Names Rule expansion prompts pushback

The SEC issued a rule proposal earlier this year aimed at expanding the agency's efforts to prevent misleading fund names, prompting a host of concerns and pushback on how the new rule could impact the investment community.

The proposal, released in May, would amend the "Names Rule" under the Investment Company Act of 1940, which requires funds with certain names — such as those specifying a type of security, industry or geographic area — to invest 80% of their assets in the investments the name suggests. The new rule would expand that requirement to any fund names that have "particular characteristics," including those with the terms "growth" and "value," or those indicating the fund incorporates one or more environmental, social and governance investing factors.

"The challenge with that is that there's no definition of what a 'characteristic' is," said Clair E. Pagnano, Boston-based partner at K&L Gates LLP. She added that the proposal "essentially captures what has historically been excluded, which are investment strategies," and added that's "very contrary" to how the industry has operated for years. The previous iteration of the Names Rule excluded fund names with terms like "growth" and "value," which indicate investment strategies rather than types of investments, Ms. Pagnano said.

Industry players are worried about several aspects of the proposal, including a lack of clarity, focusing too much attention on funds' names, and that the rigidity of the rules could force managers into making fire sales.

The SEC released the new rule proposal in tandem with another proposal that aims to address greenwashing — when a company or fund overstates its commitments to sustainable investing. The latter proposal would require fund managers and investment advisers to disclose more information on ESG strategies in their fund prospectuses, annual reports and adviser brochures.

It is unclear how many funds would be impacted by the expanded Names Rule, though data compiled by Bloomberg found there are at least 121 exchange-traded funds with "growth" or "value" in their name as of Nov. 8.

Ms. Pagnano said that in the original Names Rule, "the SEC acknowledged that names aren't the only factor in an investor's decision to buy into a fund." However, the new proposal "almost emphasizes that the name is the only thing that's important, and that investors are making their decisions almost solely based upon a fund's name," she added.

Eric Pan, CEO and president of the Investment Company Institute, a Washington-based trade association representing regulated investment funds, echoed this.

"The proposal inappropriately elevates the importance of a fund's name and doesn't help investors," Mr. Pan said in a statement Aug. 16. "It will simply add needless expenses and force funds to change how they operate just to stay in compliance with the new rule."

In October, the SEC reopened the proposal's comment period until Nov. 1. While the opinions of those in the asset management industry vary, many have expressed concerns over various aspects of the expanded rule.

One of the common criticisms of the proposal is its vagueness and lack of clarity.

ICI said in its comment letter that the terms newly subject to the Names Rule, such as "growth" and "value," are "inherently subjective and not necessarily readily reducible to quantitative, asset-based tests."

"As a result, expansion of the Names Rule to encompass these terms would introduce unnecessary complexity, subject funds and their advisers to the compliance risks associated with a vague legal standard, and lead to confusing and inconsistent application of the 80% investment policy requirement across the fund industry," ICI added.

US SIF: The Forum for Sustainable and Responsible Investment, a Washington-based membership association advocating for sustainable investing, specifically calls for changing the wording in part of the proposal to "Use of sustainability terms in fund names" instead of "Use of ESG terms in fund names," according to their comment letter. The organization said that "neither the Commission nor financial industry have adopted a universal definition of ESG," and some investors may not understand its meaning.

Even terms like "green" and "sustainable" may be subjective, J.P. Morgan Asset Management said in its comment letter. This could result in disclosure review staff "recommending long, detailed and technical disclosures, or potentially requesting changes to a fund's investment process to rely on simpler, more 'objective' measures for investment selection such as revenue tests," even if they're not appropriate, the company said.

According to Ms. Pagnano, if the new Names Rule were to take effect, "every fund complex is going to have to review every single fund in their lineup and determine whether they could potentially fall under this rule proposal."

Many comment letters recognized the SEC's efforts to reduce greenwashing and supported the proposal's mission to protect investors from misleading ESG funds, even if they didn't support the specifics of the proposal.

Evergreen Action , a climate-focused advocacy group, said in a comment letter that the new proposal, along with the accompanying disclosure proposal, "would ensure that investors have reliable and comparable information on the makeup and criteria of ESG funds," so they can make informed investment decisions.

"This is particularly important for individual investors, who are less likely to look beyond fund labels — think, for instance, about workers investing in their 401(k) retirement account," the organization added.

The CFA Institute said it supports "the Commission's view that a fund name that contains an ESG term when ESG factors are not a significant or main consideration in investment decisions should be considered materially deceptive and misleading," according to its comment letter.

However, the CFA Institute does not support extending the 80% investment policy requirement, instead recommending a requirement that "if a fund's name suggests an investment focus, the investment focus must be consistent with the key factors in the Principal Investment Strategies that are disclosed in the fund's registration statement."

"If a fund is touting an ESG strategy, it has to be consistent in that strategy with what it says in its disclosure documents," added Paul Andrews, Washington-based managing director of research, advocacy and standards at CFA Institute, in an interview.

Ms. Pagnano said that while the proposal could "level the playing field" for funds with ESG-related names, she noted there already are securities laws in place, under the existing Names Rule, to prevent misleading names. She also said it's concerning that the SEC is expanding the rule beyond ESG-related names.

The agency has "just sort of pulled in all these other terms without really delineating or really articulating to the public what the investor protection is that they're trying to serve," Ms. Pagnano said.

Another shared concern is the proposal's new restrictions regarding how funds must comply with the 80% investment requirement.

Ms. Pagnano explained that under current SEC rules, funds that are subject to the 80% investment requirement must be in compliance at the time of investment, or when a portfolio manager makes a trade.

"What the SEC is proposing now is not (at) time of investment, but essentially a continual compliance with 80% policy, which means that if there is a market appreciation … that pushes you above 20%, you're now out of compliance," she said.

She said this is risky because if a security's appreciation pushes a fund out of compliance, then the fund may have to sell at an inopportune time.

ICI's Mr. Pan reflected a similar sentiment in his statement, adding that "funds may be compelled to rebalance their investments or sell positions in a short time frame — possibly at fire sale prices — because the new SEC rule is so rigid."

The CFA Institute also expressed concerns about this in its comment letter. It said limits on departures from the 80% threshold "are likely to impose artificial constraints on active management and may not alleviate style drift, greenwashing, and name confusion."

In an interview, CFA's Mr. Andrews emphasized that while active managers should aim to adhere to the 80% requirement, "they also have to do what's in the best interest of the fund and what's in the best interest of investors."