SEC Investment Management FAQ: Investment Company Names (Rule 35d-1)

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The staff of the Division of Investment Management has prepared these responses to frequently asked questions about new rule 35d-1, which addresses certain broad categories of investment company names that are likely to mislead investors about an investment company's investments and risks. The adopting release for rule 35d-1 can be found at www.sec.gov/rules/final/ic-24828.htm .

These responses represent the views of the staff of the Division of Investment Management. They are not a rule, regulation, or statement of the Securities and Exchange Commission. Further, the Commission has neither approved nor disapproved this information.

Adoption of 80% Investment Policy

Question 1

Q: If a fund wishes to adopt a fundamental 80% investment policy to comply with rule 35d-1, does the fund need to obtain shareholder approval?

A: The Investment Company Act does not require shareholder approval to adopt a new fundamental policy unless the new fundamental policy deviates from an existing fundamental policy. 1 Therefore, if a fund currently has a non-fundamental 65% investment policy and wishes to change the policy to a fundamental 80% investment policy, the Investment Company Act would not require shareholder approval unless the new fundamental policy deviates from some other existing fundamental policy.

Similarly, under the Investment Company Act, shareholder approval would not be required by a fund that has a fundamental 65% investment policy that wishes to adopt a fundamental 80% investment policy, unless adoption of the new policy constitutes deviation from the existing policy or some other existing fundamental policy. A fund would therefore need to determine, based on its individual circumstances, whether it would be necessary to seek shareholder approval to change a fundamental investment policy to increase the investment threshold from 65% to 80%.

For example, a fund that has a fundamental policy to invest at least 65% of its assets in equity securities generally would not be deviating from that policy if it adopted a new fundamental policy to invest at least 80% of its assets in equity securities and would not be required to obtain shareholder approval. By contrast, a fund that has a fundamental policy to invest at least 65%, but not more than 75%, of its assets in equity securities would not be able to adopt a new fundamental policy to invest at least 80% of its assets in equity securities without deviating from the existing fundamental policy. In this case, shareholder approval of the new fundamental policy would be required under the Investment Company Act.

A fund should also consider whether factors outside the Investment Company Act, such as state law or the fund's charter or by-laws, would require shareholder approval in order to adopt a fundamental 80% investment policy.

Question 2

Q: May a fund that changes its investment policy from 65% to 80% in order to come into compliance with rule 35d-1 disclose that change in a post-effective amendment filed pursuant to rule 485(b) under the Securities Act?

A: Yes. A fund that changes its investment policy from 65% to 80% in order to come into compliance with the rule may disclose the change in a post-effective amendment filed pursuant to rule 485(b) under the Securities Act of 1933, provided that the post-effective amendment otherwise meets the conditions for immediate effectiveness under rule 485(b). If a fund makes other material changes to its investment policy together with a change from 65% to 80%, it must disclose the other changes in a rule 485(a) amendment. A fund should disclose its policy to invest its assets in accordance with the 80% investment requirement suggested by its name in Item 2(b) of Form N-1A, which requires a fund to identify its principal investment strategies, including the types of securities in which it invests principally. 2

Tax-Exempt Funds

Question 3

Q: How does rule 35d-1 apply to single-state tax-exempt funds? Are single-state tax-exempt funds required to satisfy the 80% investment requirement only with securities of issuers located in the named state?

A: A fund with a name that suggests that its distributions are exempt from both federal and state income tax, e.g. , the Maryland Tax-Exempt Fund, must have a fundamental policy to invest, under normal circumstances, either: (i) at least 80% of the value of its assets in investments the income from which is exempt from both federal income tax and the income tax of the named state, or (ii) its assets so that at least 80% of the income that it distributes will be exempt from both federal income tax and the income tax of the named state. 3 A single-state tax-exempt fund may include a security of an issuer located outside of the named state in the 80% basket if the security pays interest that is exempt from both federal income tax and the tax of the named state, provided that the fund discloses in its prospectus that it may invest in tax-exempt securities of issuers located outside of the named state. 4

Single state tax-exempt funds are not subject to section (a)(3) of the rule (relating to funds with names that suggest investment in a specific country or geographic region).

Question 4

Q: Are funds with the term "municipal" in their names treated like tax-exempt funds under rule 35d-1(a)(4)?

A: Yes. The terms "municipal" and "municipal bond" in a fund's name suggest that the fund's distributions are exempt from income tax. Therefore, funds that use these terms in their names would be expected to comply with rule 35d-1(a)(4). However, funds that use the term "municipal" rather than "tax-exempt" may count securities that generate income subject to the alternative minimum tax toward the 80% investment requirement, while funds that use the term "tax-exempt" may not.

Question 5

Q: The SEC recently adopted rules that require a mutual fund to include standardized after-tax returns in advertisements and sales literature that include any quotation of performance and that represent or imply that the fund is managed to limit or control the effect of taxes on fund performance. 5 Advertisements and sales literature for a fund that is eligible to use a name suggesting that its distributions are exempt from federal income tax or both federal and state income tax under rule 35d-1 are not, however, required to include standardized after-tax returns, unless they voluntarily choose to include after-tax performance information. 6 All fund advertisements and sales literature are required to comply with the new after-tax return rules no later than December 1, 2001, 7 but compliance with rule 35d-1 is not required until July 31, 2002. Prior to July 31, 2002, must a fund that relies on the exception for tax-exempt funds from the requirement to report standardized after-tax returns in advertising and sales literature meet the requirements of rule 35d-1(a)(4)?

A: Generally, yes. Rule 35d-1 was effective on March 31, 2001. Although funds are not required to comply with rule 35d-1 until July 31, 2002, any fund that relies on the exception for tax-exempt funds from the after-tax return advertising rule at any time must comply with the eligibility requirements under rule 35d-1(a)(4) for using a name suggesting that the fund's distributions are exempt from federal income tax or from both federal and state income tax. As a practical matter, this means that, prior to July 31, 2002, in order to rely on the exception for tax-exempt funds from the after-tax return advertising rule, a tax-exempt fund, including a single state tax-exempt fund, need only comply with the eligibility requirements under rule 35d-1(a)(4) for using a name suggesting that the fund's distributions are exempt from federal income tax. The requirements set forth in rule 35d-1(a)(4) for a fund that has a name suggesting that its distributions are exempt from federal income tax are generally the same as those currently applied by the Division of Investment Management.

Specific Terms Commonly Used in Fund Names

Question 6

Q: Does rule 35d-1 apply to funds that use the terms "small-cap," "mid-cap," and "large-cap?"

A: Yes. Terms such as "small-, mid-, or large-capitalization" suggest a focus on a particular type of investment, and investment companies that use these terms will be subject to the 80% investment requirement of the rule. As a general matter, an investment company may use any reasonable definition of these terms and should define these terms in its discussion of its investment objectives and strategies in its prospectus. 8 In developing a definition of the terms "small-, mid-, or large-capitalization," registrants should consider all pertinent references, including, for example, industry indices, classifications used by mutual fund rating organizations, and definitions used in financial publications. Definitions and disclosure inconsistent with common usage, including definitions relying solely on average capitalization, are considered inappropriate by the staff.

Question 7

Q: How does rule 35d-1 apply to a fund that uses the term "high-yield" in its name?

A: The term "high-yield" is generally understood in the financial and investment community to describe corporate bonds that are below investment grade, commonly defined as bonds receiving a Standard & Poor's rating below BBB or a Moody's rating below Baa. 9

Therefore, a fund using the term "high-yield" in its name generally must have a policy to invest at least 80% of its assets in bonds that are below investment grade.

However, a fund that uses the term "high-yield" in conjunction with a term such as "municipal" or "tax-exempt" that suggests that the fund invests in tax-exempt bonds would not be required to invest at least 80% of its assets in bonds that meet these rating criteria. Because the market for below investment grade municipal bonds is smaller and relatively less liquid than its taxable counterpart, tax-free high-yield bond funds have historically invested to a greater degree in higher grade bonds than taxable high-yield funds. As a result, the use of the term "high-yield" together with a term suggesting that the fund invests in tax-exempt bonds suggests that the fund has an investment strategy of pursuing a higher yield than other municipal or tax-exempt bond funds.

Question 8

Q: Does rule 35d-1 apply to a fund that uses the term "tax-sensitive" in its name?

A: No. The term "tax-sensitive" connotes a type of investment strategy rather than a focus on a particular type of investment. Therefore, use of the term "tax-sensitive" in a fund's name will not require the fund to comply with the 80% investment requirement of rule 35d-1.

We remind funds, however, that a particular fund name may be misleading under the antifraud provisions of the federal securities laws, even if it is not covered by rule 35d-1. In determining whether a particular name is misleading, the Division considers whether the name would lead a reasonable investor to conclude that the fund invests in a manner that is inconsistent with the fund's intended investments or the risks of those investments. 10

Question 9

Q: How does rule 35d-1 apply to a fund that uses the term "income" in its name?

A: Rule 35d-1 would not apply to the use of the term "income" where that term suggests an investment objective or strategy rather than a type of investment. When used by itself, the term "income" in a fund's name generally suggests that the fund emphasizes the achievement of current income and does not suggest a type of investment. For example, fund companies offering a group of "life cycle" funds, each of which invests in stocks, bonds, and cash in a ratio considered appropriate for investors with a particular age and risk tolerance, sometimes use the term "income" to describe the fund that places the greatest emphasis on achieving current income. Similarly, the term "growth and income" does not suggest that a fund focuses its investments in a particular type of investment, but rather suggests that a fund invests its assets in order to achieve both growth of capital and current income. Likewise, the term "equity income" suggests that a fund focuses its investments in equities and has an investment objective or strategy of achieving current income. By contrast, a term such as "fixed income" suggests investment in a particular type of investment and would be covered by rule 35d-1.

Question 10

Q: How does rule 35d-1 apply to a fund with a name that includes the term "global" or "international," followed by a term that suggests a particular type of investment, such as "fixed income?"

A: The terms "international" and "global" connote diversification among investments in a number of different countries throughout the world, and therefore the use of these terms in a fund name is not subject to the rule. 11 However, a fund that has a name containing both the term "global" or "international," and a term that suggests that the fund focuses its investments in a particular type of investment, e.g. , "fixed income," will be expected to comply with the 80% investment requirement with respect to the latter term.

Question 11

Q: Would rule 35d-1 require a fund that uses a term such as "intermediate term bond" in its name to invest at least 80% of its assets in intermediate term bonds?

A: No. The Division takes the position that a "short-term," "intermediate-term," or "long-term" bond fund should have a dollar-weighted average maturity of, respectively, no more than 3 years, more than 3 years but less than 10 years, or more than 10 years. Such a fund should, however, invest at least 80% of its assets in bonds in order to comply with rule 35d-1. Compliance with the Division's maturity guidelines is not intended to act as a safe harbor in determining whether a name is misleading. There may be instances where the dollar-weighted average maturity of a fund's portfolio securities may not accurately reflect the sensitivity of the fund's share price to changes in interest rates. 12

Question 12

Q: Are there any guidelines for a bond fund's use of a name that suggests that its portfolio has a specified duration, e.g. , "short-duration bond fund?"

A: The Division has not developed specific guidelines regarding a fund's use of a name, e.g. , "short-duration bond fund," suggesting that its bond portfolio has a particular duration. A fund that uses a name suggesting that its bond portfolio has a particular duration, e.g. , short, intermediate, or long, may use any reasonable definition of the terms used, and should explain its definition in its discussion of its investment objectives and strategies in the fund's prospectus. In developing a definition of a term that suggests a particular portfolio duration, registrants should consider all pertinent references, including, for example, classifications used by mutual fund rating organizations, definitions used in financial publications, and industry indices. Definitions and disclosure inconsistent with common usage are considered inappropriate by the staff. A fund that uses a name suggesting that its bond portfolio has a particular duration is not required to invest at least 80% of its assets in bonds of that duration.

Question 13

Q: A fund that uses the term "money market" in its name must invest solely in eligible securities and meet other investment requirements under rule 2a-7, in order for its name not to be deemed materially deceptive or misleading within the meaning of Section 35(d) of the Investment Company Act. 13 Is a fund that uses the term "money market" in its name also required to comply with rule 35d-1?

A: Rule 35d-1 would require a fund using the term "money market" in its name to adopt a policy to invest at least 80% of its assets in the type of money market instruments suggested by its name. For example, a fund calling itself "The XYZ U.S. Treasury Money Market Fund" would be required to adopt a policy to invest at least 80% of its assets in U.S. Treasury securities. However, a generic money market fund, i.e. , a money market fund that has a name suggesting that it invests in money market instruments generally ( e.g. , "The XYZ Money Market Fund"), would not be required to specifically adopt a policy to invest at least 80% of its assets in eligible securities since rule 2a-7, in any event, requires the fund to invest solely in eligible securities.

Notice to Shareholders of Change in Investment Policy

Question 14

Q: For a fund that has adopted a policy to provide its shareholders with at least 60 days' notice prior to changing its 80% investment policy, what should the notice include?

A: Rule 35d-1 does not prescribe the contents of a notice of a change in a fund's investment policy. We believe, however, that the notice should, at a minimum, describe the 80% investment policy, the nature of the change to the investment policy, the fund's new name, and the effective date of the investment policy and name changes. In order to comply with rule 35d-1(c), a fund's notice policy must provide that the notice will:

be provided in plain English;

be a separate written document (although the notice may be delivered to shareholders together with other communications to investors, such as an annual or semi-annual report); and

contain the statement "Important Notice Regarding Change in Investment Policy," or a similar clear and understandable statement, prominently and in bold-face type. This prominent statement also must appear on the envelope in which the notice is delivered, if the notice is not delivered separately from other communications to investors. If the notice is delivered separately, the statement must appear either on the notice or on the envelope in which the notice is delivered. 14

Compliance Date

Question 15

Q: When do new registrants have to comply with the requirements of rule 35d-1?

A: All registered investment companies must be in compliance with the rule by July 31, 2002, regardless of when they initially register. Newly registered investment companies may, however, wish to comply with rule 35d-1 from the time of registration in order to avoid the need to make portfolio adjustments, internal compliance system changes, and/or name changes, as a result of the need to come into compliance with the rule.

Endnotes

See Section 13(a)(3) of the Investment Company Act (requiring shareholder approval to deviate from a fundamental policy); Investment Company Names, Investment Company Act Release No. 22530, at n. 49 (Feb. 27, 1997) [62 FR 10955, 10960-10961 n. 49 (Mar. 10, 1997), correction 62 FR 24161 (May 2, 1997)] (Investment Company Names Proposing Release) (discussing whether funds need shareholder approval to adopt a fundamental 80% investment policy).

See Investment Company Names, Investment Company Act Release No. 24828 (Jan. 17, 2001) [66 FR 8509, 8511 n. 15 (Feb. 1, 2001), correction 66 FR 14828 (Mar. 14, 2001)] (Investment Company Names Adopting Release).

Rule 35d-1(a)(4).

See Investment Company Names Adopting Release, supra note 2, 66 FR at 8512 n. 30.

See Disclosure of Mutual Fund After-Tax Returns, Investment Company Act Release No. 24832 (Jan. 18, 2001) [66 FR 9001 (Feb. 5, 2001)].

6 Securities Act rule 482(f); Investment Company Act rule 34b-1(b)(1)(iii)(C).

The compliance date for this requirement was recently extended from October 1, 2001, to December 1, 2001. See Disclosure of Mutual Fund After-Tax Returns; Extension of Compliance Date, Investment Company Act Release No. 25175 (Sept. 26, 2001) [66 FR 50102 (Oct. 2, 2001)].

See Investment Company Names Adopting Release, supra note 2, 66 FR at 8513-8514 nn. 42-43 and accompanying text.

See , e.g. , Morningstar, Principia Pro Plus (May 2001) (including funds "with at least 65% or more of bond assets in bonds rated below BBB" in high-yield bond category of taxable bond funds); William F. Sharpe, Gordon J. Alexander, & Jeffery V. Bailey, Investments 437 (5th ed. 1995) (defining "junk bonds" as "bonds that have been assigned to one of the lower ratings (BB and below by Standard & Poor's; Ba and below by Moody's)"); Richard J. Teweles, Edward S. Bradley, & Ted M. Teweles, The Stock Market 539 (6th ed. 1992) (defining "junk" or "high-yield" securities as debt securities with ratings below BBB from Standard & Poor's or below Baa from Moody's).

See Investment Company Names Adopting Release, supra note 2, 66 FR at 8514 nn. 43-44 and accompanying text.

See Investment Company Names Adopting Release, supra note 2, 66 FR at 8513-8514 n. 42.

See Investment Company Names Adopting Release, supra note 2, 66 FR at 8514 nn. 45-47 and accompanying text.

Rule 2a-7(b)(2) and (c)(3)(i).

Cf. Delivery of Proxy Statements and Information Statements to Households, Securities Act Rel. No. 7912, Exchange Act Rel. No. 43487, Investment Company Act Rel. No. 24715 (Oct. 27, 2000) [65 FR 65736, 65738 (Nov. 2, 2000)] (describing notice to investors of intent to "household" proxy statements and information statements); Delivery of Disclosure Documents to Households, Securities Act Rel. No. 7766, Exchange Act Rel. No. 42101, Investment Company Act Rel. No. 24123 (Nov. 4, 1999) [64 FR 62540, 62541 (Nov. 16, 1999)] (describing notice to investors of intent to "household" prospectuses, annual reports, and investment company semi-annual reports).

http://www.sec.gov/divisions/investment/guidance/rule35d-1faq.htm

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Modified: 12/04/2001