Exchange-Traded Funds: Proposed Rule 6c-11

by WilmerHale
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After 26 years and the issuance of over 300 exemptive orders, the Securities and Exchange Commission (SEC or Commission), through the rulemaking process, is seeking to simplify and streamline the regulatory process for new exchange-traded funds (ETFs) to reach the market, and to level the competitive playing field among existing ETFs.1 Proposed Rule 6c-11 under the Investment Company Act of 1940 (the Proposed Rule) would permit most ETFs to operate by adhering to the conditions of the Proposed Rule, rather than having to go through the burdensome and time-consuming process of first obtaining an SEC exemptive order. The Proposed Rule also would replace the patchwork of exemptive orders governing how existing ETFs operate and would “create a consistent, transparent, and efficient regulatory framework for ETFs.”2

We discuss below a few of the noteworthy aspects of the Proposed Rule.

Scope

The Proposed Rule covers almost all “plain vanilla” ETFs, whether index-based or actively managed, that are organized as registered investment companies. ETFs that are organized as unit investment trusts (UITs), which include some of the largest ETFs, would not be covered.3 Also excluded are leveraged and inverse ETFs, potentially leaving two sponsors that currently have exemptive orders to operate these ETFs with a dominant market position.4 Because the Proposed Rule covers the vast majority of plain vanilla products, the adoption of the Proposed Rule would enable the SEC and its staff to focus on more novel products. Importantly, all the existing exemptive orders previously issued to ETFs that are within the scope of the Proposed Rule would be rescinded so that all ETFs would be subject to the same requirements and the same constraints.5

Conditions

The Proposed Rule would eliminate distinctions between index-based and actively managed ETFs that are reflected in existing orders. As described in greater detail below, the Proposed Rule generally would enhance disclosure to investors in certain respects, add flexibility in how ETF portfolios are managed and simplify the conditions under which ETFs operate.

  1. Transparency of holdings and basket composition: Each day before trading begins, an ETF would be required to disclose on its website the portfolio holdings used to calculate the ETF’s net asset value, and the composition of the creation and redemption basket that the ETF would accept if presented by any authorized participant. The Proposed Rule does not require the disclosure of each basket (i.e., custom baskets), although the Proposing Release requests comment as to whether ETFs should be required to disclose each basket after the close of trading each day.
  2. Disclosure regarding trading costs: ETFs would be required to disclose the number of days the ETF’s shares have traded at a premium or discount during the most recently completed calendar year and completed quarters since, including a line graph showing the premiums or discounts over that period. If the premium or discount is greater than 2% for more than seven calendar days, the ETF would have to disclose the reasons believed to have contributed to such premium or discount, and this disclosure would be posted on the website for at least one year.
    The Commission also proposed amendments to Form N-1A to significantly enhance the requisite discussion regarding the costs of trading ETFs. Instructions to proposed amended Form N-1A also would require enhanced website disclosure regarding bid-ask spreads, including the median bid-ask spread for the most recent fiscal year, and an interactive calculator to provide investors with the ability to calculate customized trading costs.6
  3. Basket flexibility: In a significant departure from the conditions of recent exemptive orders, ETFs would be able to use custom baskets—baskets of securities that deviate from a pro rata slice of the ETF’s shares—to create and redeem shares. ETFs would be able to tailor the baskets to minimize trading costs and enhance tax efficiency, including the ability to use different creation and redemption baskets, and different baskets on a given day. ETFs would have to adopt written policies and procedures to govern basket construction and the acceptance of custom baskets as part of their Rule 38a-1 compliance program, and thus be subject to oversight by the ETF’s board of trustees.
  4. Elimination of certain requirements: Conversely, certain requirements included in existing exemptive orders would be eliminated by the Proposed Rule. In the past, ETFs have been required to disseminate an intraday indicative value (IIV) every 15 seconds. The Proposing Release acknowledges that the IIV is of little value since it is at best imprecise and rarely if ever relied upon by market-making participants.7 The Proposed Rule also omits the requirement included in exemptive orders (and the 2008 proposal) that certain prescribed language be included in ETF sales literature.8 The Commission noted in the Proposing Release that the prescribed language, originally believed to be necessary to prevent confusion between mutual funds and ETFs, is no longer necessary due to the current market familiarity with ETFs. The elimination of these requirements represents the evolution of the SEC’s understanding of and experience with ETFs.
  5. Investment Company Act requirements: ETFs would continue to be subject to the applicable requirements of the Investment Company Act that are not addressed in the Proposed Rule, such as the limits on the imposition of redemption fees in accordance with Rule 22c-2, which caps such fees at 2% of the value of the transaction.9

While the Proposed Rule would simplify the ability of ETFs to operate in compliance with the Investment Company Act, there continue to be other regulatory requirements that must be considered. ETFs would continue to need relief from certain provisions of the Securities Exchange Act of 1934 (the Exchange Act), which for most ETFs is covered by a number of class-relief letters issued by the Division of Trading and Markets (pursuant to delegated authority of the Commission).10 For more specialized products (i.e., those that do not fall within the parameters of the class-relief letters), individual issuers may need separate relief, which could take months to obtain.11 Moreover, the various exchanges have adopted requirements (standards) that an ETF must adhere to in order to list its shares. If an ETF does not satisfy the applicable generic listing standards, the exchange must apply to the SEC for permission to list the shares through a rule change pursuant to Rule 19b-4 under the Exchange Act, which can be a lengthy process.

* * * * *

The Proposed Rule takes a streamlined and straightforward approach to ETF regulation, affording consistency and investor protection while attempting to ensure that investors and capital markets participants receive relevant information suited to their purposes. The Proposing Release seeks comment on all aspects of the Proposed Rule, and asks numerous questions about the scope of the Proposed Rule, the manner in which authorized participants will interact with ETFs (baskets, arbitrage, etc.) and, particularly, the proposed disclosure requirements. The Commission’s approach is sensible and not overly complex, and should facilitate the stated goals.

  1. The SEC previously proposed a rule to provide similar relief in 2008. See Exchange-Traded Funds, Investment Company Act Release No. 28193 (March 11, 2008). That rule was never adopted. The 2018 proposing release acknowledges that the current proposal takes into account comments submitted during the 2008 process. Exchange-Traded Funds, Investment Company Act Release No. 33140 (June 28, 2018) (the Proposing Release). 
  2. Proposing Release at 1.
  3. Only a limited number of ETFs are organized as UITs rather than registered investment companies, but this includes some of the largest funds (e.g., the SPDR S&P 500 ETF and the Invesco QQQ ETF).
  4. The Proposed Rule also excludes ETFs that are not registered under the Investment Company Act (e.g., commodity pools), exchange-traded notes and ETFs that operate as a share class of an investment company.
  5. The exemptive orders would not be rescinded with respect to relief from the limits of Section 12(d)(1) of the Investment Company Act (fund-of-funds relief). 
  6. Proposing Release at 164.
  7. Proposing Release at 72–73.
  8. The Proposed Rule does not include “a condition requiring each ETF to identify itself in any sales literature as an ETF that does not sell or redeem individual shares.” Proposing Release at 130.
  9. Proposing Release at 67. 
  10. See, e.g., Letter from James A. Brigagliano, Acting Associate Director, to Stuart M. Strauss, Clifford Chance US LLP (October 24, 2006) (Equity Index Class Letter).
  11. The Proposing Release is helpful in this regard in clarifying that ETF shares should be considered “redeemable securities issued by open-end investment companies” for purposes of Regulation M and Rule 10b-17(c) under the Exchange Act, and thus excepted from those rules, but other provisions of the Exchange Act still would need to be addressed in industry letters, individual relief or rule amendments. For example, the Equity Index Class Letter also addresses Rules 10a-1 and 14e-5 under the Exchange Act as well as Rule 200(g) of Regulation SHO.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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