The New ETF Rule: Initial Impressions

The US Securities and Exchange Commission (SEC) unveiled in final form the regulatory framework that will govern the operation of most exchange-traded funds (ETFs) going forward.[1] Rule 6c-11 (Rule) under the Investment Company Act of 1940 (1940 Act) is designed to modernize the regulation of ETFs, whose operation for more than two decades has been shaped by the terms of individual exemptive orders that in many cases differ from ETF to ETF.

The Rule becomes effective 60 days after publication in the Federal Register. All ETFs covered by the Rule must comply with the Rule within one year of the effective date. Existing ETFs, thus, have 425 days after the Rule is formally published to transition from their exemptive orders to the Rule and comply with related disclosure requirements.

The SEC adopted the Rule largely as proposed in 2018 (Proposal).[2] However, it reflects important changes, many made in response to industry comments. We discuss some of those changes below as well as other significant aspects of the new regulatory framework.

Scope

The Rule is available to most ETFs organized as open-end funds. ETFs organized as unit investment trusts (UITs), ETFs structured as a share class of a multiclass fund or a master-feeder arrangement, leveraged and inverse ETFs, and nontransparent ETFs are not able to rely on the Rule and instead must continue to operate under their existing exemptive orders or obtain new exemptive relief. All ETFs, however, are subject to new disclosure requirements, which are designed to provide investors with additional ETF-specific information, including information about the cost of investing in ETFs.

Leveraged/Inverse ETFs. The Rule excludes ETFs that directly or indirectly seek to provide leveraged or inverse returns over any predetermined period of time, whether daily, weekly, or otherwise. The SEC’s discussion of this exclusion makes clear that it intends to capture not only those ETFs that clearly state they intend to seek leveraged or inverse returns, but also ETFs with objectives and strategies that substantively seek leveraged or inverse exposure. The SEC also confirmed that leveraged and inverse ETFs are excluded from the Rule regardless of whether the returns they seek over a predetermined time period are evenly divisible by 100.

Self-Indexing ETFs. The SEC reaffirmed its position that the existing securities laws adequately address the special concerns presented by self-indexing ETFs. The Rule, therefore, includes self-indexing ETFs within its scope and does not impose any conditions specific to such ETFs.

Actively Managed Versus Index-Based ETFs. Consistent with the Proposal, the Rule does not distinguish between fully transparent actively managed ETFs and index-based ETFs – the Rule’s conditions apply equally to each. Thus, the Rule levels the playing field between these two types of ETFs. For example, the Rule does not perpetuate the requirements that index-based ETFs track a “securities” index and invest 80% of assets in index components.

Observations Regarding the Rule’s 1940 Act and Other Exemptive Relief

As expected, the Rule essentially codifies the specific exemptive relief provided by exemptive orders from various provisions of the 1940 Act (e.g., Section 22(d), Rule 22c-1, Section 17(a), Section 22(e)), and does not differ significantly from the Proposal in this regard. There are, however, a few items worthy of discussion.

Redeemable Security. Consistent with the Proposal, and unlike relief granted by exemptive orders, the SEC decided not to exempt ETFs from the 1940 Act’s definition of “open-end company” (Section 5(a)(1)) or an ETF’s shares from the definition of “redeemable security” (Section 2(a)(32)); rather, the SEC determined that an ETF is an open-end company that issues redeemable securities. The SEC was also careful to clarify its view that securities of all ETFs, including those not relying on the Rule, are redeemable securities. As a result, shares issued by ETFs are eligible for the “redeemable securities” exceptions in Rules 101(c)(4) and 102(d)(4) of Regulation M and Rule 10b-17(c) under the Securities Exchange Act of 1934 (Exchange Act) in connection with secondary market transactions in ETF shares and the creation or redemption of creation units. ETFs also qualify for the “registered open-end investment company” exemption in Rule 11d1-2 under the Exchange Act. In a separate order, the SEC exempted ETFs that rely on the Rule from the requirements of Section 11(d)(1) of the Exchange Act and Rules 10b-10, 15c1-5, 15c1-6, and 14e-5 thereunder, provided certain conditions are met.^[3] Importantly, unlike the redeemable securities exceptions discussed above, which are available to all ETFs, only ETFs that rely on the Rule may rely on the exemptive relief granted under this order.

Affiliated Transactions. The Rule provides exemptions from Sections 17(a)(1) and (a)(2) of the 1940 Act with regard to the deposit and receipt of baskets of securities by an affiliated person of an ETF (or an affiliated person of such a person) solely by reason of: (i) holding with the power to vote 5% or more of an 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.

Despite requests from commenters, the SEC declined to extend the relief from Sections 17(a)(1) and 17(a)(2) to additional affiliated relationships, such as exempting broker-dealers that are affiliated with the ETF’s adviser, or permitting an ETF’s adviser or its affiliates to transact with the ETF to provide in-kind seed capital to the ETF.

Additional Time for Delivering Redemption Proceeds. As expected, the Rule permits an ETF holding foreign investments to delay payment of redemption proceeds for up to 15 days (but in all cases as soon as practicable) when local market holidays or the extended delivery cycles of a foreign jurisdiction make timely delivery infeasible. Unlike the Proposal, the Rule does not include a sunset provision limiting this relief. In a welcome departure from the Proposal, the Rule also includes a modified definition of “foreign investment” that eliminates the proposed requirement that a foreign investment have no established US public trading market. The SEC confirmed that the definition was not intended to require an ETF to buy and sell the US-traded equivalent of a foreign-traded security when one is available. The Rule defines a “foreign investment” as any security, asset, or other position of the ETF issued by a foreign issuer and that is traded on a trading market outside of the United States.

Conditions

Although largely consistent with the Proposal, the SEC modified some of the Rule’s conditions to reflect various industry comments.

Portfolio Transparency. Unchanged from the Proposal, the Rule requires daily transparency of portfolio holdings in a standardized manner before the opening of regular trading on the ETF’s primary listing exchange. The SEC, however, streamlined the information required to be disclosed about an ETF’s holdings by aligning the disclosure obligation with that of the exchanges’ generic listing rules for actively managed ETFs.

The Proposal would have required an ETF to publish on its website a single basket each day (regardless of the number of baskets an ETF uses on that day) it would accept for orders. The Rule as adopted does not require an ETF to publish a basket. The SEC was persuaded that publication of a basket would be of limited value in light of the Rule’s requisite portfolio transparency. The SEC also noted that the Rule’s required policies and procedures for all ETFs’ basket construction would further substantiate the basket process.

T-1 Orders. The Proposal would have required an ETF to disclose its basket and portfolio holdings before it accepts creation unit orders. The Rule as adopted does not include this requirement and, as a result, accommodates T-1 orders even in the absence of basket and portfolio holdings information.

Website Disclosure Requirements that Differ from the Proposal

• The Rule requires daily website disclosure of an ETF’s median bid-ask spread calculated over the most recent 30 calendar days instead of over the ETF’s most recent fiscal year.
• To promote uniformity, the Rule requires the use of National Best Bid and National Best Offer (NBBO) to calculate median bid-ask spreads.
• The Rule requires an ETF to disclose its median bid-ask spread only on its website instead of both on its website and in its prospectus, as proposed.
• The SEC did not adopt proposed requirements that ETFs provide
  • hypothetical bid-ask spread examples in their prospectus; or
  • an interactive calculator on their website to allow investors to customize those hypothetical calculations.

Intraday Indicative Value. Under the Rule, ETFs are not required to disseminate their intraday indicative value (or IIV). As the SEC notes, however, exchange listing standards currently require such dissemination.

Creation Unit Sizes. The Rule defines a “creation unit” to mean a specified number of ETF shares. It does not, however, mandate a maximum or minimum creation unit size or otherwise place requirements on creation unit size. In addition, Form N-1A was amended to eliminate disclosure requirements relating to creation unit sizes.

Reorganization, Merger, Conversion, or Liquidation. On the day of a reorganization, merger, conversion, or liquidation, an ETF may sell or redeem individual shares and is not limited to transacting with authorized participants.

Custom Baskets. The custom basket provisions of the Rule were adopted largely as proposed. An ETF is permitted to use custom baskets if the ETF adopts written policies and procedures: (1) setting forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders (including process for any revisions to, or deviations from, those parameters), and (2) that specify the title or roles of employees of the adviser who are required to review each custom basket for compliance with those parameters. These two elements are required in addition to the policies and procedures that all ETFs must adopt pertaining to the construction of any basket.

Listing Requirement. ETFs are defined in part to mean a fund that issues shares that are listed on an exchange. To the extent shares of an ETF are delisted from an exchange, the ETF would no longer qualify as an ETF under the Rule. The SEC noted that an ETF that does not comply with the provisions of the Rule would be required to comply with the 1940 Act in all respects unless it was relying on other relief. The Release states that circumstances such as a trading suspension, a trading halt, or a temporary noncompliance notice from the exchange would not constitute a “delisting” for purposes of the Rule. An ETF also may request temporary relief from the SEC to permit the ETF to suspend redemptions for a limited period of time where necessary to protect ETF shareholders.

Amendments to Form N-1A

The SEC made several changes to Form N-1A that are designed to provide ETF investors with additional information regarding ETF trading and associated costs. Some of these amendments differ in some respects from those included in the Proposal.

• The Proposal would have required ETFs to include a series of questions and answers in the Fee Table section of the prospectus that would provide narrative disclosure regarding ETF trading and associated costs. Form N-1A as amended requires that this information instead be included in the “Purchase and Sale of Fund Shares” section and does not require the use of a question-and-answer format.
• The Proposal also would have required ETFs relying on the Rule to provide quantitative information about bid-ask spreads in both the ETF’s prospectus and on its website. As amended, an ETF must provide in its prospectus a cross reference to its website where investors can find more information about bid-ask spreads.
• ETFs providing historical premium and discount information on their websites in accordance with the Rule are not required to disclose this information in their prospectuses or shareholder reports. ETFs that are not eligible to rely on the Rule must still comply with the historical premium and discount disclosure requirements of Form N-1A, unless such ETFs opt to comply with the Rule’s website disclosure requirements.
• The SEC added the term “selling” to the current narrative fee disclosure requirements to clarify that the fees and expenses reflected in the fee table may be higher for investors if they buy, hold, and sell shares of the fund. This requirement applies to both mutual funds and ETFs that do not rely on the Rule.
• Finally, Form N-1A was amended to eliminate disclosures applicable only to ETFs with creation unit sizes of less than 25,000 shares.

Fund of Funds Exemptive Relief

Fund of funds relief from Section 12(d)(1) of the 1940 Act and Sections 17(a)(1) and 17(a)(2) of the 1940 Act will not be rescinded. ETFs relying on the Rule that do not have fund of funds relief may enter into fund of funds arrangements as set forth in the SEC’s recent exemptive orders, provided that they satisfy the terms and conditions for fund of funds relief in those orders.[4] The fund of funds relief provided by ETF orders and the exemptive relief provided by the Release for ETFs without such orders will be available only until the SEC adopts a fund of funds exemptive rule.

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We are continuing to review the contents of the Release and expect to provide our further thoughts on the Rule in the near future.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Washington, DC
W. John McGuire
Laura E. Flores
Christopher D. Menconi

Philadelphia
Sean Graber
John J. O’Brien