The SEC has in recent months proposed a flurry of new ESG-related rules. The first to come into force is an amendment to Rule 35d-1 of the Investment Company Act of 1940, better known as the ‘Names Rule’.1 The rule requires that “registered investment companies whose names suggest a focus in a particular type of investment to adopt a policy to invest at least 80 percent of the value of their assets in those investments (an “80 percent investment policy”).”2
The new amendment expands the scope of the existing rule to include terms associated with ESG (such as ‘green’ and ‘sustainable’) and wider investment approaches (including ‘growth’ and ‘value’). It also introduces new recordkeeping and reporting requirements. Most observers see this as a response to misleading environmental claims, commonly known as greenwashing. However, the application of the rule to non-ESG terms means that as many as 76% of all funds will now be covered.3
New requirements
The amended Names Rule comes with new recordkeeping and disclosure requirements, some of which we set out below.4
Source: SEC
Meeting these requirements involves enhancements to fund disclosures, technology systems, and control frameworks. Firms should seek to coordinate these initiatives, integrating controls and governance directly into systems and processes where possible to minimize the risk of non-compliance, whether accidental or otherwise.
Definitions and disclosures
Funds that are subject to the Names Rule will need to define any of the proscribed terms used in its name, disclosing those definitions in their prospectus and detailing the criteria used to make relevant investments. Firms will need to ensure close coordination between portfolio managers, marketing teams, and legal departments to identify in-scope funds and the terms to be defined. These parties will then be responsible for approving those definitions and investment criteria, as well as associated investor communications.
Ideally, the enhanced Rule will encourage a consistent definition of terms across all funds that use them – while this is not an SEC requirement per se, it would greatly simplify compliance and oversight. Firms should also design and implement processes and controls that ensure changes made to definitions or investment criteria are properly reviewed, approved, and communicated to investors.
After initial implementation, firms must maintain robust oversight to ensure ongoing consistency and coordination when defining new terms, documenting and evidencing investment criteria, and updating prospectuses. A governance committee – including representatives from portfolio management, marketing, and legal teams – should proactively review proposed definitions or changes to ensure compliance with both the SEC’s requirements and the fund’s strategy.
Time for technology
Firms must also prepare for a significant expansion in their recordkeeping and reporting activities. While a challenge, by automating and integrating compliance functions into existing systems and processes they will minimize the burden of manual oversight and reporting on their compliance staff.
Technology updates should particularly focus on the point of investment itself – the calculation and recording of basket value should be automatic at the point of trade execution to avoid manual errors or timing issues. Order management systems should also include a control requiring the portfolio manager to record the rationale for the investment prior to submitting the trade for execution.
Firms should also seek to automate quarterly reporting of the basket and a breakdown of the assets within it. Similarly, automated alerts and escalations should be incorporated into portfolio monitoring and reporting systems for timely identification and remediation of breaches of the 80% investment threshold.
Control frameworks
In addition to automated controls at the point of investment to capture the necessary data, firms should implement post-trade manual controls to confirm data accuracy. Daily or weekly reviews of the portfolio manager’s basis for inclusion, although time consuming, significantly reduce the risk inherent in waiting for quarterly reviews.
Furthermore, the quarterly requirement to review the composition and value of the 80% basket requires additional monitoring. At a minimum, there must be evidence of a positive compliance review. Here, best practice dictates that a manager or a committee, not directly accountable for the fund’s performance, review the assets’ eligibility for inclusion and certify on a quarterly basis that the definitions in the fund’s prospectus are being followed.
Finally, firms should put in place monitoring controls to identify if a fund breaches its 80% threshold along with subsequent escalation procedures. Under the revised Rule, in the event of a breach funds must demonstrate a return to compliance within 90 days, so timely identification of breaches is critical. The longer it takes to identify a breach, the less flexibility the portfolio manager has to address it.
Implementing solutions
Changes to the Names Rule will have a significant impact on firms, their employees, processes and technology. Successful implementation requires strong program management to coordinate a large number of departments and stakeholders. Technology and governance must work hand-in-hand to ensure seamless coverage.
Starting with a clear understanding of the current end-to-end technology infrastructure and investment process will enable firms to quickly identify gaps for remediation. Likewise, key stakeholders should be included when designing the target state. Compliance teams must be satisfied that the solution meets their demands, while technology teams should be on hand to confirm feasibility. It is also key that portfolio managers and traders are able to understand and incorporate new controls into their workflows.
The Names Rule may appear a less complicated piece of regulation than the Uncleared Margin Rules of Basel III Endgame, for example, and tactical solutions may accordingly seem appealing in the short term, However, attempts to align via manual processes alone places a major burden on compliance staff. This approach also exposes the firm to additional regulatory risk through the potential for manual errors or misconduct. Firms should instead take a holistic view and implement a strategic solution for compliance from day one.
