Proposed ETF Rule Comes with Widely Expected Conditions and Some Notable Twists
Date: July 09, 2018
The Securities and Exchange Commission (SEC) on June 28, 2018 proposed Rule 6c-11 under the Investment Company Act of 1940 (1940 Act), which would permit most exchange-traded funds (ETFs) that satisfy certain conditions to operate without the expense and delay of obtaining an exemptive order. The rule proposal also adds new ETF regulations unrelated to the exemptive process, some of which are beneficial to the ETF industry while others may prove costly to implement with potentially little value to retail investors.
Based on the SEC Commissioners’ opening statements and their paucity of questions to the Division of Investment Management staff who drafted the rule, proposed Rule 6c-11 likely will be adopted sooner than expected. On the other hand, the Proposing Release contains numerous questions, revealing the SEC’s continuing struggle to regulate ETF products.
Set forth below is a high-level summary of proposed Rule 6c-11. Thompson Hine’s ETF practice group will delve into the many issues that the rule raises in subsequent alerts.
Present ETF Exemptive Process
The first ETF exemptive order was issued in 1992. The SEC proposed an ETF rule in 2008, but it was never adopted, partly because the SEC had to pivot to propose and adopt urgent rulemaking that addressed the financial crisis. As a result, financial firms entering the ETF business since 1992 have had to submit exemptive applications that have taken generally 150 days, and in many cases longer, to process.
The type of exemptive relief issued by the SEC’s Division of Investment Management staff has not remained static over the past 26 years; rather, the required representations and conditions have become more onerous as each year has passed. In its Proposing Release, the SEC recognized that “the terms of the exemptive relief granted to ETFs have evolved over time and have resulted in an uneven playing field among ETF complexes, subjecting ETFs that pursue the same or similar investment strategies to different operational requirements.” Most notably, those ETF complexes (many of which are the largest in the industry) have been allowed to liberally use “custom baskets,” containing securities that do not match their ETF’s index, in the creation and redemption process instead of a basket that exactly replicates the index or cash in lieu of certain basket securities. For example, newer S&P 500 ETFs must require authorized participants to deliver a basket of each stock in the S&P 500, while older ETFs are able to allow authorized participants to deliver a subset of the stocks in the S&P 500 and substitute other stocks that mimic S&P 500 constituents. Among other benefits, this has allowed certain ETF complexes to deliver a product with fewer embedded costs than other complexes.
Proposed Rule 6c-11
Under proposed Rule 6c-11, a financial firm with an effective registration statement for an ETF could enter the ETF business immediately by relying upon the rule instead of filing an application for an exemptive order, provided it could meet the rule’s conditions. Besides replacing the cumbersome exemptive process, the SEC has taken the opportunity to impose new substantive regulations on all ETFs. Therefore, proposed Rule 6c-11 is of great interest to those looking to enter the ETF ecosystem as well as the ETF issuers and their service providers that currently make up this ecosystem.
Eligible Investment Company
In order to rely on proposed Rule 6c-11, an investment company must be an ETF that has three basic features:
- It is a registered open-end management company.
- It issues (and redeems) creation units to (and from) “authorized participants” in exchange for a basket of securities and a cash balancing amount, if any.
- Its shares are listed on a national securities exchange and traded at market-determined prices.
An ETF organized in the form of a unit investment trust (UIT) may not rely upon the proposed rule. However, existing UITs may remain in business without relying upon the rule, and a proposed ETF structured as a UIT may apply for an exemptive order to operate as such.
New and existing ETFs must meet the following conditions to operate in reliance upon proposed Rule 6c-11 because, with respect to the former, the SEC will no longer issue standard ETF exemptive orders and, with respect to the latter, existing ETF exemptive orders will be rescinded to the extent the relief is covered by the rule.
Net Asset Value (NAV) Per Share
Like any investment fund, an ETF’s portfolio may change throughout the trading day. Unlike other investment funds, an ETF must disclose to the market its portfolio holdings that will form the basis of its NAV calculation for that day so that authorized participants and investors through authorized participants can engage in arbitrage to drive the price at which the ETF’s shares trade on the market to the ETF’s NAV per share.
Proposed Rule 6c-11 requires an ETF to reflect changes in its portfolio holdings in the first calculation of the NAV per share on the first business day following the trade date. Trades in the ETF’s portfolio in the prior business day must be reflected, prior to the opening of trading, in the next business day’s disclosure of portfolio holdings. Thus, the portfolio holdings that form the basis for the ETF’s NAV calculation would be the ETF’s portfolio holdings as of the close of business on the prior business day and would need to be disclosed before trading in the ETF’s shares commences on the next business day. Changes in an ETF’s holdings of portfolio securities would therefore be reflected on a T+1 basis. The SEC in its Proposing Release noted that this condition is consistent with current ETF practices and will enable an ETF to disclose at the beginning of the business day the portfolio that would form the basis for the next NAV calculation, helping to facilitate the efficient functioning of the arbitrage process.
ETFs currently are required to make a number of disclosures on their websites. Proposed Rule 6c-11 would add numerous other website disclosures, likely requiring ETFs to make costly investments in their website capabilities.
Each business day, an ETF would be required to disclose prominently on its website:
- before the opening of regular trading onthelistingexchangeoftheETFsharesandbeforetheETF starts accepting orders for the purchase or redemption of creation units:
- the portfolio holdings that would form the basis of the next calculation of current NAV per share;
- a basket applicable to orders for the purchase or redemption of creation units to be priced based on the next calculation of current NAV; and
- the estimated cash balancing amount, if any;
- the ETF’s current NAV per share, market price, and premium or discount, each as 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 recently completed calendar year and the most recently completed calendar quarters since that year (or the life of the ETF, if shorter);
- a line graph showing ETF share premiums or discounts for the most recently completed calendar year and the most recently completed calendar quarters since that year (or the life of the ETF, if shorter);
- if the ETF’s premium or discount is greater than 2 percent for more than seven consecutive trading days, a discussion of the factors that are reasonably believed to have materially contributed to the premium or discount, which must be maintained on the website for at least one year thereafter; and
- the description, amount, value and unrealized gain/loss in the manner prescribed within Article 12 of Regulation S-X for each portfolio holding or basket asset required to be disclosed.
In its Proposing Release, the SEC stated that an ETF’s portfolio holdings disclosure must be made each business day before the opening of regular trading and before the ETF starts accepting orders for the purchase or redemption of creation units. These timing requirements, therefore, are designed to prevent an ETF from disclosing its portfolio holdings only after the beginning of trading or after the ETF has begun accepting orders for the next business day.
Baskets and Custom Baskets
Each ETF relying upon proposed Rule 6c-11 will be required to adopt and implement written policies and procedures that govern the construction of baskets and the process that would be used for the acceptance of baskets. “Baskets” are the collection of securities, assets or other positions in exchange for which an ETF issues (or in return for which it redeems) creation units. For example, an S&P 500 ETF’s basket would include each security that makes up the S&P 500. The creation unit is a specified number of ETF shares (e.g., 50,000) that the ETF would issue to (or redeem from) an authorized participant in exchange for the deposit (or delivery) of a basket and a cash balancing amount, if any. Thus, an authorized participant that delivers 100 shares of Apple, 80 shares of Exxon and so forth would receive 50,000 shares of S&P 500 ETF in return.
Notably, proposed Rule 6c-11 permits “custom baskets,” which are baskets composed of a non-representative selection of the ETF’s portfolio holdings (or different baskets used in transactions on the same business day). In the example above, the authorized participant would be able to deliver to the ETF perhaps only 100 stocks that make up the S&P 500 in return for 50,000 ETF shares. This may be more efficient because the 100 stocks may provide almost the exact same statistical return as the 500 stocks (since the smallest stocks in the S&P 500 Index have little statistical impact on its return), and there will be fewer transaction costs to assemble a 100-stock basket versus a 500-stock basket. In other situations, custom baskets are desirable because an index constituent may be difficult to locate, but a stock or bond that is an excellent proxy for that constituent is readily available.
In order to use custom baskets, an ETF must have written policies and procedures as part of its 38a-1 compliance program that include:
- detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, including the process for any revisions to, or deviations from, those parameters; and
- the titles or roles of the ETF’s investment adviser’s employees who are required to review each custom basket for compliance with those parameters.
Custom baskets include baskets that are not pro rata based on the ETF’s portfolio or a representative sampling thereof, as well as baskets that reflect changes due to a rebalancing or reconstitution of the index.
Commentary on this requirement in the Proposing Release states that these policies and procedures should detail when representative sampling would be used to create a basket and how the ETF would select the securities. If an ETF constructs two or more different baskets using representative sampling that are used in transactions with authorized participants, both would be considered custom baskets under the proposed rule, and the circumstances under which they would be used would therefore have to be addressed in the ETF’s policies and procedures.
For each custom basket used, an ETF is required to create a record stating that the basket complies with the relevant policies and procedures. Given this internal recordkeeping requirement, the SEC determined not to require an ETF to publish multiple custom baskets on its website, even if more than one is used on a particular day.
As with any rule the SEC proposes, Rule 6c-11 contains recordkeeping provisions that facilitate its inspection of the ETF for compliance with the rule. ETFs relying on the rule must maintain and preserve for a period of not less than five years, the first two years in an easily accessible place:
- all written agreements (or copies thereof) between an authorized participant and the ETF or one of its service providers that allow the authorized participant to place orders for the purchase or redemption of creation units;
- for each basket exchanged with an authorized participant, records setting forth:
- the names and quantities of the positions composing the basket exchanged for creation units; and
- if applicable, identification of the basket as a custom basket and a record stating that the custom basket complies with the basket policies and procedures that the ETF has adopted;
- the cash balancing amount, if any; and
- the identity of the authorized participant transacting with the ETF.
When proposing Rule 6c-11, the SEC also proposed amendments to Form N-1A designed to provide investors who purchase ETF shares in secondary market transactions with additional information regarding the ETF, including information regarding costs associated with an investment in the ETF. The proposal also would eliminate certain disclosures that would be duplicative.
The fee table in an ETF’s statutory and summary prospectuses required by Item 3 of Form N-1A would be revised to contain:
- a narrative disclosure that would clarify that, in addition to the current disclosures relating to investors who buy or hold shares, the fees and expenses reflected in the Item 3 expense table may be higher for investors if they sell shares of the fund; and
- a statement that investors may be subject to other fees not reflected in the table, such as brokerage commissions and fees to financial intermediaries.
A new section in Item 3 of Form N-1A would require disclosure of certain trading information and trading costs of ETFs on the secondary market in the form of a series of six questions and answers (Q&As):
- Q&A 1 requires disclosure that (i) shares may only be purchased and sold on a national securities exchange through a broker-dealer; and (ii) the price of ETF shares is based on market price, and since ETFs trade at market prices rather than at NAV, shares may trade at a price greater than NAV (premium) or less than NAV per share (discount).
- Q&A 2 requires the identification of specific costs associated with trading shares of an ETF, such as brokerage commissions, bid-ask spread costs and potential costs attributable to premiums and discounts.
- Q&A 3 requires ETF-specific disclosures relating to the median bid-ask spread for the ETF’s most recent fiscal year. This proposed Q&A would describe the bid-ask spread as the difference between the highest price a buyer is willing to pay to purchase shares of the ETF (bid) and the lowest price a seller is willing to accept for shares of the ETF (ask). It also would explain that the bid-ask spread can change throughout the day due to the supply of or demand for ETF shares, the quantity of shares traded and the time of day the trade is executed, among other factors. In addition, the ETF must calculate and disclose its median bid-ask spread over the most recently completed fiscal year. The proposed N-1A instructions have detailed requirements on how this would be calculated.
- Q&A 4 requires ETFs to include questions on how the bid-ask spread impacts the return on a hypothetical $10,000 investment. The proposed example in Q&A 4 would require disclosure of hypothetical trading costs attributable solely to the median bid-ask spread based on data from the ETF’s prior fiscal year. Specifically, the spread costs example would demonstrate the hypothetical impact of the ETF’s bid-ask spread for one $10,000 “round-trip” trade (i.e., one buy and sell transaction).
- Q&A 5 requires a follow-on question to that posed by Q&A 4, which is “What if I plan to trade ETF shares frequently?” Instead of the hypothetical trading costs attributable to a single round trip, the ETF would disclose the trading costs of 25 round trips (each trade being $10,000).
- Q&A 6 requires that the prospectus contain the following cross-reference to the ETF’s website disclosures of the information in Q&As 1 through 5:
Where can I get more trading information for the ETF?
The ETF’s website at [www.[Series-SpecificLandingPage.com]] includes recent information on the Fund’s NAV, market price, premiums and discounts, as well as an interactive calculator you can use to determine how the bid-ask spread would impact your specific investment.
Website Interactive Calculator
Proposed Instruction 5(e) to Item 3 of Form N-1A would require an ETF to provide an interactive calculator in a clear and prominent format on its website. The calculator must provide investors with the ability to customize the hypothetical calculations to their specific investing situation by entering two data points: investment amount and number of trades. The SEC included in its Proposing Release examples showing how an investor could compare an investment of $2,500 to one of $10,000 or trading 10 times versus 25 times.
The calculator is intended to provide investors with information about the costs of ETF investing in addition to the costs shown in the typical fee and expense table in the prospectus. The calculator would, using the inputs supplied by an investor, calculate the hypothetical impact of the bid-ask spread during an ETF’s prior fiscal year on an investor’s proposed investment and would provide answers to the questions in the new N-1A Q&As (3-5), discussed further below. Since the calculations must use bid-ask data from 10-second intervals during each trading day of the ETF’s prior fiscal year, creating and maintaining this kind of website functionality will likely require the assistance of outside vendors.
If proposed Rule 6c-11 is adopted, the SEC would eliminate a number of disclosure items currently required by Item 6(c)(i) and (ii) of Form N-1A. An ETF would no longer need to (i) specify the number of shares it would issue or redeem in exchange for the deposit or delivery of baskets; (ii) explain that the individual shares of the ETF may only be purchased and sold on a national securities exchange through a broker or dealer; (iii) disclose that the price of ETF shares is based on the market price and as a result, shares may trade at a price greater than NAV (premium) or less than NAV(discount); (iv) disclose its minimum initial or subsequent investment requirements; (v) disclose that the shares are redeemable; and (vi) describe the procedures for redeeming shares.
ETFs would no longer be subject to (i) Item 11(a)(2) of Form N-1A, which requires a fund to disclose when calculations of NAV are made and that the price at which a purchase or redemption is effected is based on the next calculation of NAV after the order is placed, and (ii) Items 11(b) and (c), which require a fund to describe the procedures used for purchasing and redeeming the fund’s shares.
Item 11(a)(1) of Form N-1A, which requires a fund to explain that the price of fund shares is based on the fund’s NAV and the method used to value fund shares, would be tweaked to additionally state that if a fund is an ETF, the price of the ETF shares is based on market price.
ETFs would also no longer be required to disclose in their SAI local market holidays that may delay settlement of an in-kind security in a redemption transaction beyond the seven-day time period required by Section 22(e) of the 1940 Act. The Proposing Release notes that the SEC expects this would be covered in the ETF’s agreements with authorized participants.
Other Features and Modifications
The Rule 6c-11 proposal was packed with a number of ancillary regulatory actions, which are highlighted below.
Active Versus Passive ETFs
Unlike the current exemptive orders, proposed Rule 6c-11 would not distinguish between actively managed and index-based ETFs by applying a separate set of conditions to each. Rather, the rule applies equally to both, as that distinction in ETF exemptive orders was a matter of historical development, and market practice has migrated toward full portfolio transparency, which is the key distinction of actively managed ETF orders.
Elimination of the Intraday Indicative Value (IIV)
The SEC did not include the IIV requirement, a key feature of prior exemptive orders, in proposed Rule 6c-11’s conditions. The IIV is an intraday estimate of an ETF’s NAV per share. ETFs under current orders are required to widely disseminate their IIVs at least every 15 seconds during regular trading hours (60 seconds for international ETFs). The rationale for IIVs in the prior orders was that the IIV requirement allows investors to determine (by comparing the IIV to the market value of the ETF’s shares) whether and to what extent the ETF’s shares are trading at a premium or discount. Proposed Rule 6c-11 would dispense with the IIV requirement because the SEC found that market makers typically calculate their own intraday value of an ETF’s portfolio with proprietary algorithms that use an ETF’s daily portfolio disclosure and available pricing information about the assets held in the ETF’s portfolio. Furthermore, the SEC stated that market makers generally use the IIV, if at all, as a secondary or tertiary check on the value that their proprietary algorithms generate.
Settlement of Foreign Securities in a Redemption Basket
Proposed Rule 6c-11 grants relief from Section 22(e) of the 1940 Act to permit an ETF to delay satisfaction of a redemption request for more than seven days (the limit in that provision) if a local market holiday, or series of consecutive holidays, the extended delivery cycles for transferring foreign investments to redeeming authorized participants, or the combination thereof prevents timely delivery of the foreign investment included in the ETF’s basket. To rely on this exemption, an ETF would be required to deliver foreign investments as soon as practicable, but in no event later than 15 days after the tender to the ETF.
Sponsors could not launch “leveraged ETFs” in reliance on proposed Rule 6c-11. Leveraged ETFs are those that seek, directly or indirectly, to provide returns that exceed the performance of a market index by a specified multiple or to provide returns that have an inverse relationship to the performance of a market index over a fixed period of time. The Proposing Release notes that this prohibition would extend to an ETF that simply seeks to track an index with an embedded leverage component. Existing leveraged ETFs may continue to rely upon the unique exemptive orders they received.
Master-Feeder ETFs and Funds-of-Funds Relief
The SEC noted that many existing ETF orders contain relief to allow master-feeder ETF structures; however, only one fund complex has established a master-feeder arrangement involving ETF feeder funds. Thus, the SEC decided in proposed Rule 6c-11 to rescind the master-feeder relief granted to ETFs that do not rely on the relief as of June 28, 2018.
The SEC in its Proposing Release further noted that its exemptive orders also provide relief allowing mutual funds and other types of funds to invest in ETFs beyond the limits of Section 12(d)(1) of the 1940 Act. It stated that it was not addressing this relief at this time, but would not rescind relief previously granted.
SEC Reporting (Form N-CEN)
ETFs would be required to report on Form N-CEN if they are relying on proposed Rule 6c-11. The SEC wants this information so it can better monitor reliance on the rule and to assist with its accounting, auditing and oversight functions.
Proposed Rule 6c-11 provides that an ETF would not be prohibited from selling (or redeeming) individual shares on the day of consummation of a reorganization, merger, conversion or liquidation.
Share Class ETFs
Proposed Rule 6c-11 would not disturb Vanguard’s exclusive ability to offer ETF share classes and mutual fund classes of shares of the same fund. Other ETFs could not rely on the rule to do the same. While ETFs could file an exemptive application with the SEC requesting relief from Sections 18(f)(1) and 18(i) of the 1940 Act for similar relief, Vanguard has patented the dual mutual fund/ETF class structure.
As is the case with existing ETF exemptive orders, proposed Rule 6c-11 would provide exemptions from Sections 17(a)(1) and (a)(2) of the 1940 Act with regard to the deposit and receipt of baskets to a person who is an affiliated person of an ETF (or who is an affiliated person of such a person) solely by reason of (i) holding with the power to vote 5 percent or more of an ETF’s shares; or (ii) holding with the power to vote 5 percent or more of any investment company that is an affiliated person of the ETF. The SEC declined to extend this relief to permit broker-dealers affiliated with an ETF’s adviser to act as authorized participants, as requested by some commenters on the 2008 proposal, citing the increased flexibility proposed Rule 6c-11 gives with respect to custom baskets.
The 300-plus ETF exemptive orders the SEC has issued would be rescinded (to the extent they relate to the operation and formation of ETFs covered by proposed Rule 6c-11), and the ETF recipients of such orders would have to rely on the rule. UIT ETFs, leveraged ETFs and the Vanguard mutual fund/ETF class exemptive orders would not be rescinded.
Questions and More Questions
It is notable that almost every condition in proposed Rule 6c-11 was accompanied by a half dozen or more questions from the SEC. Surprisingly, many of these questions are far-reaching and their answers have the potential to fundamentally change the rule’s basic conditions. Examples of such questions are:
- Is the proposed relief sufficient to facilitate transactions in ETF shares on the secondary market?
- Would the arbitrage mechanism contemplated by the proposed rule keep ETF market prices at or close to NAV per share under normal market conditions?
- Should we establish requirements for creation unit sizes and/or dollar amounts?
We expect the industry and its various participants to generate numerous comments and be especially vociferous in response to SEC questions that have the potential to invite more regulation and threaten the proposed rule’s flexibility. The deadline for comments to the SEC is 60 days from the date the proposal is published in the Federal Register. The industry is also mindful that based on history, it may be another decade or two before the SEC revisits the ETF rule.
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 See Exchange Traded Funds, Investment Company Act Rel. No. 10515 (June 28, 2018) (Proposing Release).
 An “authorized participant” is a bank or broker-dealer member or participant of an SEC-registered clearing agency that has a written agreement with the ETF or one of its service providers that allows the authorized participant to place orders for the purchase and redemption of creation units. Only authorized participants may engage in in-kind purchase and redemption transactions with the ETF.
 See paragraph (a) of proposed Rule 6c-11 under the definition of “exchange-traded fund.”
 See paragraph (c)(2) of proposed Rule 6c-11.
 See Rules 210.12-12, 12-12A, 12-13, 12-13A, 12-13B, 12-13C, and 12-13D of Regulation S-X.
 See paragraph (c)(1) of proposed Rule 6c-11.
 See paragraph (c)(3) of proposed Rule 6c-11.
 See paragraph (c)(3) of proposed Rule 6c-11.
 See paragraph (d) of proposed Rule 6c-11.
 See paragraph (b)(4) of proposed Rule 6c-11.
 See paragraph (c)(4) of proposed Rule 6c-11.
 See paragraph (c)(5) of proposed Rule 6c-11.
 See paragraph (b)(3) of proposed Rule 6c-11.