New SEC Names Rule getting mixed reaction from industry

Opinions vary on the SEC's choice to expand the scope of its Names Rule — while some industry players feel the new rule will help prevent misleading fund names, others say it will be a disruption to the industry.

According to SEC Chair Gary Gensler, the rule amendments "will help ensure that a fund's portfolio aligns with a fund's name. Such truth in advertising promotes fund integrity on behalf of fund investors," he said in a news release Sept. 20 when the amendments were adopted.

The Names Rule, which the SEC originally adopted in 2001, requires that funds with certain names — such as those specifying a type of security, industry or geographic area — invest 80% of their assets in the investments the name conveys. The new rule expands that requirement to any fund name with "particular characteristics," such as those with the terms "growth" and "value," or terms indicating that the fund invests with environmental, social and governance factors in mind.

Some industry groups, especially those with an environmental focus, view the rule as a step in the right direction to prevent greenwashing — when companies falsely claim they're focused on "green" practices. However, others say it will cause significant issues for the investment industry.

"The only thing that this rule achieves is to insert the SEC deeper into funds' investment decision-making processes," said Eric Pan, president and CEO of the Investment Company Institute, a trade association representing regulated investment funds, in a Sept. 20 statement. "Portfolio managers won't be able to make routine investments without the SEC second-guessing whether it fits neatly with the subjective terms that make up their fund's name."

"This rule is going to present a real compliance burden for investment funds going forward," said Abigail P. Hemnes, a partner in K&L Gates' asset management and investment funds practice group.

Besides the initial requirement that investment companies make sure they comply with the 80% investment policy, Hemnes said, firms will also have to regularly confirm their compliance, as the rule requires them to review their assets quarterly. This is a change from the SEC's original rule proposal, in which it proposed continual compliance with the 80% requirement. Instead, the SEC is now requiring "reassessment of each portfolio investment on an at-least quarterly basis," according to the final rule.

"This modification will address concerns commenters raised related to cost burdens associated with the proposed scope expansion, to the extent that those concerns largely related to the costs of continuous monitoring and assessment of a fund's 80% investment policy," the SEC wrote in its final rule.

During the rule proposal's initial comment period, industry players voiced a host of concerns, which led to other changes in the final version of the rule as well.

According to Hemnes, the biggest change in the final rule is that the SEC dropped a section from its original proposal that would have "prohibited ESG integration funds from using ESG terms in their name."

The proposal described an integration fund as "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."

In its final rule, the SEC wrote that it's "continuing to consider comments and (is) not adopting the proposed approach to integration fund names at this time."

The 80% investment requirement does still apply to fund names with terms indicating the fund invests with ESG factors in mind.

Separately, the new rule changes the time allotment for funds to deviate from the 80% requirement before coming back into compliance. The original proposal allowed funds to "depart temporarily" from the requirement for 30 days, under certain circumstances.

"In response to industry pushback, the SEC did expand that from 30 days to 90 days," Hemnes said.

However, with some exceptions, the rule was adopted "very, very much as proposed," she said.

Most industry groups expressed concern that expanding the 80% investment requirement to funds with particular characteristics in their name would greatly extend the scope of the rule and make it difficult to comply with — "I don't necessarily see how the SEC responded to that criticism," Hemnes added.

The rule-making is just one of many that has received industry pushback lately, as some have criticized the pace of the SEC's rule-making agenda under Gensler.

"Today's rule-making is another example of the commission adopting sweeping, disruptive, and duplicative proposals that will confuse investors and create numerous problems for firms and the SEC alike," said Chris Iacovella, president and CEO of the American Securities Association, a trade association representing regional financial services firms, in a Sept. 20 statement. "This rule-making is deeply troubling because it grants the SEC unfettered authority to determine what investments are worthy to be included in a fund's portfolio."

In an August 2022 comment letter on the original rule proposal, the ASA wrote that the term ESG remains ill-defined, and the rule "could lead to unnecessary disclosures because firms and advisers have no guidance on what actually constitutes ESG. This will only lead to an increase in investor confusion."

On the other hand, some organizations — chiefly those with a focus on sustainable investing — commended the SEC for its effort to prevent greenwashing and deceptive fund names.

"These new rules will help provide needed truth in advertising and make a statement that financial greenwashing with misleading or deceptive ESG labels is not acceptable," said Andrew Behar, CEO of As You Sow, a nonprofit organization advocating for environmental and social corporate responsibility, in a Sept. 20 statement.

In an interview, Behar added that ESG is a "framework for assessing risk," and even though it's not a new way to assess risk, "those three letters have been somewhat demonized."

Other organizations were complimentary of the new rule and its aim to bring transparency to investors.

"As individual investors increasingly seek responsible investment options that consider climate risks, regulations that bolster investor confidence and prevent greenwashing are critical," said Steven M. Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets, in a Sept. 20 statement. "The SEC's new rule will help ensure truth in advertising for fund names and allow investors to make more informed decisions. We commend the SEC for its ongoing efforts to provide the market with consistent, decision-useful information."

US SIF: The Sustainable Investment Forum, a nonprofit organization whose members represent $5 trillion in assets under management, also supported the final rule.

"The final rule brings further clarity to the marketplace around investment company names," CEO Maria Lettini said in a separate Sept. 20 statement. "Fund names offer important signaling for investors in assessing their investment options. The final rule from the SEC succeeds in combating misleading fund names and provides additional transparency for investors and important guidance for funds."

Better Markets, a nonprofit organization focused on promoting public interest in the financial markets, was complimentary of the rule as well.

"This long-overdue modernization of the Names Rule is particularly relevant today as investors seek to invest in mutual funds and ETFs that focus on ESG and sustainability," said Stephen Hall, legal director and securities specialist, in the organization's Sept. 20 statement. "We applaud the SEC for adopting a strong final rule. It will benefit all investors, while also resisting the often baseless arguments by the funds that seek to greenwash their investment products by including terms such as 'ESG' and 'Sustainable' in their names to attract investors, without changing the investment policy of the fund."

Ultimately, it will be interesting to see how fund managers implement the proposal, Behar said, and whether funds out of compliance change their names and keep their holdings or vice versa.

"We might also see funds that sort of take a step away and include more genericized terms in their names," K&L Gates' Hemnes said.

The rule "takes some steps toward that goal (of truth in advertising), but it doesn't get us all the way there," she added.