ESG,  Sustainable Investing and the SEC's Request for Comments on Fund Names

Protecting Investors in the New Age of Sustainable Finance 

As the United States Securities and Exchange Commission (the "SEC") evaluates existing investor protections in light of market developments, such as explosive growth in sustainable finance, it should be careful to anticipate any harm rule revisions might cause. Green and environmental, social and governance ("ESG")¹ investing has become a critical component of global markets. Long before Larry Fink's powerful investor letter in January 2020,² championing stakeholder interests, investor demand for green products had been growing. According to the Climate Bonds Initiative, the value of green bonds and loans issued between 2018 and 2019 surged by 51%, jumping from USD170.6 billion in 2018 to USD257.7 billion in 2019, and these figures are only projected to increase in the coming years.³

As demand for sustainable investment products has intensified, so too has the need for comparative metrics and reliable classification. Concerns around "green-washing" and meaningful standards provide critical challenges for market participants and regulators alike, and there is still no consensus on definition. While regulators such as the SEC would no doubt welcome more clarity so they can adequately protect investors, mandating overly-prescriptive standards for a fast-moving area such as ESG may prove not only premature but also damaging. 

The Names Rule as a Tool for Investor Protection

One existing rule, the SEC's so-called "Names Rule" (Rule 35d-1 under the Investment Company Act of 1940), which regulates the names of funds that are registered with the SEC, is proving difficult to apply in the context of new and rapidly evolving market developments, including ESG, and has prompted a recent request for comment. 

The Names Rule was adopted in 2001 to prohibit funds from using materially deceptive or misleading names and has not been updated since. If a fund's name suggests a particular type of investment (e.g. stock or bonds), industry (e.g. utilities or health care) or geographic focus (e.g. country or region), the Names Rule requires the fund to invest at least 80% of its assets in the corresponding investment type, industry or geography.

On March 2, 2020, the SEC requested public comment on the Names Rule, querying whether its restrictions regarding the use of potentially misleading fund names are effective or if alternatives are needed. At its core, the SEC's request showcases its desire to provide effective protections for market participants and ensure that fund names, which often provide initial information to investors, are not misleading. However, as the SEC acknowledged in its request, the Names Rule has several limitations. Aside from reevaluating the level of the 80% threshold itself, the SEC identified several challenge areas, including ESG, where the Names Rule provides inconsistent or inadequate coverage. For funds that are not covered by the Names Rule, the standard for names continues to be, as per the SEC's guidance when the rule was originally adopted, "whether the name would lead a reasonable investor to conclude that the company invests in a manner that is inconsistent with the company’s intended investments or the risks of those investments."⁴  Anti-fraud provisions also apply to all fund names.

Inconsistent Application of the Names Rule

In its current form, the Names Rule does not apply the 80% test to significant swathes of the market or does so inconsistently. For instance, because it relies on an asset-based test, the Names Rule may not be appropriate for derivatives that provide exposure to a "type" of investment, such as when the market value of derivative investments is small but potential exposure is significant. Indices are also not covered by the current rule so a fund whose name refers to a misleadingly named index (e.g. one that includes "small cap" in its name but has a number securities that do not qualify as such) does not necessarily violate the Names Rule. Equally, funds are increasingly using hybrid financial instruments that may not be easily linked to a specific asset type, making them difficult to characterize for the purposes of the 80% test. 

In addition, the Names Rule may not cover or only inconsistently apply to funds operating in new sectors such as ESG and blockchain, which can be difficult to define, a potentially critical gap in coverage given the rapid pace of development in such areas. The ESG space, in particular, has experienced massive growth in recent years and shows little sign of stopping. Data from the SEC's EDGAR system suggests that there were 65 funds at the end of 2017 that used terms related to sustainability in their names. By the end of 2019, the number of such funds had leapt to 291.

Treatment of ESG as an Investment Type Versus a Strategy Can Create Confusion

In the context of ESG, it may be unclear whether a fund's name is subject to the Names Rule, and funds take different approaches. Some funds treat ESG as a type of investment, which is covered by the Names Rule, while others treat ESG as an investment strategy, which sits outside the purview of the Names Rule. Even when a fund does treat ESG as a type of investment, this classification may be subject to the fund's own qualitative assessment as to what constitutes an ESG investment, since there is no market consensus as to what is "green" or "ESG" compliant. Unfortunately, the distinction between investment strategy and investment type can mean little to the average investor so the inconsistent application of the Names Rule, whose very goal is to bolster investor protection, may ultimately prove ineffective or create further confusion for those clamoring for green products. 

Ensuring Both Transparency and Flexibility as the ESG Market Develops

In its request, the SEC is quite right to query if the Names Rule should apply to terms such as "ESG" or "sustainable" but until there is sufficient clarity on these, it should be careful to avoid over-regulating a space where the market is continuing to develop. Taxonomy remains an ongoing challenge for green investment products. Unless and until there is better consensus on classification, the SEC may be better advised to ensure greater transparency without compromising flexibility, which may ultimately mean eliminating the Names Rule entirely. Otherwise, the SEC risks undermining sustainable investment at a time when it is urgently needed and in high demand.

Given the number of funds that are already not subject to the Names Rule, the SEC should take a pragmatic approach to any rule revisions. ESG investors should be able to expect consistency in what a fund name means. Even if the SEC concludes that funds and investors benefit from a prescribed level of investment in a particular product, be it 80% or otherwise, it will still need to reevaluate the scope of coverage. If the number of funds not covered by the Names Rule because they treat ESG as a strategy continues to grow or ESG classification systems continue to be applied differently by different funds, simply imposing a strict numeric threshold will provide no greater consistency or protection than the current rule. The SEC could therefore consider whether it should expand the scope of the Names Rule to include the various ways funds are approaching ESG as well as the types of funds focused on this area or eliminate the rule entirely.

The SEC's request for comments is available at https://www.sec.gov/rules/other/2020/ic-33809.pdf. Comments are due by May 5, 2020. 

Author:  Elizabeth (ZZ) Friedman, Associate with special thanks to Partners, Jennifer Schneck, Margaret Sheehan and Anna-Marie Slot for their contributions.

1. Terms such "green" and "ESG" are often used interchangeably, along with "sustainability." Green or sustainable investments constitute a subset of ESG, and satisfy its environmental prong. ESG also encompasses investments associated with social and governance initiatives.
2. Fink, Larry. "A Fundamental Reshaping of Finance." Jan. 2020. Available at: https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter.
3. Climate Bonds Initiative. "2019 Green Bond Market Summary." Feb. 2020. Available at: https://www.climatebonds.net/files/reports/2019_annual_highlights-final.pdf.
4. Investment Company Names, Investment Company Act Release No. 24828 (Jan. 17, 2001) [66 Fed. Reg. 8509 (Feb. 1, 2001), correction 66 Fed. Reg. 14828 (Mar. 14, 2001)]. Available at: https://www.sec.gov/rules/final/ic-24828.htm.