The SEC recently adopted a final rule (the “ETF Rule”) designed to modernize the registration of exchange-traded funds (“ETFs”).[1]  Since 1992, an ETF coming to market has required an exemptive relief order from the SEC to operate under the Investment Company Act of 1940.[2]  This process was expensive and inefficient for both registrants and the SEC.  The ETF Rule establishes a framework applicable to open-end funds[3] that will allow an ETF to come to market without obtaining exemptive relief, provided that it meets the following criteria:

 1. Provide standardized daily portfolio transparency on the ETF’s website, including the ticker, CUSIP, trailing 30-day median bid-ask spread, premium or discount, and quantity and weight of holdings in the ETF, before the opening of trading on the ETF’s primary listing exchange[4];

2. Adopt written policies and procedures governing the construction of baskets and the process used for acceptance of baskets, if applicable[5]; and

3. Preserve and maintain all written agreements with service providers.[6]

In addition to introducing the new registration framework, the SEC introduced several amendments to Form N-1A (the registration statement utilized by ETF registrants) that are designed to provide investors with more ETF-specific information (the “N-1A Amendments”).[7]  Specifically, the N-1A Amendments require registrants to:

1. Include disclosures regarding the fees and expenses incurred from buying, holding, and selling shares on secondary markets[8];

2. Include cross-references to the ETF’s website where more granular details about the ETF will be available[9]; and

3. Remove duplicative disclosures regarding the number of shares and creation units.[10]

The ETF Rule and the N-1A Amendments are intended to provide a less expensive and more efficient registration process that draws more registrants into the market while providing more detailed disclosure to investors about the ETFs offered.  While ETFs have been a fast growing investment tool under the old system, the SEC believes that the new rule-based process will encourage even greater use of ETFs.

We believe the ETF Rule and the N-1A Amendments offer an opportunity for investment managers to accelerate or initiate their ETF offerings under a simplified registration regime.  However, a failure to appreciate the limits of the relief provided by the ETF Rule or the N-1A Amendments can be a trap for the unwary. 

As an example, the ETF Rule reforms the registration process, but does not affect ETF fund of funds “participation agreements”, which generally allow an investment company to acquire more shares of an ETF than would otherwise be allowed under Sections 12(d)(1)(A) and (B) of the Investment Company Act, subject to certain limits. Rather, ETFs relying on the ETF Rule that do not already have their own exemptive relief may enter into fund of funds arrangements as set forth in recent ETF exemptive orders, provided that they satisfy the terms and conditions for fund of funds relief in those orders, until such time as the SEC issues a rule governing fund of funds arrangements.

Experienced service providers, including legal counsel, can help registrants navigate the complexities of participation agreements post-ETF Rule, as well as the benefits of the ETF Rule and the N-1A Amendments.
If you have any questions about the ETF Rule, the N-1A Amendments, or about the regulation of ETFs in general, please feel free to contact us.

[1] SEC, 2019-190, https://www.sec.gov/news/press-release/2019-190.
[2] Id.
[3] Id. The majority of ETFs currently available are open-end funds.  These funds are eligible for relief under the ETF Rule.  Meanwhile, ETFs organized as unit investment trusts, leveraged and inverse ETFs, ETFs structured as a share class of a multi-class fund (e.g., the majority of Vanguard ETFs), and non-transparent ETFs will not be able to rely on the ETF Rule.
[4] SEC Exchange Traded Funds, 17 C.F.R parts 210, 232, 239, 270 and 274 (2019).
[5] Id.
[6] Id.
[7] SEC, 2019-190, https://www.sec.gov/news/press-release/2019-190.
[8] SEC Exchange Traded Funds, 17 C.F.R parts 210, 232, 239, 270 and 274 (2019).
[9] Id.
[10] Id.