What's to fear in a name? Fund liability risks under the amended Names Rule

The SEC on September 20 approved amendments to the Investment Company Act “Names Rule” governing the use of descriptive terms in the names of mutual funds, ETFs and other registered investment companies. Fund advisers and boards should carefully consider the heightened enforcement and litigation risks posed by the new requirements, including for funds with ESG-themed names.

In its release on the amendments, the SEC explained that the purpose of the Names Rule (Rule 35d-1) is to protect investors from misleading and deceptive fund names, “recognizing the concern that investors may focus on a fund’s name to determine its investments and risks.”

Since its adoption in 2001, the Rule has required that if a fund’s name suggests a focus on a particular type of investment, or in investments in a particular industry or geographic focus, at least 80% of the fund’s assets must be invested in the manner suggested by the name. The amendments bring more names within the scope of the Rule’s 80% requirement – that is, names with terms suggesting that the fund focuses on investments or issuers that have “particular characteristics.” Although “particular characteristics” is not defined in the amendments, the SEC release calls out ESG terms like “sustainable,” “green,” or “socially responsible” as especially prone to investor confusion and potential greenwashing, and thus within the scope. Also now within scope are longstanding non-ESG terms like “growth” and “value.”

The key source of the increased liability risks is this: the new Names Rule imposes ostensibly objective standards on inherently subjective concepts. The current Rule focuses mainly on fund names that suggest a geographic or industry focus. In practical terms, there is not much “eye of the beholder” variability in whether 80% of a fund’s holdings are in Japanese companies or in utilities when a fund name signals such an investment focus.

But when a fund name declares a “sustainable,” “green,” or “socially responsible” investment focus, reasonable minds could obviously differ greatly on what types of securities should or shouldn’t fall within the 80% bucket consistent with these labels. The same is true for “growth” and “value” funds, which have hardly signified a uniform style historically. Different advisers will take different approaches to these concepts. So naturally, an investor would then turn to the fund’s prospectus to understand how a given fund and its adviser defines the relevant terms for purposes of carrying out the fund’s objectives – in order to select among similarly-named funds for those that best align with the investor’s goals.

Here’s the rub: the new Names Rule requires that such definitions “be consistent with those terms’ plain English meaning or established industry use.” And just who is to be the judge of the supposed “plain English meaning or established industry use” of terms like “sustainable,” “green,” “socially responsible,” “growth,” and “value”? The unfortunate answer is probably the SEC Enforcement staff, with the private plaintiffs’ bar to follow – meaning a serious threat of aggressive second-guessing as to how advisers approach thematic investing. The implication is that full transparency is not enough.

What’s more, the SEC release also makes clear that compliance with the 80% rule is not a “safe harbor” against claims of a misleading fund name. In other words, if the staff concludes that a holding in the other 20% bucket is nevertheless “antithetical” to a fund’s “sustainable” or “value” label, charges for violation of the Rule might still be asserted.

There should be room in the diverse fund marketplace for a variety of approaches to thematic investing using subjective terms, fully explained to investors in fund disclosures. The amended Names Rule threatens to limit that variety, especially if the SEC and plaintiffs’ bar undertake to impose a one-size-fits-all set of definitions. 

In readying for compliance with the Names Rule, funds and advisers will need to take care to assess the risks of their defined investment approaches being second-guessed, even if they are fully transparent.