SEC Seeks Comment on Amending “Names Rule” to Eliminate Misleading Fund Names

Investment Management Update

Date: March 13, 2020

 
 Key Notes:
  • Rule 35d-1 (the “Names Rule”) of the Investment Company Act of 1940, as amended, is ill-equipped to address the issues facing today’s investors from ever-changing markets and new investment products.
  • The SEC’s request for comment indicates a heightened scrutiny on fund names and renewed concern for the protection of investors from deceptive and misleading fund names.

Overview

In 2001, the SEC recognized that a fund name is the often first piece of information that an investor receives about a potential investment. To protect investors, the SEC adopted the Names Rule and prohibited materially deceptive or misleading fund names. The Names Rule requires mutual funds and exchange-traded funds to invest at least 80% of their assets in the investment type, industry and geographic location their names suggest. For example, if a fund’s name includes “U.S. Bond,” the Names Rule requires it to invest at least 80% of its assets in domestic bonds. In recent years, SEC staff have invoked the Names Rule to disallow fund names suggesting protection from loss or diminished risk.

The Current Names Rule Is Outdated

The SEC has never amended the Names Rule even though mutual funds and exchange-traded funds have evolved greatly since 2001. The Names Rule does not address many risks that investors now face, leading SEC staff and industry professionals to find its application to be inconsistent and insufficient to protect investors.

The Names Rule does not apply to derivatives and other financial instruments that provide leverage. A fund that invests a relatively small amount of its assets in derivatives could potentially have significant exposure to an investment type. The Names Rule focuses on a fund’s holdings but does not consider the potential risks of those holdings. Similarly, the Names Rule does not account for hybrid instruments, such as convertible securities, that have elements of several investment types. An investor in an “Equity Fund” may not appreciate the fund’s potential exposure to fixed income risks because of its holdings in convertible securities. Relatedly, it is difficult for funds focused on emerging industries to satisfy the 80% test of the Names Rule.

Index-based funds are growing in number, yet index constituents are not always closely tied to an index’s name and the Names Rule does not govern indices. If a fund name includes the name of an index, the Names Rule offers no protection. Fund names that include the names of well-known organization or affinity groups are also beyond the Names Rule’s reach, leaving investors wondering whether the fund is specifically tailored to members or available only to members of the named group. The Names Rule has no application to ticker symbols, which advisers commonly use to convey information about a fund’s holdings.

SEC staff have treated the increasingly popular environmental, social and governance-oriented (“ESG”) funds inconsistently. Some staff view ESG as an investment type covered by the Names Rule and others treat ESG as an investment strategy falling outside of its scope.

Request for Comments

The SEC seeks help of interested parties and market participants with improving the Names Rule. The SEC requests their input on the following areas, among other items:

  • How should funds select names to reach investors, and to what extent do investors rely on fund names to make investment decisions?
  • Should the Names Rule require that the investment type suggested by a fund’s name contribute to at least 80% of the fund’s returns?
  • Should the Names Rule provide flexibility to funds that focus in nascent or emerging industries?
  • Are fund names that identify an index or a well-known organization or affinity group potentially misleading?
  • Should the Names Rule apply to ticker symbols intended to convey information about how a fund invests?
  • Should the Names Rule apply to business development companies and closed-end funds?

The comment period on these and related questions closes on May 5, 2020.

Outlook

The SEC’s request for comment indicates a renewed focus on misleading fund names and heightened scrutiny on whether a fund’s name reflects what the fund is trying to accomplish. The push towards more standard naming conventions could lead to generic fund names which would require investors to do more research to understand what they are about. Ultimately, the effort to protect investors could lead to more investors being left in the dark.

FOR MORE INFORMATION

For more information, please contact:

Andrew J. Davalla
614.469.3353
Andrew.Davalla@ThompsonHine.com

Philip B. Sineneng
614.469.3217
Philip.Sineneng@ThompsonHine.com

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