number of
Selected Critical Arguments
amendments to provide enhanced information to investors
Groups criticizing the proposal include the Heritage
and the SEC on how fund names track their investments.
Foundation (a think tank), the U.S. Chamber of Commerce
Among them, a fund’s prospectus disclosure would define
(a business trade group), the Investment Company Institute
the terms used in the fund’s name. Also, amendments to
(a mutual fund trade group), the Securities Industry and
Form N-PORT, a monthly SEC fund reporting protocol,
Financial Markets Association (a brokerage trade group),
would require greater transparency on how the fund’s
and the CFA Institute (an association of financial
investments match the fund’s investment focus. In addition,
professionals), among others. They assert:
funds would be required to keep certain records on how
they comply with the rule or the rationale behind why they
 Terms such as ESG and sustainable in fund names
have determined that they are not subject to it.
should not be included in the Names Rule in the first
place, as they depict investment strategies, not
Materially deceptive and misleading use of ESG
investment types.
terminology. Under the proposal, an integration fund, a
fund that considers ESG factors alongside but more than
 The proposal places excessive emphasis on the salience
other non-ESG factors in its investment decisionmaking,
of fund names, implying that investors can rely heavily
would not be allowed to use ESG or similar terminology in
on funds’ names when they make investment decisions,
its name. Doing so would be defined to be either materially
thus minimizing other available investor information,
deceptive or misleading.
including fund prospectuses, which detail fund
investment objectives, strategies, and historical
Selected Supportive Arguments
performance.
Groups supporting the proposal include the North American
Securities Administrators Association (a state and
 Applying the 80% investment policy requirement to
provincial securities regulator group), the Consumer
funds whose names suggest a focus on investments with
Federation of America (a consumer advocacy group),
“particular characteristics” will problematically involve
Public Citizen (a social justice group), and various
subjective judgments. Given the expansiveness of terms
environmental activists, among others. They assert:
such as ESG, growth, and value, it will be challenging
for funds to implement the proposal and for the SEC to
 Some funds have reportedly claimed that the current
enforce it.
Names Rule does not apply to them, while outside
observers claim that it does. Broadening the scope of the
 By restricting the time in which a fund could depart
Names Rule would provide clarity in these cases.
from the 80% investment policy rule during episodes of
persistent market volatility, the proposal would place
 A large number of funds have names that incorporate
greater limits on a fund’s ability to respond to those
terms such as growth, value, or sustainable and may not
market conditions by changing its portfolio mix to
be subject to the Names Rule. Under the proposal, such
benefit its shareholders.
funds would be subject to the rule, which would enable
them to better communicate that they have investment
 Combined with the SEC’s proposed May 2022 enhanced
concentrations that are consistent with the
fund disclosures for ESG-oriented funds, the proposal’s
characteristics suggested by their names.
prohibition on integration funds’ use of ESG in their
names could have unintended consequences. While
 Currently, funds generally have significant discretion to
facing more pronounced disclosure requirements, the
determine when market conditions are “not normal,”
funds would not be able to use ESG-based names to
allowing them to depart from compliance with the
relay to investors that they have integrated ESG factors.
Names Rule for an indeterminate period of time. By
specifying the circumstances under which a fund can
 Valuing a fund’s derivative assets at market value, as is
temporarily depart and imposing a 30-day time limit on
done now, provides more useful information than does
such departures, the proposal would result in more
the proposal’s notional value requirement, because
alignment between a fund’s name and investments over
market values tend to generally provide more accuracy,
longer time periods.
timeliness, and comparability.
 The proposal would require funds that use derivatives
Gary Shorter, Specialist in Financial Economics
instruments to report on the notional (as opposed to the
market value) of the derivatives, as is often currently the
IF12226
case. This better aligns with the fact that for most types

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Environmental, Social, and Governance Funds: SEC Proposed Names Rule Reform

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