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The Securities and Exchange Commission adopted a new rule Wednesday aimed at preventing investment companies from using misleading names to market their funds to investors.
The rule was proposed in response to a growing trend of investment funds labeling themselves as ESG-focused, suggesting that they invest in companies that meet certain environmental, social or governance criteria.
The rule “reflects the basic idea of funds investment portfolio should match a funds advertised investment focus,” said SEC Chair Gary Gensler. “In essence, if a client’s name suggests an investment focus, the fund in turn needs to invest shareholders dollars…in a manner consistent with that investment.”
The rule requires investment advisers to make sure that a fund with a name that implies a focus on companies with a particular set of characteristics has 80% of its investments reflect the plain English meaning or established industry use of a term in question.
Fund managers will also have to add disclosures to their prospectuses to define the terms in their fund names and the criteria used to determine which investments meet those criteria.
Closed-end funds, like mutual funds that issue a fixed number of shares in a one-off initial public offering, will now have to hold a shareholder vote in order to change their investment policies, unless the fund manager conducts a tender or repurchase offer in advance of the change.
“Investment companies, especially mutual funds and ETFs, are increasingly using terms such as ‘ESG’ and ‘sustainable’ in their fund names to attract hundreds of millions of dollars from investors even when there has been little or no change in the funds’ investment holdings,” said Stephen Hall, legal director at the market-reform advocacy group Better Markets, in a Tuesday statement.
The fund industry has pushed back vigorously against the reform plan since its proposal in May 2022, arguing that the $5 billion in new compliance costs initially estimated by the SEC was an underestimate, and that these outlays would ultimately be borne by investors.
Eric Pan, CEO of the Investment Company Institute, an industry group, said in a statement that the new rules “has nothing to do with ESG,” given that the rule will affect the vast majority of funds, not just ESG vehicles.
“The only thing that this rule achieves is to insert the SEC deeper into funds’ investment decision-making processes,” Pan said. “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 will hurt American retail investors.”
The proposal was approved by a 4-1 vote, with Republican Commissioner Hester Peirce joining Gensler and the Commission’s other two Democrats in voting for the rule. Mark Uyeda, a Republican, voting against adoption.
“With these amendments, the Commission overemphasizes the importance of a fund’s name, as if to suggest that investors need not look at the prospectus disclosure,” said Uyeda said. “These amendments also will entail significant compliance costs for funds to implement, which ultimately will be borne by investors.”
Uyeda also predicted that funds may seek to avoid these costs by “generic or exceedingly complex names that do little to help investors.”
The SEC modified the proposal somewhat in response to industry concerns, increasing the timeline funds had to remedy temporary departures from the 80% investment benchmark to 90 days, up from the 30 days.
The rule will have a wide-ranging impact, with the SEC officials estimating that it would affect roughly three quarters of all funds.
The new regulation will go into effect 60 days after its publication in the Federal Register. Fund groups with assets of $1 billion or more will have 12 months to comply with the amendments, and fund groups with assets of less than $1 billion will be given 18 months.
