The amendment has updated the ‘Names Rule' under the Investment Company Act to ensure the name of a fund "adequately and accurately represents the investment strategy of the fund", the SEC said.
The rule also takes aim funds using terms such as 'growth' and 'value', which the industry has pushed back on because different firms define those strategies differently.
Previously, the names rule required funds that had a name suggesting a particular type of investment to have at least 80% of its assets in the suggested investment.
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However, the regulator explained this will now apply to ESG funds as well, requiring fund names to meet "plain English meaning or established industry use".
The extension will prevent greenwashing, the SEC said, where for instance a fund technically conforms with the 80% requirement but contradicts the fund name with the remaining 20% of its holdings.
This means that funds with a ‘fossil-fuel free' label will not be able to include fossil fuel holdings in the 20% basket. However, the SEC admitted that a section aimed at preventing misleading labelling was not included in the final rules.
Under the proposed rule, if funds considered ESG factors but those were not the principal purpose of their investment strategy, it would have been deemed "materially deceptive" to use ESG or similar term in its label. Yet, such labelling considerations did not make it into the final rules.
Andrew Behar, CEO of national shareholder representative organisation As You Sow, said: "When investors put their hard-earned savings into an ‘ESG' or ‘fossil free' fund, they expect to reduce their climate risk and not own big oil, coal, and deforestation.
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These new rules will help provide "needed truth" in advertising and make a statement that financial greenwashing with misleading or deceptive ESG labels "is not acceptable", he noted.
"Today, we see funds with ESG in their names holding dozens of fossil fuel extraction companies and coal-fired utilities," he added.
"The plain English meaning of ‘fossil free' should rule out these holdings. We call on asset managers to embrace the spirit of these rules and ensure that their ESG funds have holdings that align with the fund name and prospectus language."