ESG Claim to Fame: Addressing Fund Names and Safeguarding Investor Expectations Under the SEC's Amended Names Rule

Regulators across the globe continue to focus on disclosures and marketing relating to environmental, social, and governance (ESG) issues.[1] Consistent with this trend, on September 20, 2023, the U.S. Securities and Exchange Commission (SEC) adopted amendments to Rule 35d‑1 (the “Names Rule”) under the Investment Company Act of 1940, as amended (the “1940 Act”).[2] The amendments expanded the scope of the Names Rule to require any investment company registered under the 1940 Act (a “fund”) with a name that includes terms suggesting that it focuses on investments that have, or investments whose issuers have, particular characteristics, to adopt a policy to invest at least 80 percent of the value of its assets (an “80% policy”) in such investments.

According to the SEC, the amendments to the Names Rule are designed to address fund names that are likely to mislead investors about a fund’s investments and risks, including names that have a thematic investment focus (e.g., “growth” or “value”) and, most notably, names that indicate a fund’s investment decisions incorporate one or more ESG factors. As the SEC continues to focus enforcement efforts on ESG-related marketing, funds and their investment advisers should expect SEC scrutiny of any ESG-related terms used in a fund’s name following the compliance date of the Names Rule. We summarize the Names Rule and key takeaways below.

 Inside the Amended “Names Rule”

• 80% Policy. As noted above, under the Names Rule, as amended, a fund that uses a term in its name that suggests a particular investment focus, including any term that references a thematic investment focus, must, under normal circumstances, invest at least 80% of its assets (such assets, the “80% basket”) in securities or assets suggested by the fund’s name or investment themes.[3] In an effort to ensure that the Names Rule remains evergreen, the SEC did not identify specific ESG-related terms that necessarily represent a thematic investment focus and would subject a fund to the Names Rule. However, the SEC did note that terms such as “sustainable” or “socially responsible” may present a risk of greenwashing, suggesting that the use of such terms will likely subject a fund to the Names Rule.[4]

• Testing. Whether an investment complies with a fund’s 80% policy is assessed at the time of investment.[5] The Names Rule also requires funds to conduct at least quarterly reviews of their portfolio investments for consistency with the 80% policy, and to adopt time frames to remedy departures from that 80% policy, including those that occur due to inadvertent style drift or intentional departures.[6] The Names Rule provides a 90-day window to remedy such departures and to realign the fund’s portfolio with its 80% policy.[7] 

• Enhanced Disclosure. A fund’s prospectus must define the terms used in its name that are subject to the Names Rule, including the criteria the fund uses to select the investments described by such terms.[8] The Names Rule also requires that any terms used in the fund’s name that suggest an investment focus must be consistent with those terms’ plain English meanings or established industry uses.

• Form N-Port Reporting. The SEC also adopted amendments to Form N-PORT that require a fund to report the value of its 80% basket and whether an investment is included in the fund’s 80% basket. The amended Form N-PORT also requires a fund to include the definition(s) of terms used in its name that are subject to the Names Rule. Funds will have to report this information in the third month of every quarter.

• Recordkeeping. Finally, the Names Rule imposes new recordkeeping requirements related to a fund’s compliance with the new rule requirements. For example, a fund must maintain written records documenting, at the time the fund invests its assets, whether the investment is included in the fund’s 80% basket and, if so, the basis for including that investment in the 80% basket, among other records.[9] 

Regardless of whether a fund is required to adopt an 80% policy under the Names Rule, a fund must, consistent with Rule 38a-1 under the 1940 Act, adopt and implement written policies and procedures reasonably designed to prevent violations of federal securities laws, which includes section 35(d) of the 1940 Act and the Names Rule.

Blurred Lines

Importantly, the Names Rule does not explain what qualifies as an ESG factor or to what extent a fund should incorporate ESG factors in its investment process if it does use an ESG-related term in its name. In the Adopting Release, the SEC did not provide guidance regarding the “plain” meaning of any ESG-related terms (e.g., “sustainable” or “socially responsible”) that might suggest a certain investment focus and would be subject to the Names Rule. Accordingly, funds and their investment advisers should consider looking elsewhere for more robust taxonomy or terminology guidance for defining and scoping fund names and criteria to align with the Names Rule.

• The FTC Green Guides[10] could provide direction for funds and their investment advisers. Increasingly, guidance documents such as the Green Guides may, in the absence of a SEC-approved taxonomy, serve as starting points to define environmental benefits or other considerations to be evaluated by a fund in defining the scope an 80% policy that complies with the Names Rule.
• The ESG Data Convergence Initiative (EDCI) metrics guidance,[11] which integrates popular adopted standards and frameworks from entities such as the Taskforce for Climate-related Financial Disclosures (TCFD), Climate Disclosure Project (CDP), the Sustainability Accounting Standards Board (SASB), and the Global Reporting Initiative (GRI) Standards, may also provide helpful guidance. The EDCI is a partnership of private equity stakeholders working to streamline ESG data collection and reporting. The EDCI has four goals: (1) simplified data-sharing with investors; (2) benchmarking against peers; (3) translating ESG to material impact; and (4) shaping private equity’s ownership of ESG performance.[12] Although the EDCI is designed for private equity funds, the guidance may be used as a helpful tool for registered funds to assess how certain ESG-related terms are used and/or understood more broadly. These disclosure standards are designed for diverse but related objectives as follows:
• The CDP is a disclosure system that is designed to elicit environmental impact information from public and private stakeholders.[13]

• The TCFD framework provides guidance on four thematic areas that represent core elements of how companies operate in terms of governance; strategy; risk management and metrics; and targets to help inform climate-related financial disclosures.[14]

• The SASB Standards are designed to cater to industry-based disclosures on sustainability related risks focusing on financially material information.[15] The International Sustainability Standards Board (ISSB), which integrates the SASB and CDP standards, recently published its inaugural standards for eliciting comparable sustainability and climate related disclosures.[16]

• The GRI Standards[17] are designed for public and private stakeholders to understand and report on their impacts on the economy, environment, and people.

These standards and frameworks are useful tools to identify industry usage and descriptions of ESG or sustainability-related terms. Funds and their investment advisers should consider consulting these and similar resources to ensure that any ESG-related fund name subject to the Names Rule is consistent with industry usage.

Best Practices and Recommendations

In complying with the Names Rule, funds and their investment advisers should consider the following:

• Simplicity and specificity should inform terms, definitions, and related disclosures. Taxonomy regulations in peer jurisdictions such as the EU Taxonomy for Sustainable Activities may be considered for guidance in understanding how to carefully scope and define terms or investment themes suggested by fund names in a fund’s prospectus.

• Compliance with the Names Rule is not a safe harbor for materially deceptive and misleading names or for other violations of the antifraud provisions of the federal securities laws. Accordingly, funds and their investment advisers should confirm that a fund’s name, in all cases, accurately describes the fund and its investment strategy.

• With greater transparency comes greater need for clarity. Because portfolios may shift or evolve as markets change, the Names Rule anticipates situations where market or business exigencies, or intentional decisions, may cause portfolios to depart from underlying themes or names. It is good practice to implement a comprehensive monitoring process to ensure continued compliance with a fund’s 80% policy. Adviser and fund personnel should understand their roles in ensuring continued compliance with the Names Rule.

• Compliance continues throughout a fund’s lifespan; thus, it is important that a fund and its investment adviser(s) establish processes for periodic reporting to management and the fund’s board.

• A fund and its investment adviser(s) should consider whether ESG-related statements in the fund’s prospectus are supportable by data. A fund that incorporates an ESG-related term in its name should identify practical ways to elicit relevant data from its underlying investments, such as considering whether the companies in which it invests have adopted voluntary reporting standards, which could inform how the fund assesses compliance with its 80% policy. For example, the ISSB’s IFRS S1 and S2 standards,[18] which are increasingly adopted by regulators and leading asset managers for ESG reporting, are great starting points. The IFRS S1 standards are designed to facilitate disclosures from entities, as part of their general‑purpose financial reports, about sustainability risks and opportunities, while IFRS S2 standards encourage companies to disclose information about how an entity manages potential negative effects of climate change, including physical risks (e.g., extreme weather events), transition risks (e.g., policy changes), and opportunities to refer to positive effects of climate change.

Conclusion

The Names Rule is effective 60 days after publication in the Federal Register.  Fund groups with net assets of $1 billion or more have 24 months to comply with the Names Rule and fund groups with less than $1 billion of net assets have 30 months to comply.

We are well equipped to continue advising our clients on compliance infrastructure and strategy to remain aligned with the SEC’s objectives and regulatory requirements. We look forward to working with clients to ensure compliance with the Names Rule and other evolving ESG-related regulations.

[1] Recent developments include, for example, the EU’s Corporate Sustainability Directive (CSRD), which  became effective on January 5, 2023, the EU’s Sustainability Reporting Standards (ESRS), which were adopted on July 31, 2023, and the International Sustainability Standards Board’s IFRS S1 and S2 standards on sustainability- and climate-related disclosures, which were adopted on June 26, 2023.

[2] See Investment Company Names, SEC Rel. No. IC-3500 (Sept. 20, 2023), (the “Adopting Release”).

[3] See Rule 35d-1(a)(2). For purposes of determining compliance with this requirement, a fund may include in its 80% basket derivative instruments that provide investment exposure to: (i) investments suggested by the fund’s name or (ii) one or more of the market risk factors associated with the investment focus that the fund’s name suggests. See Rule 35d-1(b)(2) under the 1940 Act.

[4] See Adopting Release at 14.

[5] See Rule 35d-1(b)(1) under the 1940 Act.

[6] See Rule 35(d)-1(g) under the 1940 Act.

[7] See Rule 35(d)-1(b)(1) under the 1940 Act. If a fund departs from this 80% policy in other-than-normal circumstances, the fund must come back into compliance with the requirements within 90 consecutive days, measured from the time of the initial departure. However, if the fund, subsequent to an investment, identifies that the 80% policy is no longer met, the fund must make future investments in a manner that will bring the fund into compliance as soon as reasonably practicable, and in all circumstances within 90 consecutive days of the fund’s identification that those requirements are no longer met.

[8] See Form N-1A, Instructions to Item 4(a)(1) and Item 9(b).

[9] See Rule 35d-1(b)(3) under the 1940 Act.

[10] See Guide for the Use of Environmental Marketing Claims, 77 Fed. Reg. 62, 122 (Oct 11, 2012). On December 14, 2022, the FTC requested comments on potential updates and changes to the Green Guides seeking to clarify certain issues such as the guides’ interaction with other marketing regulations, carbon offsets and renewable energy claims, the use of certain terms such as “recyclable,” “recycled content,” and “sustainable,” among others. See FTC Seeks Public Comment on Potential Updates to its ‘Green Guides’ for the Use of Environmental Marketing Claims, 16 CFR 260 (Feb. 6, 2023).

[11] See EDCI Metrics Reporting Guidance (March 2023).

[12] See ESG Data Convergence Initiative (last visited Oct. 7, 2023).

[13] See CDP Guidance for Companies (last visited Oct. 7, 2023).

[14] See TCFD Recommendations (last visited Oct. 7, 2023).

[15] See SASB Standards Overview (last visited Oct. 7, 2023).

[16] See IFRS Standards Navigator (last visited Oct. 7, 2023).

[17] See GRI Standards (last visited Oct. 7, 2023).

[18] See Client Alert ‒ Inside the IFRS S1 and S2 Sustainability Disclosure Standards – Understanding Current Intersections and Future Outlooks.