On September 26, 2019, the Securities and Exchange Commission (“SEC”) adopted a new rule to modernize the regulation of most exchange-traded funds (“ETFs”). Rule 6c-11 (the “Rule”) under the Investment Company Act of 1940, as amended (the “1940 Act”),^[1] is a positive development for the investment management industry as it removes regulatory hurdles for advisers looking to enter the ETF market, streamlines and simplifies certain disclosure and other requirements associated with managing an ETF and eliminates certain differences in regulatory requirements for individual products that have arisen over the years. The final Rule clearly reflects serious consideration by the SEC and its staff of industry concerns expressed in comments submitted since the Rule was first proposed in June 2018.

Importantly, the Rule eliminates the need for advisers to seek individual exemptive relief from the SEC prior to launching an ETF, thereby eliminating the cost and delay associated with obtaining exemptive relief. In addition, the Rule eliminates, from a regulatory perspective, the distinction between fully-transparent actively managed and index-based ETFs. Going forward, both fully-transparent active and index-based ETFs will be subject to the same rules and conditions. The Rule also provides much desired flexibility to managers in designing “custom” baskets which should allow for even more efficiencies in managing the purchase and redemption process for ETFs.

The Rule will take effect 60 days after it is published in the Federal Register. Therefore, advisers seeking to launch new ETFs will be able to do so on that date without the need to file for exemptive relief. One year after the Rule takes effect, advisers currently managing ETFs pursuant to an existing exemptive order will need to transition to the Rule, as we discuss further below.

Leveraged or inverse ETFs, semi-transparent ETFs (which do not disclose portfolio holdings daily), ETFs that are a separate share class of multiple-class funds, and ETFs that are organized as unit investment trusts are not eligible to rely on the Rule.

Summary of the Rule

The Rule provides the necessary regulatory exemptions to allow for the operation of an ETF so long as the ETF meets certain conditions.^[2] As noted above, the Rule does not distinguish between index-based and fully transparent actively-managed ETFs. The conditions of the Rule apply equally to both types of products. As a result, managers will have flexibility in the types of strategies offered in the ETF format, from pure, high active share strategies, to more plain vanilla index-based strategies, to hybrid strategies. Importantly, the Rule also does not impose any specific conditions on ETFs that track indexes provided by affiliated index providers or by the fund’s management company (“self-indexed ETFs”). In the past, exemptive orders granted for these types of products imposed certain “firewall” provisions limiting interaction between index developers/managers and portfolio managers.^[3]

In short, the Rule permits an ETF, without the need to obtain exemptive relief, to (i) redeem shares only in creation unit aggregations;^[4] (ii) permit shares to be purchased and sold at market prices, rather than at net asset value;^[5] (iii) in certain cases, engage in in-kind transactions with affiliates;^[6] and (iv) pay authorized participants the proceeds of redemptions in more than seven days.^[7]

Conditions that MUST be Met in Order to Rely on the Rule

Authorized Participants. The Rule requires that an ETF issue (and redeem) creation units only to (and from) Authorized Participants. An Authorized Participant is defined as a member or participant of a clearing agency registered with the SEC that has a written agreement with the ETF or its service provider that allows the Authorized Participant to place orders for the purchase and redemption of creation units.

Listing on a National Securities Exchange. The Rule requires that an ETF issue shares that are listed on a national securities exchange and that are traded at market-determined prices.^[8]

Website Disclosure. An ETF relying on the Rule will have to publish the following information on its website:

• Before the opening of trading each day on the ETF’s primary listing exchange, the portfolio holdings and cash that will form the basis for calculating the fund’s NAV at the end of the day. The Rule states that these holdings must be the ETF’s holdings as of the end of the prior business day;^[9]
• The ETF’s NAV per share, market price^[10] and premium or discount as of the end of the prior business day;
• A table showing the number of days the ETF’s shares traded at a premium or discount during the most recent calendar year and calendar quarter;
• A line graph showing the ETF’s shares’ premiums or discounts for the most recent calendar year and calendar quarter;
• The ETF’s median bid-ask spread for the most recent 30 days;^[11] and
• If applicable, a statement of the fact that the ETF’s premium or discount was greater than 2% for more than seven consecutive trading days and a discussion of contributing factors.

Conditions Imposed by Certain Exemptive Orders that are NOT Required by the Rule

Many ETFs that operate today pursuant to exemptive orders are required to comply with certain other conditions. In adopting the Rule, the SEC determined that these conditions were no longer necessary and therefore they are not required in order to rely on the Rule.

• Intraday Values. The Rule would not require ETFs to disseminate intraday values (an “IIV”) that are designed to approximate the value of the fund’s portfolio holdings. The SEC noted that the Authorized Participants and market makers that transact in fund shares can continue to use their proprietary methodologies to estimate the value of a fund’s holdings to determine if the fund’s shares are trading at a premium or discount to NAV. Therefore, the lack of an IIV would not be expected to reduce the efficiency of the arbitrage in the fund’s shares. We note, however, that the listing standards of the exchanges on which ETFs list their shares still require the dissemination of an IIV every 15 seconds.
• Creation Unit Sizes. The Rule does not mandate a maximum or minimum creation unit size or otherwise place requirements on creation unit sizes.
• Marketing. The Rule does not require that ETFs identify themselves in sales literature as funds that do not sell or redeem individual shares nor explain that investors may purchase or sell ETFs through a broker via a national securities exchange.

Other Key Elements of the Rule

Custom Baskets. One of the most highly anticipated provisions of the Rule is that it permits the creation and redemption of shares in exchange for “custom” baskets of securities and other assets. Custom baskets are those that contain a non-representative selection of the ETF’s portfolio holdings or that differ from other baskets on the same business day. In order to use custom baskets, an ETF would have to first adopt written policies and procedures describing in detail how custom baskets would be used in the best interests of the ETF and its shareholders. The policies and procedures would also have to specify the titles or roles of the employees of the ETF’s investment adviser who are required to review each custom basket for compliance with those parameters. Importantly, the procedures should detail the circumstances under which the basket may omit positions that are not operationally feasible to transmit in kind, when the ETF will use representative sampling to create its basket and how the ETF would sample in those circumstances.

The use of custom baskets can help promote efficient arbitrage in a fund’s shares, better index tracking and tax efficiencies. The earliest ETF exemptive orders place limited restrictions on the use of custom baskets, but more recent orders generally limit creation and redemption baskets to pro rata slices of fund’s portfolio, with limited exceptions. When the exemptive orders are rescinded, all ETFs relying on the Rule will be subject to the same requirements with respect to basket construction.

Recordkeeping. The Rule requires ETFs to maintain all written agreements with Authorized Participants, as well as detailed records regarding baskets, including custom baskets, exchanged with Authorized Participants, generally for 5 years, the first two in an easily accessible place.

Reorganization, Merger, Conversion or Liquidation. The Rule removes a technical hurdle to the merger of funds into ETFs, where the acquiring ETF issues its shares to the target fund in exchange for the target fund’s assets. In such a transaction, the acquiring ETF would be issuing shares to an entity other than an Authorized Participant in even creation unit sizes. This would be inconsistent with the requirements of existing ETF exemptive relief and the general requirements of the Rule. However, under the Rule, on the day of consummation of a reorganization, merger, conversion or liquidation, the Rule would except ETFs from the requirements to transact only with Authorized Participants and in creation units.

Fund of Funds Exemptive Relief. Current ETF exemptive orders permit 1940 Act registered funds to invest in ETFs, subject to certain conditions, in excess of 1940 Act limitations. The Rule would not rescind this relief. Rather, the SEC states that it will rescind such relief in the event that it adopts another rule governing such “funds of funds” arrangements. New ETFs that rely on the Rule and do not receive funds of funds exemptive relief may nonetheless enter into fund of funds arrangements if they satisfy the conditions of recent ETF exemptive orders.

Prospectus and Other Disclosures

• Form N-1A. The Rule amends the disclosure requirements applicable to mutual funds and ETFs to add narrative disclosure to the fee table regarding costs incurred by transacting in fund shares. In addition, the Rule amends the requirements for the statutory section of an ETF’s prospectus to include narrative disclosure identifying specific costs associated with buying and selling ETF shares, including, for example, a statement that an investor may incur costs attributable to an ETF’s bid-ask spread. The prospectus will direct investors to an ETF’s website for information regarding the ETF’s NAV, market price, premiums and discounts and bid-ask spreads. For ETFs that do not rely on the Rule and, thus, are not required to provide median bid-ask spreads on their websites, the revised prospectus requirements will give them the option of providing this information on their websites or in their prospectuses. The SEC notes in the Rule’s adopting release that this information disclosed on the website is not incorporated by reference into the registration statement, thereby relieving funds of potential prospectus liability for this information.
• Form N-CEN. An ETF will be required to identify in its Form N-CEN whether it is relying on the Rule to operate as an ETF.

When does the Rule take effect?

The Rule will go effective 60 days after its publication in the Federal Register, which is when new ETFs will be able to rely on the Rule. Existing ETF exemptive orders for ETFs that are eligible to rely on the Rule will be rescinded one year after the effective date of the Rule. Existing ETFs will be able to rely on current exemptive order until that date. Likewise, the compliance date for Form amendments, including to Form N-1A and Form N-CEN, will be one year after the effective date. All ETFs eligible to rely on the Rule must meet the Rule’s conditions going forward.

Endnotes

^[1] See Final Rule: Exchange Traded Funds, SEC Rel. No. IC-33646 (Sept. 25, 2019), available at https://www.sec.gov/rules/final/2019/33-10695.pdf.

^[2] The Rule defines an ETF as an open-end fund that (i) issues (and redeems) standardized blocks of shares, called “creation units,” to (and from) large financial institutions, or “Authorized Participants,” in exchange for a basket of securities, other assets and a cash balancing amount and (ii) issues shares that are listed on a national securities exchange and trade at market-determined prices.

^[3] While these specific “firewall” procedures are not an element of the Rule, the SEC is of the view that existing fiduciary and other legal requirements already provide a regulatory framework which governs advance communications between index providers and portfolio management. Advisers should work closely with their counsel to ensure that they have appropriate policies and procedures in this area.

^[4] The Rule classifies ETF shares as “redeemable securities” and, thus, ETFs as open-end companies for purposes of the 1940 Act, as well as Regulation M and certain trading rules under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). This relief is necessary in light of the fact that ETF shares are not individually redeemable. This classification relieves ETFs of their current need to rely on exemptive or no-action relief from applicable Exchange Act requirements.

^[5] This relief is necessary because Section 22(d) of the 1940 Act prohibits investment companies, their principal underwriters, and dealers from selling a redeemable security to the public except at a current public offering price described in a fund’s prospectus. ETF shares are bought and sold on exchanges at market-determined prices, and not on the basis of the next calculated net asset value (“NAV”).

^[6] The Rule provides relief from the 1940 Act provisions limiting affiliated transactions in order to permit the in-kind purchase and redemption of creation units by a person who is an affiliated person of the ETF (or who is an affiliated person of such a person) solely by reason of: (i) holding with the power to vote 5% or more of the ETF’s shares; or (ii) holding with the power to vote 5% or more of any investment company that is an affiliated person of the ETF. This exemption will have the effect of permitting an Authorized Participant or other market participant that becomes an affiliated person of an ETF due to its holdings to transact in an ETF’s shares, including to arbitrage the ETF’s shares, using an in-kind basket.

^[7] The Rule allows in-kind redemptions of ETF shares to settle beyond the seven-day period generally permitted by the 1940 Act with respect to redemption proceeds consisting of securities that are “traded on a trading market outside of the U.S.” The redemption period may be extended for up to 15 days after the tender of the ETF shares. The Rule’s adopting release states that this would apply even if the foreign investment has a U.S.-traded equivalent security.

^[8] If an ETF loses its listing on a national securities exchange, it will no longer be eligible to rely on the Rule and must therefore liquidate or convert to a traditional open-end fund (and meet individual redemption requests within seven days). The Rule’s adopting release clarifies that circumstances such as trading suspensions, trading halts, or temporary non-compliance notices from an exchange would not constitute a “delisting” for this purpose.

^[9] The Rule requires disclosure, for each position, of the ticker symbol, CUSIP or other identifier, description of the holding, the quantity of each security and the percentage weight in the portfolio.

^[10] Market price is defined as the official closing price for an ETF share or, if more accurate, the midpoint of the national best bid and best offer (“NBBO”) for the share at the time as of which the ETF calculates current NAV per share.

^[11] Calculated using the NBBO.