United States: SEC Adopts Rule Prohibiting Misleading Mutual Fund Names

Under the rule, it is misleading for a fund to have a name that suggests that it focuses its investments in a particular type of investment, or investments in a particular industry (or group of industries), unless it has adopted a policy to invest, under normal circumstances, at least 80% of the value of its net assets in the type of investment or industry suggested by its name. That policy must be a fundamental policy (i.e., a policy that can be changed only with the approval of the holders of a majority of the Fund's outstanding shares), or the fund must adopt a policy under which it will provide shareholders at least 60 days' prior notice of any change in its investment policy, given in accordance with the notice requirements of the rule. These requirements do not apply to funds with names that connote types of investment strategies (e.g., growth or value) rather than types of investments.

Similar requirements apply to funds whose names suggest that their investments are focused in a particular country or geographic region. Such a fund must adopt a policy to invest, under normal circumstances, at least 80% of the value of its net assets in investments that are tied economically to the particular country or geographic region suggested by its name. The fund must also disclose in its prospectus the specific criteria it uses to make this determination. If the policy is not a fundamental policy, the fund must adopt a policy to provide shareholders 60 days' notice of any change in its investment policy.

The notice that a fund sends to satisfy the rule's requirement that shareholders be notified of a change in investment policy must be a separate "plain English" written document. It must include the following statement, or a similar clear and understandable statement, in bold-face type: "Important Notice Regarding Change in Investment Policy." This statement must also appear on the envelope in which the notice is delivered, but need only be included on the notice itself if the notice is delivered separately from other investor communications.

Rule 35d-1 also applies to tax-exempt funds. If a fund name suggests that the fund's distributions are exempt from federal income tax, or from federal and state income tax, the fund must have a fundamental policy either: (1) to invest, under normal circumstances, at least 80% of the value of its net assets in investments the income from which is exempt from federal income tax, or from both federal and state income tax (as applicable); or (2) to invest, under normal circumstances, its assets so that at least 80% of the income that it distributes will be exempt from such taxes. The adopting release states, consistent with existing SEC Staff positions, that investments generating income that is subject to alternative minimum tax, and distributions that are subject to such tax, are not considered exempt from federal income tax for purposes of the rule. Unlike the policies of other funds covered by Rule 35d-1, a tax-exempt fund's 80% policy must be a fundamental investment policy.

Consistent with the provisions of Section 35(a) of the 1940 Act, Rule 35d-1 also prohibits funds from using names that suggest that the funds or their shares are guaranteed or approved by the U.S. government or by any U.S. government agency. Use of words such as "guaranteed" or "insured" in conjunction with the words "United States" or "U.S. government" are prohibited.

It is important to recognize that Rule 35d-1 does not provide a "safe harbor" for investment company names. As an example, the SEC stated that the name of an index fund may be misleading if the fund invests only 80% of its net assets in securities included within the relevant index because it is generally expected that index funds will invest a greater percentage of their assets in those securities.

A fund's 80% policy must be met only at the time it makes an investment. Changes in the value of a fund's assets, whether due to market fluctuations in the value of its portfolio holdings or redemptions of fund shares, will not cause a fund to violate the rule or require the fund to sell non-conforming investments. However, under those circumstances, future investments must be made in a manner to bring the fund into compliance with its policy.

By requiring that funds comply with their policies "under normal circumstances," the rule contemplates that funds may deviate from their 80% policies for temporary defensive purposes and in other limited circumstances, such as when a fund experiences significant cash inflows or anticipates large redemptions. The SEC noted in this regard that new funds should generally be invested in accordance with their investment objectives and policies within six months, but expressed the view that new funds investing in relatively liquid assets should generally be fully invested within a much shorter period.

A fund's 80% policy must apply to the value of the fund's net assets plus any borrowings for investment purposes. Thus, a fund cannot circumvent the intent of the 80% test by borrowing money and investing the proceeds of borrowings in investments that are not consistent with its name. Neither the adopting release nor the provisions of Rule 35d-1 explain how short sales of securities should be treated by a fund in applying its 80% policy.

Rule 35d-1 does not apply to fund names that connote the maturity of instruments in which the funds invest, such as "short-term," "intermediate-term" or "long-term." Historically, the SEC Staff has required funds using these terms to have weighted average portfolio maturities of no more than three years, more than three years but less than ten years, and more than ten years, respectively. ICA Rel. No. 15612 (Mar. 9, 1987) (proposal to codify this Staff position). Although in proposing Rule 35d-1 the SEC stated that the Staff would no longer apply these criteria, the Staff has determined that it will continue to apply its historic position in this area. The SEC cautioned, however, that the Staff position is not a "safe harbor" and that a fund complying with the Staff's maturity guidelines may nonetheless have a misleading name if the "duration" of its portfolio is inconsistent with the sensitivity to interest rates suggested by the fund's name.

New Rule 35d-1 becomes effective on March 31, 2001. However, funds have until July 31, 2002 to comply with the requirements of the rule. The Commission believes that this will provide sufficient time for funds to adjust their portfolios, change internal compliance systems and adopt name changes as necessary to effect compliance. Funds with names of the types covered by the rule need to review their investment policies, determine what modifications are necessary to effect compliance, and amend their policies or change their names to comply with the rule.