On June 28, 2018 at an open meeting (the "Open Meeting"), the Securities and Exchange Commission ("SEC") unanimously voted to propose new Rule 6c-11 (the "Proposed Rule") under the Investment Company Act of 1940, as amended ("1940 Act"), which, if adopted, would permit exchange-traded funds ("ETFs") that satisfy certain conditions to organize and operate without the expense and delay of obtaining an exemptive order from the SEC. In addition to several key takeaways from the SEC release describing the proposals1 (the "Release"), we describe the Proposed Rule in detail below and offer insights into how the Proposed Rule may affect ETFs and their sponsors.
The Proposed Rule seeks to "create a consistent, transparent, and efficient regulatory framework for ETFs and to facilitate greater competition and innovation among ETFs."2 If adopted, the Proposed Rule would significantly ease the regulatory burdens associated with bringing an ETF to market and create a more level playing field for new and existing ETF sponsors. To accomplish this, the SEC proposes to take the following steps:
- Rescind Prior Exemptive Orders. To help establish a consistent ETF regulatory approach and remove the existing "patchwork" of exemptive orders, the SEC would, except with respect to ETF fund of funds relief described below, rescind exemptive orders previously granted to ETFs eligible to rely on the Proposed Rule. As noted below, certain types of ETFs will not be able to rely on the Proposed Rule and will not have their exemptive orders rescinded under the proposal.
- Allow Custom Creation and Redemption Baskets. An ETF relying on the Proposed Rule would be permitted to use non-pro rata baskets and/or baskets that differ from other baskets used in transactions on the same business day ("custom baskets").
- Eliminate the Distinction Between Index-Based and Actively Managed ETFs. All ETFs relying on the Proposed Rule, whether index-based or actively managed, must comply with the same conditions.
- Implement New Disclosure Requirements. The Proposed Rule and related amendments to Form N-1A (for open-end ETFs) and Form N-8B-2 (for UITs) would require ETFs to disclose certain information on their websites and in their prospectuses, including historical information regarding the ETF's premiums and discounts and bid-ask spreads.
The Proposed Rule would provide certain exemptions from the 1940 Act, including most of those currently included in ETF exemptive orders, and also impose many similar conditions. The new conditions in the Proposed Rule include the following:
- Transparency. Each ETF relying on the Proposed Rule must post its portfolio holdings daily on its website.
- Custom Basket Policies and Procedures. An ETF relying on the Proposed Rule would be permitted to use custom baskets if the ETF adopts written policies and procedures that set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders and 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.
- Website Disclosure. The Proposed Rule and related form amendments would require ETFs to disclose certain information on their websites to increase transparency, including historical information regarding premiums and discounts, bid-ask spread information and information regarding a published creation/redemption basket.
The SEC expects that permitting ETFs to utilize custom baskets will reduce transaction costs, promote efficient portfolio management and lead to a more efficient and effective arbitrage process. In addition, the new disclosure requirements, including full portfolio transparency, should enable the SEC, investors and other market participants to evaluate the functioning of an ETF's arbitrage mechanism.3
SUMMARY OF THE RELEASE
The SEC's proposals aim to level the playing field among existing ETF sponsors, as well as to make it easier for new entrants to break into the ETF business. The SEC hopes the Proposed Rule will "facilitate greater competition and innovation in the ETF marketplace, leading to more choice for investors."4 The proposals in the Release would make substantial progress toward leveling the regulatory landscape for ETF sponsors and promoting the efficient operation of the arbitrage mechanism that supports an ETF's shares trading at a market price approximating the ETF's net asset value per share ("NAV"). In particular, the proposals set forth in the Release would:
- Codify much of the relief granted on a case-by-case basis to ETF sponsors under the current exemptive order regime, permitting ETFs organized as open-end funds, with some exceptions, to operate without obtaining individual exemptive relief from the SEC.5
- Rescind exemptive relief previously granted to those ETFs able to rely on the Proposed Rule.6 In addition, the Release proposes rescinding exemptive relief permitting ETFs to operate in a master-feeder structure for all ETFs that do not currently rely on such relief.7
- Permit an ETF relying on the Proposed Rule to use custom creation and redemption baskets that do not reflect a pro rata representation of the ETF's portfolio and/or that differ from other baskets used in creation or redemption transactions on the same business day.
- Require ETFs relying on the Proposed Rule to disclose certain information on their websites, including (i) portfolio holdings that will form the basis of the ETF's next NAV calculation; (ii) historical information regarding the ETF's NAV, premiums and discounts, and bid-ask spreads; and (iii) information regarding a basket of securities that the ETF would accept or provide in connection with a creation or redemption, updated at the beginning of each business day.
- Amend Form N-1A and Form N-8B-2 to require disclosure by all ETFs (not just ETFs eligible to rely on the Proposed Rule) of information relevant to investors who purchase and sell ETF shares in the secondary markets. These new disclosure requirements seek to ensure that ETFs provide more useful, ETF-specific information to investors who purchase ETF shares in the secondary market.
As the SEC noted in the Release, the proposals are based on the SEC's experience in regulating ETFs for more than 25 years, and have been informed by the feedback received in response to the SEC's 2008 Exchange-Traded Funds Rule Proposal8 and the SEC's 2015 Request for Comment on Exchange-Traded Products.9
1. Exchange Traded Funds, Investment Company Act Release No. 28193, available at https://www.sec.gov/rules/proposed/2018/33-10515.pdf.
2. Id. at 6.
3. The Release contains an extensive discussion of the purpose and operation of the ETF arbitrage mechanism. See Release at pp. 41-49 ("The arbitrage mechanism is the foundation for why retail and other secondary market investors generally can buy and sell ETF shares at prices that are at or close to the prices at which authorized participants are able to buy and redeem shares directly from the ETF at NAV.")
4. Securities and Exchange Commission. (2018, June 28). SEC Proposes New Approval Process for Certain Exchange-Traded Funds [Press release]. Available: https://www.sec.gov/news/press-release/2018-118.
5. ETFs organized as unit investment trusts ("UITs"), ETFs structured as a share class of a multi-class fund, and leveraged or inverse ETFs would be unable to rely on the Proposed Rule. At the Open Meeting, however, Commissioner Peirce said that she hoped commenters would weigh in on whether and how the Proposed Rule could accommodate leveraged or inverse ETFs.
6. Note that, with the exception of rescissions related to master-feeder relief discussed herein, the proposed rescissions would be limited to the portions of an ETF's exemptive order that grant relief related to the formation and operation of an ETF. The Staff does not propose to rescind exemptive relief from Section 12(d)(1) and the related relief from Sections 17(a)(1) and (a) (2) of the 1940 Act that permits certain ETF fund of funds arrangements.
7. The proposal would grandfather existing master-feeder arrangements that were in use as of June 28, 2018, but would prevent the formation of new master-feeder arrangements by amending existing exemptive orders.
8. Investment Company Act Release 28193 (March 11, 2008).
9. Securities Exchange Act Release 75165 (June 12, 2015).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.