SEC Proposes New ETF Rule

The new rule would permit ETFs to operate without the need to obtain individual exemptive orders from the US Securities and Exchange Commission.

At an open meeting[1] on Thursday, June 28, the US Securities and Exchange Commission (SEC) voted unanimously to propose Rule 6c-11 (Rule) under the Investment Company Act of 1940 (1940 Act), as well as amendments to Forms N-1A, N-8B-2, and N-CEN.

As we continue to review the proposal, we wanted to share some of its highlights:

Applicability
The Rule would only be available to ETFs organized as open-end funds. ETFs organized as unit investment trusts (UITs), ETFs structured as a share class of a multi-class fund, and leveraged or inverse ETFs would not be able to rely on the Rule and instead would continue to operate under their existing exemptive orders. Existing leveraged ETFs and ETFs organized as UITs would, however, be subject to the proposed amendments to Forms N-1A and N-8B-2, which are designed to provide investors with additional ETF-specific information, including information about costs specific to ETFs (collectively, Form Amendments).

Existing Exemptive Orders
The Rule would rescind exemptive relief previously granted to ETFs eligible to rely on the Rule.

• Master-feeder funds. The Rule would rescind exemptive relief permitting ETFs to operate in a master-feeder structure. In so doing, the SEC cited a lack of industry interest in this structure as well as a concern that, where an ETF feeder fund transacts with a master fund on an in-kind basis and non-ETF feeder funds transact with the master fund on a cash basis, all feeder fund shareholders would bear costs associated with the cash transactions. The Rule would, however, grandfather existing master-feeder arrangements involving ETF feeder funds, but prevent the formation of new ones, by amending relevant exemptive orders.
• Funds of funds. The Rule would not rescind exemptive relief that permits ETF fund of funds arrangements.

Index vs. Active
Although the Rule would provide exemptions for both index-based ETFs and actively managed ETFs, it would not establish different requirements based on whether an ETF’s investment objective is to seek returns that correspond to the returns of an index.

• Rationale. The SEC believes that index-based and actively managed ETFs that comply with the Rule’s conditions function similarly with respect to operational matters, despite different investment objectives or strategies, and do not present significantly different concerns under the provisions of the 1940 Act from which the Rule grants relief. The SEC further believes that it would be unreasonable to create a meaningful distinction within the Rule between index-based and actively managed ETFs given the evolution of indexes over the last decade, and that eliminating the regulatory distinction between index-based ETFs and actively managed ETFs would help to provide a more consistent and transparent regulatory framework for ETFs organized as open-end funds.

Conditions
To rely on the Rule, an ETF would have to satisfy, among others, the following conditions:

• Transparency. An ETF would be required to provide daily portfolio transparency on its website.
• Custom basket policies and procedures. An ETF relying on the Rule would be permitted to use baskets that do not reflect a pro rata representation of the fund’s portfolio or that differ from other baskets used in transactions on the same business day (i.e., “custom baskets”) if the ETF adopts written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders.
• Website disclosure. The Rule and Form Amendments would require ETFs to disclose additional information on their websites that is not currently required under existing exemptive orders, including historical information regarding premiums and discounts and bid-ask spread information. These disclosures are intended to inform investors about the efficiency of an ETF’s arbitrage process. Additionally, the Rule would require an ETF to post on its website information regarding a published basket at the beginning of each business day.

ETFs as “Redeemable Securities”
The SEC believes that the rules under the Securities Exchange Act of 1934 (Exchange Act) that apply to redeemable securities issued by an open-end fund would apply to ETFs relying on the Rule. Thus, ETFs relying on the Rule would become 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 Exchange Act in connection with secondary market transactions in ETF shares and the creation or redemption of creation units. Similarly, the SEC would view ETFs relying on the Rule as within the “registered open-end investment company” exemption in Rule 11d1-2 under the Exchange Act.

• Request for comment. Noting that ETFs also request relief from Section 11(d)(1) of the Exchange Act and Rules 10b-10, 11d1-2, 15c1-5, and 15c1-6 under the Exchange Act, the SEC is asking for comment on (1) whether it should also provide relief from these provisions and (2) if so, what conditions should apply to such relief, if any, and why.

Elimination of IIV Requirement
The Rule would not require the dissemination of an ETF’s intraday indicative value (or IIV) as a condition. We note, however, that exchange listing standards currently require such dissemination.

Comment Period
Comments on the Rule will be due sometime in early September, or 60 days after the Rule is published in the Federal Register. If you would like assistance with submitting comments to the SEC, please contact us.

We are continuing to review the contents of the proposal and expect to issue further analysis 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
Laura E. Flores
W. John McGuire
Christopher D. Menconi
K. Michael Carlton
Magda El Guindi-Rosenbaum
Joseph (Beau) Yanoshik
Erica L. Zong Evenson

Philadelphia
Sean Graber
John J. O’Brien
David W. Freese