National Association for Variable Annuities
From PLI’s Course Handbook
Nuts & Bolts of Financial Products 2010
#23341
4
Evolution of exchange traded products: how new sec rules may tip the competitive balance
W. Thomas Conner
Sutherland
© 2009 Sutherland Asbill & Brennan LLP.
All Rights Reserved.
This conference outline is intended for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making a decision or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland Asbill & Brennan and the recipient.
The author would like to express his gratitude to his colleague Eric Freed, who contributed to this outline.
Introduction
Exchange traded funds or “ETFs” are a relatively new type of investment vehicle. From an investment perspective, most ETFs function as index mutual funds. Unlike indexed-based mutual funds, however, ETF shares trade on an exchange and investors can buy and sell shares throughout the day at market determined prices. This feature, potentially greater transparency and liquidity than mutual funds, the opportunity for use in sophisticated trading and hedging strategies, and lower costs and certain tax advantages, have made ETFs more popular with some investors than conventional mutual funds.
These relative advantages have contributed to fast growth in the ETF market. By one estimate, since the first ETF was introduced in 1992, assets grew to $417 billion by year-end 2006. It took the U.S. mutual fund industry from 1924 to 1984 to grow to this level of assets.[1] By year-end 2008, the number of ETFs had grown to 728 and total assets had grown to $531 billion.[2]
ETFs are regulated like mutual funds under the federal securities laws, but their unique structural and operational characteristics require exemptions from the Securities and Exchange Commission (“SEC” or the “Commission”) that mutual funds do not need. At the end of the day though, forming, registering, and operating a conventional ETF is, at this point, relatively “old hat” from a regulatory standpoint.
Recent years have seen the development of a new type of exchange traded product that tracks the performance of specified commodities, currencies or other “hard assets.” This outline refers to these products as “exchange traded vehicles” (“ETVs”). Because ETVs invest in commodities, currencies, or other hard assets, they are not subject to the Investment Company Act of 1940 (the “1940 Act”), the special set of statutes and rules that govern mutual funds, ETFs, and other types of investment companies. However, ETVs are subject to the same registration requirements that apply to mutual funds, ETFs and other investment companies under the Securities Act of 1933 (the “1933 Act”), plus additional rules under the 1933 Act and the Securities Exchange Act of 1934 (the “1934 Act”) that do not apply to funds.
Yet another variation on the ETF theme is the “exchange traded note” or “ETN.” Like ETFs and ETVs, ETN shares trade in the secondary market and seek to provide investors returns based on underlying securities, commodities or other indexes. Importantly, however, ETNs do not seek to track the index by investing in the component securities or commodities comprising the index; rather, ETNs are notes constituting the general debt obligation of a bank issuer. Unlike conventional notes, however, ETNs do not promise the return of an investor’s principal at maturity. Instead, the amount due at maturity is determined by reference to the underlying index. This structural characteristic of ETNs is designed to eliminate the potential for tracking error inherent in ETFs and ETVs, but ETN investors are subject to the general credit risk of the issuer and there are potential tax issues.
This conference outline is being submitted in the beginning of December 2009, for a panel entitled “Exchange Traded Funds/Exchange Traded Notes” at the 2010 Nuts & Bolts of Financial Products Conference. It addresses the following topics:
• How will a recently proposed SEC rule change the regulatory landscape for ETFs?
• Will the rule permit ETF sponsors to register new ETFs and bring them to market more quickly and with less legal cost, and if so, when?
The answer to the second question is relatively straightforward – it’s “yes.” If the SEC adopts the rule changes as proposed, ETF sponsors generally may be able to register new ETFs and bring them to market more quickly and with less cost. However, recent speeches by senior SEC officials indicate the final adoption of the rule may not be as imminent as once thought.
The first question is more difficult to answer, but equally important. The exchange traded product industry now has three distinct dimensions – ETFs, ETVs, and ETNs. The SEC’s proposed rule changes would affect only ETFs, which leaves open the very significant question of whether and how the new rules will change the competitive dynamics between ETFs and the other two products.
This outline goes about answering the two questions by first explaining how each product is currently regulated and how associated costs and regulatory burdens impact the viability of each product. The outline then examines how the SEC rule initiatives may change the current competitive balance between these exchange traded products.
General Operation and Regulation of Exchange Traded Funds and exchange traded vehicles
1 Typical Operation of an ETF
Most ETFs are index funds. Their investment objective is to track the performance of a specified index, up or down, by investing in all, or a representative sample of, the component securities of the index. For example, the “SPDR” ETF invests in the stocks comprising the S&P 500 Composite Stock Price Index. There are also numerous sector-specific ETFs, ranging from industrials to health care and medical development, which track a variety of other market indices.
Because ETFs track indices, it is not surprising to find that most of the largest ETF sponsors are index specialists that consider ETFs a natural extension of their business. Some of the biggest ETF sponsors include Baclays Global Investors (iShares), State Street Global Advisors (SPDRs), Vanguard, Invesco Ltd (PowerShares), ProFunds, Security Benefit’s Rydex Investments, First Trust, and Claymore. The unique nature of the exchange traded products industry, however, has permitted the entrance of several ETF sponsors, like Wisdom Tree, that were not part of the “mainstream” mutual fund industry.
Although the exchange traded products industry until recently has enjoyed dramatic growth, we are now seeing some consolidation and restructuring in the industry that may impact competition among ETF sponsors in the future. There are also signs that the launching of new ETFs slowed down in 2008 compared with 2007, and the majority of newly introduced ETFs were currency and commodity-based ETVs.[3] 20009, however, has seen the introduction of a wide range of new ETFs, ETVs, and ETNs, although the recent financial crisis and resulting credit concerns may have decreased the popularity of ETNs, which as discussed below, subject holders to the general credit worthiness of the ETN issuer.
Unlike index and other mutual funds, ETFs do not sell shares to, or redeem shares from, individual investors at net asset value (“NAV”). Instead, ETFs sell and redeem their shares at NAV only in large blocks called “creation units” (such as 100,000 shares). Brokerage firms and institutional investors that purchase or redeem ETF shares in creation units (referred to as “Authorized Purchasers” or “APs”) typically do so through “in-kind” transactions involving a “portfolio deposit” equal in value to the aggregate NAV of the ETF shares in the respective creation unit. The ETF’s sponsor (typically the fund’s investment adviser) announces the contents of the portfolio deposit at the beginning of each business day. The portfolio deposit generally consists of a basket of securities that mirrors the composition of the ETF’s portfolio. Because the purchase price of the creation unit must equal the aggregate NAV of the underlying ETF shares, the requisite portfolio deposit generally also includes a small amount of cash to account for the difference between the market value of the deposit basket and the aggregate NAV of the ETF shares. The value of a creation unit typically exceeds several million dollars.
After purchasing a creation unit, the AP may hold the ETF shares, or sell some or all of the ETF shares to other brokerage firms, institutional investors, or individual investors. Thereafter, the shares are listed on a national stock exchange (such as the New York Stock Exchange) and trade through purchase and sale transactions in the secondary market, just like shares of stock of any public company, until such time as an Authorized Purchaser purchases the shares in the secondary market to sell them back to the ETF in a creation unit.
In this regard, ETFs possess characteristics of “closed-end” funds, which generally issue shares that trade at negotiated prices on national securities exchanges and are not redeemable. Like closed-end funds and conventional corporate issuers generally, in order for their shares to be traded in the secondary market, ETFs must list their shares for trading on a national securities exchange under the 1934 Act. As with any listed security, investors also may trade ETF shares in the secondary market in off-exchange transactions. In either case, ETF shares trade at negotiated prices determined by the demand and supply for the ETF shares and by the values of the securities in the ETF portfolio. The market price of ETF shares may be higher or lower than the NAV of the ETF shares. Such pricing discrepancies are more common for ETFs that do not trade as frequently, but all in all, most ETFs experience a price discrepancy of 1% or so, which is better than closed-end funds, which on average reportedly trade roughly 4% below the value of their holdings.[4]
The development of the secondary market in ETF shares depends upon the activities of the market makers assigned to make a market in the ETF shares and upon the willingness of Authorized Purchasers buying creation units to sell the corresponding ETF shares in the secondary market. ETF shares purchased in the secondary market are not redeemable with respect to the ETF itself except in creation units. If an Authorized Purchaser purchases enough shares of an ETF in the secondary market to make up a creation unit and presents this block of shares to the ETF for redemption, the AP receives a “redemption basket,” the contents of which are identified by the ETF sponsor at the beginning of every business day. The redemption basket (usually the same as the portfolio deposit) consists of securities and a small amount of cash. As with purchases from the ETF, redemptions are priced at NAV (i.e., the value of the redemption basket is equal to the NAV of the ETF shares sold back to the fund in the creation unit-sized block of shares). An investor holding fewer ETF shares than the amount needed to redeem a creation unit-sized block of shares may dispose of those ETF shares only by selling them in the secondary market. The investor receives market price for the ETF shares, but pays customary brokerage commissions on the sale and the purchase of ETF shares.
2 Regulation of ETFs under the Federal Securities Laws
Like index and other types of mutual funds, ETFs fall within the definition of an “investment company” under the 1940 Act and consequently are required to be registered with the SEC under the 1940 Act as “open-end management investment companies.”[5] (The term “open-end management investment company” is the technical reference for what we commonly think of as “mutual funds.”) As is also the case for index and other funds, ETFs are required to register their shares with the SEC in accordance with the registration provisions of the 1933 Act. As is the case for mutual funds generally, applicable exemptions save the ETF from having to file periodic reports such as 10-Ks and 10-Qs with the SEC as would otherwise be required by the 1934 Act. Instead, ETFs and mutual funds generally are required to provide investors with semi-annual and annual shareholder reports.
3 Benefits of Exchange Traded Funds
ETFs offer investors several important potential benefits. First, ETFs provide investors with the opportunity to invest in a diversified basket of securities through the purchase of a single exchange traded security. As a result, investors may obtain the diversification benefits of a mutual fund while still being able to trade the shares of the ETF with the flexibility of a listed stock. In addition, unlike closed-end funds (the traditional type of investment company that issues exchange traded shares), ETFs may avoid the discounts and premiums in market price often associated with closed-end fund shares by continuously issuing and redeeming ETF shares in creation units and thereby creating an arbitrage mechanism (discussed in more detail below).
1 ETFs as a Tool for Individual Investors
As the ETF marketplace has developed, individual investors have accepted ETFs as an index investment with trading flexibility. Certain individual investors invest in ETF shares as a long-term investment for asset allocation purposes, while others apparently trade ETF shares frequently as part of market timing investment strategies. For those investors who trade more frequently, ETFs offer the ability to purchase and sell ETF shares in the secondary market at a known price anytime during the trading day, to purchase ETF shares on margin, to sell ETF shares short and to sell futures and options contracts on ETFs.[6] Unlike mutual funds, ETFs provide full portfolio transparency by disclosing their portfolio holdings every day, while mutual funds disclose their portfolio holdings only four times a year with a 60-day delay.[7]
2. Use of ETFs by Institutional Investors
Institutional investors may choose to purchase ETF shares in the secondary market for a variety of reasons. Pension funds, for example, whose investment restrictions prohibit investment in index derivatives (such as futures and options) may instead invest in ETF shares. Other institutional investors may prefer to hold ETF shares instead of index futures because ETF shares do not have the margin requirements or expiration dates of futures. Hedge funds may employ ETF shares in hedging strategies by taking certain short or long positions in individual securities of a certain market sector, while taking opposite positions in ETF shares tracking that sector. Institutional money managers and mutual funds may use ETFs as a temporary means of keeping cash invested in a broad market segment during transitions in investment strategy or management.
3. Potential Cost Savings Offered by ETFs
ETFs may offer lower expense ratios and certain potential tax advantages as compared to conventional index or other mutual funds. Like index funds, the majority of the ETFs are “passively” managed to track an index and are not expected to have significant levels of turnover in their portfolio securities. As a result, ETF expenses typically are lower than the expenses of actively managed mutual funds, which generally have higher management fees and brokerage expenses due to the ongoing purchases and sales of portfolio securities. Some ETFs have even lower expense ratios than comparable index funds, because ETFs have lower level of shareholder recordkeeping and service expenses than index funds offered and sold to individual investors. The individual investor information for ETFs is kept at the retail broker-dealer level, while the ETF transfer agent keeps only information on the APs, which are fewer than the retail investors of a typical index mutual fund. Offsetting the lower expense ratios associated with owning ETF shares are brokerage commissions paid in connection with the secondary market transactions paid by individual investors who purchase and sell ETF shares. Brokerage commissions constitute a separate discrete cost not reflected in the expense ratio of the ETF.
4. Potential Tax Advantages Offered by ETFs
ETFs also potentially offer certain tax advantages. When a mutual fund sells portfolio securities to pursue its investment strategies or to generate cash for shareholder redemptions, the mutual fund may realize capital gains if the value of the securities increased while they were in the fund portfolio. As the mutual fund sells more securities, higher capital gains may be generated, as the mutual fund manager digs deeper into the fund’s portfolio holdings, and as a result is forced to sell securities with lower and lower cost basis. Mutual funds generally are required to distribute accumulated capital gains to their shareholders, who may in turn be required to pay income taxes on the distributions. This can lead to an anomalous outcome: if a large number of mutual fund investors withdraw their holdings during a market downturn, mutual funds sell larger than usual portions of their portfolio holdings, potentially generating taxable capital gains. The mutual fund investors may be saddled with higher tax liability during a year with declining values of their mutual fund holdings.
An ETF also may accumulate and distribute capital gains to investors. However, like index funds, an ETF may be more tax efficient than many mutual funds because of the low turnover in its portfolio securities. In addition, the ETF structure may allow an ETF to avoid capital gains to an even greater extent than index funds. Because an ETF typically redeems creation units of its shares by delivering securities in the redemption basket, an ETF does not have to sell securities (and possibly realize capital gains) in order to pay redemptions in cash. The redemption basket also may include securities from the ETF portfolio that have the highest unrealized capital gains (i.e., securities that have appreciated in value the most while in the ETF portfolio). Because the ETF may be able to eliminate securities with significant unrealized capital gains from its portfolio through the redemption process, the ETF may avoid realizing some capital gains if the ETF needs to sell securities for cash at a later date to track its index.
5 Commodity-Based and Other Exchange Traded Vehicles: A New
Generation of ETFs[8]
As the above discussion indicates, ETFs offer investors important potential advantages. As a result, there has been a steady increase in the number of ETFs and ETF assets. Witnessing this success, several years ago creative fund sponsors began to explore whether the ETF structure could be used to “equitize” non-security asset classes such as gold, silver, crude oil or other types of commodities not generally available to individual investors.
1 Precious Metal Exchange Traded Vehicles
After a significant investment of time, resources and creative thinking, the answer to the above-stated question was proven to be “yes.” The first ETV to be offered in the United States was the “Equity Gold Trust” (now called “StreetTracks” Gold Trust). The Gold Trust was designed for the purpose of making physical gold available to a broader investor base than previously existed by enabling individual investors to beneficially own gold bullion in the form of a listed equity security. As a result, investors were no longer burdened by traditional barriers to investing in physical gold such as hauling and storage costs. In addition, the Gold Trust made investing in gold available to those who lacked the scale, ability and/or expertise to invest in the futures market.
The Gold Trust operates by holding gold bullion transferred to it in exchange for Trust shares issued in creation units. Each Gold Trust share represents a fractional undivided beneficial interest in the net assets of the Trust. The assets of the Trust consist primarily of gold held by the custodian on behalf of the Trust. The objective of the Trust is for the value of the shares to reflect, at any given time, the price of the gold owned by the Trust at that time less the Trust’s expenses and liabilities. The Trust issues creation units of 50,000 shares in exchange for actual gold bullion deposited with the custodian as consideration, and delivers gold in exchange for creation units of shares surrendered for redemption.
2 Crude Oil-Based Exchange Traded Vehicles
Other precious metal ETVs followed on the heels of the StreetTracks Gold Trust, sharing with the Trust the goal of creating a vehicle to permit individual investors access to investments in gold and other precious metals without the traditional barriers of storage and other physical impediments. Around the same time, similar interest began developing in creating an exchange traded vehicle that would provide individual investors a direct means of investing in and/or hedging their exposure to the spot price of crude oil and other petroleum-based products. Notwithstanding certain similarities, though, there were fundamental differences in the two types of funds’ respective underlying commodity-based investments that had to be taken into account from a regulatory perspective.
First, transporting and storing crude oil is exponentially more expensive than transporting gold or other precious metals. Therefore, investing directly in crude oil was unworkable; selling and redeeming creation units in in-kind transactions in crude oil also would have been fundamentally unworkable. This left crude oil-based derivative instruments as the only viable alternative. Fortuitously, crude oil futures contracts are traded in well-developed commodities markets, including the New York Mercantile Exchange (“NYMEX”).
There were other challenges as well. Futures contracts, unlike securities and precious metals, cannot be transferred in an in-kind transaction ( futures contracts are agreements between two parties, and the corresponding obligation between the parties is fundamentally different from a legal standpoint than property such as securities or precious metals. The first oil-based ETV, United States Commodities Funds’ United States Oil Fund (“USO”), therefore required creation units to be purchased and redeemed through cash transactions, with the cash then being used as a basis for the fund’s entering directly into crude oil futures contracts.[9]
3 Other Commodity-Based Exchange Traded Vehicles
Exchange traded vehicles that invest in commodities other than gold and oil have been developed and successfully brought to market. Such ETVs include broad based commodity ETFs like GreenHaven Continuous Commodity Index, iShares GSCI Commodity-Indexed Trust and PowerShares DB Commodity Index Tracking Fund. There are also sector-specific commodity ETVs like PowerShares DB Agriculture Fund, PowerShares Base Metals Fund and MLCS Grains Index Elements ETF. Commodity ETVs are generally like index funds but they track non-securities indexes. Although some commodity-based ETVs attempt to track the price of a single commodity, more frequently they track a basket of commodities by purchasing futures contracts or engaging in other commodity-based investment strategies involving derivative instruments. In addition to the variety of commodity-based ETVs, investors also can find currency ETVs, which as the name suggest, invest in a particular foreign currency. In 2005, Rydex Investments launched the first currency ETV called the Euro Currency Trust, which holds euros, accepts deposits of euros and distributes euros in connection with redemption requests. Rydex has also launched a series of funds tracking other major currencies. In 2008, Deutsche Bank launched two other currency ETVs.
Commodity-based ETVs have not been regulated as investment companies under the 1940 Act, because they do not invest in securities. Commodity-based ETVs are nevertheless subject to SEC review and regulation, because they make public offerings of securities, and they need SEC no-action relief under the 1934 Act.
Investing in commodity futures contracts rather than in the commodities themselves presented other legal questions as well. Commodity futures contracts, unlike the actual underlying commodities, are regulated by the United States Commodity Futures Trading Commission (“CFTC”). In addition, collective investment vehicles that invest in commodity futures contracts are regulated by the CFTC and the National Futures Association (“NFA”) as “commodity pools.” Commodity futures contracts, unlike the commodities themselves, have from time to time been the subject of a rich and often contentious jurisdictional debate between the SEC and CFTC, and although there have long been commodity pools that have registered their shares or “units” under the 1933 Act, the treatment of commodity pools and their underlying investments in futures contracts for purposes of the 1940 Act has been at times somewhat murkier. “Funds” that invest in precious metals clearly do not invest in “securities,” the fundamental definitional aspect that triggers regulation under the 1940 Act; in part because of the jurisdictional issues associated with commodity futures contracts, “funds” that invest in commodity futures contracts, and perhaps particularly those that invest in “over-the-counter” derivatives contracts, may present a less clear distinction, although clearly these types of funds have not registered under the 1940 Act.
In addition to these issues, there are tax issues, basic corporate structuring issues, and other legal questions that must be addressed to successfully negotiate the maze of regulations that apply to ETVs. The maze has been successfully navigated, but the voyage is not for the weak-of-heart.
ETFS VERSUs ETVs: Application of the Federal Securities Laws
1 Registration Requirements for ETFs Under the 1933 Act and the 1940 Act
Absent an applicable exemption, securities issued by general corporate issuers are required to be registered under the 1933 Act by filing a registration statement on the prescribed form. Mutual funds and other investment companies are no different in this regard, and accordingly register their shares under the 1933 Act. However, the mechanics of registering and paying the registration fees on mutual fund shares can, in certain situations, be significantly more streamlined than for corporate and other non-investment company issuers that offer securities on a continuous basis. Specifically, non-investment company issuers are not permitted to sell an unlimited number of shares. They must instead register a definite amount of securities, and when those securities are sold, a new registration statement must be filed. Mutual funds, on the other hand, are permitted to register an indefinite amount of shares, and moreover, are then permitted to pay registration fees in arrears.
Absent an available exemption, mutual funds and other investment companies are also required to register under the 1940 Act, again using the prescribed registration form.
1 Registration Statement Form for Mutual Funds — Form N-1A
Although mutual funds are required to register their shares under the 1933 Act and the fund under the 1940 Act, both registrations can be accomplished through the same “integrated” registration form – Form N-1A. Form N-1A is a three-part form. Part A is the prospectus, Part B is the “Statement of Additional Information” (“SAI”) containing more detailed and technical information, and Part C contains exhibits and other information relating to the mutual fund and certain other affiliates.
2 Prospectus Delivery Requirements
Pursuant to Section 5(b) of the 1933 Act, mutual fund prospectuses generally must be provided to investors upon a sale of shares. Although not required to be delivered initially to all investors, the SAI must be sent to investors upon request. Part C of these forms (as well as any exhibits) is filed with the SEC, but not required to be provided to investors.
Like conventional mutual funds, after an ETF’s registration statement is effective and it begins offering and selling shares, it is required to deliver its prospectus to purchasers.[10] APs, however, are the only direct purchasers of ETF shares. As to investors who purchase shares in the secondary market, without an exemption, ETFs would be subject to a separate 1940 Act provision that generally requires prospectus delivery.[11] As discussed in detail below, however, ETFs are required to apply for and receive certain exemptions from the SEC, and until recently also obtained an exemption from prospectus delivery requirements to share purchasers in the secondary market. Specifically, a condition of the exemptive relief obtained from the SEC was that summary “Product Descriptions” be provided to secondary market purchasers. In the newly proposed exemptive rules for ETFs, however, the SEC noted that it was not proposing to require the delivery of Product Descriptions to purchasers in the secondary market due to the fact that it understands that liability concerns may lead, and in fact have led, ETFs to require delivery of full prospectuses to purchasers in the secondary market.
When the SEC proposed the ETF rules, the agency also proposed revisions to Form N-1A to take into account the unique features of ETFs and the need to provide ETF investors purchasing shares in the secondary market with information that would be relevant to their investment decisions. However, rather than waiting for the proposed ETF rules to be adopted, the SEC adopted these proposed revisions when it recently adopted amendments to Form N-1A, the registration form required for mutual funds, and new “summary prospectus rules.”[12] It took guidance from, and essentially codified, the additional disclosures that had routinely been required to be included in the prospectus or product description as a condition of existing exemptive orders.
The revisions to Form N-1A require ETFs to make different or additional disclosures than those required of mutual funds. Most of these required disclosures are intended to impart information that is more relevant to retail investors than to the APs that purchase ETF shares in the first instance. The new required disclosures include information on:
• ticker symbol and principal U.S. trading market;
• purchasing and redeeming shares;
• fees and brokerage expenses; and
• share prices, premiums, and discounts.
The SEC’s new summary prospectus rule will permit ETFs to satisfy their prospectus delivery obligations by delivering a summary prospectus to secondary-market investors. The SEC apparently intends the summary prospectus to, in effect, replace the condition in typical ETF exemptive orders that a product description be provided.[13] However, as is the case for mutual funds generally, a summary prospectus may be sent or given to secondary-market investors in lieu of a full statutory prospectus only if the full statutory prospectus is made available on a Web site and the ETF sponsor agrees to send a paper copy of the full prospectus, at no charge, to investors upon request.
3 Keeping Registration Statements and Prospectuses Current
Section 10(a)(3) of the 1933 Act has the effect of requiring mutual funds, because they engage in “continuous offerings” of their shares, to maintain a current or “evergreen” prospectus. In particular, when a prospectus is used more than nine months after the effective date of the registration statement, the financial and other information contained therein must be as of a date no more than sixteen months prior to such use.
Disclosure may be updated using one of two procedures — amending the registration statement by filing a post-effective amendment with the SEC, or by supplementing or “stickering” the prospectus. Which procedure is appropriate depends on the nature and extent of the disclosure changes being made. Because any change to the audited financial statements (including updating) may only be made by filing a post-effective amendment, such an amendment must be filed at least once a year.
Importantly, the SEC has taken the position that each purchase payment of additional shares of a mutual fund may constitute the sale of a new security. Under this interpretation, a copy of the updated prospectuses for the fund typically is sent at least annually to mutual fund investors, although prospectuses are not actually required to be provided to shareholders until a confirmation is delivered upon the purchase of additional shares.
2 Registration Requirements for ETVs under the 1933 Act
As noted, absent an applicable exemption, ETFs and other mutual funds are required to register their shares under the 1933 Act by filing a registration statement on the prescribed form. ETFs and ETVs do not differ with respect to this fundamental requirement; an ETV also must register its shares under the 1933 Act. However, as noted, the mechanics of registering and paying the registration fees on ETV shares, as opposed to mutual fund and ETF shares, can be significantly more complex. Because ETVs are not investment companies, they are not permitted to sell an unlimited number of shares; they must register a definite amount of securities, and when those securities are sold, a new registration statement must be filed. Moreover, unlike mutual funds, redemptions cannot be netted against sales. Therefore, while there are certain “shelf” registration procedures that can potentially be used by an ETV to streamline registration requirements, generally a new Form S-1 must be filed when the ETV has sold all of the shares it has registered. This requirement effectively obligates the ETV to pay significant amounts of ongoing SEC registration fees. The ETV incurs significant related legal, accounting, and other expenses.[14] At the same time ETVs are not required to register under the 1940 Act because they are not investment companies.
1 Registration Statement Form For ETVs — Form S-1
The general or “default” registration form for registrants under the 1933 Act is Form S-1. There are disadvantages to Form S-1 as compared to Form N-1A. For example, there is no concept of an SAI containing more detailed and technical information that is required to be provided to investors only upon request (although some ETV prospectuses attach the moniker of “Statement of Additional Information” to the second half of their prospectus).
2 Prospectus Delivery Requirements
As discussed above, pursuant to Section 5(b) of the 1933 Act, mutual fund prospectuses generally are required to be provided to investors upon a sale of shares. As also noted, however, until recently ETFs received exemptions from the SEC permitting the delivery of a “Product Description” for secondary market sales rather than full prospectuses. ETVs, on the other hand, are not required to obtain the same exemptions from the SEC (because they are not regulated under the 1940 Act), and therefore are not subject to the exemptive relief condition that Product Descriptions be provided in secondary market transactions. ETVs therefore remain subject to the prospectus delivery requirements imposed on other exchange-traded issuers and, if they are commodity pools, to certain disclosure document delivery requirements imposed under federal commodities laws.
3 Keeping Registration Statements and Prospectuses Current
As with ETFs and other mutual funds making a “continuous offering” of their shares, ETVs must maintain a current or “evergreen” prospectus as long as they are selling shares. Prospectuses may be updated as with mutual funds by using one of two procedures — amending the registration statement by filing a post-effective amendment with the SEC, or by supplementing or “stickering” the prospectus ─ but importantly, as noted above a new registration statement must be filed when the amount of shares currently registered runs out.
ETFs VERSUS ETVs: Application of Substantive Regulatory Requirements of the 1940 Act
1 Exemptive Relief from the 1940 Act and Rules Adopted Thereunder
Because of their unique structure, ETFs must obtain exemptive relief from certain provisions of the 1940 Act. Specifically, an ETF, because it is organized as an open-end fund, generally is required to request an order (i) under Section 6(c) of the 1940 Act granting relief from Sections 2(a)(32) and 5(a)(1) of the 1940 Act so that the ETF may register under the 1940 Act as an open-end fund and issue shares that are redeemable in creation units only; (ii) under Section 6(c) granting relief from Section 22(d) of the 1940 Act and Rule 22c-1 under the 1940 Act to permit the purchase and sale of individual ETF shares in the secondary market at negotiated prices; and (iii) under Sections 6(c) and 17(b) of the 1940 Act granting relief from Sections 17(a)(1) and (a)(2) of the 1940 Act to permit in-kind purchases and redemptions of creation units by persons who may be affiliated with the ETF by reason of owning more than 5%, and in some cases more than 25%, of its outstanding securities. Certain ETFs that track foreign indices also have obtained relief under Section 6(c) from Section 22(e) of the 1940 Act so that they may satisfy redemption requests more than seven days after the tender of a creation unit for redemption due to delivery cycles for securities in the local market.
In considering whether to grant relief from each of the sections outlined above, the SEC is required by Section 6(c) of the 1940 Act to find that the exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act. Under Section 17(b) of the 1940 Act, the SEC may exempt a proposed transaction from Section 17(a) only if evidence establishes that the terms of the transaction, including the consideration to be paid or received, are reasonable and fair and do not involve overreaching, and the proposed transaction is consistent with the policies of the registered investment company and the general provisions of the 1940 Act. These statutory standards present high thresholds, and obtaining an exemptive order may take an extended period of time and require a significant commitment of legal and other resources. The SEC staff has made a concerted effort to streamline the process, and as a result, the process may now take six months as opposed to one or two years or more. Of course, preparing the exemptive application requires a significant amount of time and resources and necessarily involves a careful analysis of multiple legal and technical operational issues.
1 Relief for ETFs to Redeem Shares in Large Aggregations Only
Section 5(a)(1) of the 1940 Act defines an “open-end company” as a management investment company that is offering for sale or has outstanding any redeemable security of which it is the issuer. Section 2(a)(32) defines a redeemable security as any security, other than short-term paper, under the terms of which the holder, upon its presentation to the issuer, is entitled to receive approximately the holder’s proportionate share of the issuer’s current net assets, or the cash equivalent. Because ETF shares are not individually redeemable, an ETF is required to request a regulatory exemption from the SEC to permit the ETF to register and operate as an open-end fund and to issue shares that are redeemable in creation units only.
In support of the relief, ETFs have noted that Authorized Purchasers may redeem ETF shares in creation units. ETFs also have noted that because the market price of creation units is disciplined by arbitrage opportunities, investors in ETF shares generally should be able to sell ETF shares in the secondary market at approximately their NAV. ETFs organized as open-end funds have agreed as a condition to the exemptive relief that the ETF will not be advertised or marketed as an open-end fund or mutual fund. The prospectuses and advertising materials for ETFs prominently disclose that ETF shares are not individually redeemable and that shareholders may acquire shares from an ETF and tender those shares for redemption to the ETF in creation units only.
Because of arbitrage opportunities inherent in the ETF structure, ETF shares generally have not traded in the secondary market at a significant premium or discount in relation to NAV. The mechanism at work here is that if ETF shares begin to trade at a discount (i.e., a price less than NAV), arbitrageurs may purchase ETF shares in the secondary market and, after accumulating enough shares to equal a creation basket-sized block, redeem them with the ETF at NAV, and thereby acquire the more-valuable securities in the redemption basket. In purchasing the ETF shares, arbitrageurs create greater market demand for the shares, which may raise the market price to a level closer to NAV. If ETF shares trade at a premium (i.e., a price greater than NAV), arbitrageurs may purchase the securities in the creation basket, use them to obtain the more-valuable shares from the ETF and then sell the individual ETF shares in the secondary market to realize their profit. As the supply of individual ETF shares available in the secondary market increases, the price of the ETF shares may fall to levels closer to NAV. An exchange specialist designated to maintain a market in the ETF shares also works to provide appropriate amounts of shares in the secondary market in response to supply and demand.
2 Relief for ETF Shares to Trade at Negotiated Prices
Section 22(d) of the 1940 Act, among other things, prohibits a dealer from selling a redeemable security that is being currently offered to the public by or through an underwriter, except at a current public offering price described in the prospectus. Rule 22c-1 generally requires that a dealer selling, redeeming, or repurchasing a redeemable security do so only at a price based on its NAV. Because secondary market trading in ETF shares takes place at negotiated prices, and not at a current offering price described in the prospectus or based on NAV, existing ETFs have been required to obtain exemptions from Section 22(d) and Rule 22c-1.
In support of their requests for relief, ETFs generally have noted that the provisions of Section 22(d), as well as Rule 22c-1, appear to be designed to prevent dilution caused by certain riskless-trading schemes by principal underwriters and contract dealers, to prevent unjust discrimination or preferential treatment among buyers resulting from sales at different prices, and to assure an orderly distribution of investment company shares by eliminating price competition from dealers offering shares at less than the published sales price and repurchasing shares at more than the published redemption price. ETFs have accordingly posited in support of the requested exemptions that secondary market trading in ETF shares does not cause dilution for ETF shareholders because the secondary market transactions do not directly involve ETF portfolio assets (the transactions are with other investors, not the ETF), and thus have no impact on the NAV of ETF shares held by other investors. In addition, ETFs have successfully argued that to the extent different prices for ETF shares exist during a given trading day, or from day to day, these variances occur as a result of third-party market forces, such as supply and demand, and not as a result of discrimination or preferential treatment among purchasers. With respect to the orderly distribution of ETF shares, ETFs have noted that anyone may acquire creation baskets from the ETF, and that no dealer should have an advantage over any other dealer in the sale of ETF shares. ETFs also have argued that the distribution system for ETF shares should be orderly because arbitrage activity ensures that the difference between the market price of shares and their NAV remains narrow.
3 Relief for In-Kind Transactions between an ETF and Certain Affiliates
Section 17(a) of the 1940 Act generally prohibits an affiliated person of a registered investment company (or an affiliated person of such person) from selling any security to or purchasing any security from the fund. Because purchases and redemptions of creation units may be in-kind rather than cash transactions, Section 17(a) may prohibit affiliated persons of an ETF from purchasing or redeeming creation units. Section 2(a)(3)(A) of the Act defines “affiliated person” as any person owning 5% or more of an issuer's outstanding voting securities. Certain large investors may be affiliated persons of an ETF under Section 2(a)(3)(A) of the Act (“5% Affiliates”). In addition, some investors may own more than 25% of an ETF’s outstanding voting securities and therefore may be deemed an affiliated person of the ETF under section 2(a)(3)(C) of the Act (“25% Affiliates”). ETFs have obtained exemptions from Section 17(a) to permit 5% Affiliates and 25% Affiliates to purchase and redeem creation units through in-kind transactions.
In seeking this relief, ETFs have submitted that because 5% Affiliates and 25% Affiliates are not treated differently from non-affiliates when engaging in purchases and redemptions of creation units, there is no opportunity for these affiliated persons to effect a transaction detrimental to the other ETF shareholders. The securities to be deposited for purchases of creation units and to be delivered for redemptions of creation units are announced at the beginning of each day and are equally applicable to all investors. All purchases and redemptions of creation units are at an ETF's next calculated NAV, and the securities deposited or received upon redemption are valued in the same manner, using the same standards, as those securities are valued for purposes of calculating the ETF’s NAV.
4 Relief for Certain ETFs to Redeem Shares in More Than Seven Days
Section 22(e) of the 1940 Act generally prohibits a registered open-end investment company from suspending the right of redemption, or postponing the date of payment or satisfaction of redemption requests more than seven days after the tender of a security for redemption. Some ETFs that track foreign indices have found that local market delivery cycles for transferring securities to redeeming investors, together with local market holiday schedules, require a delivery process in excess of seven days. These ETFs have requested relief from Section 22(e) so that they may satisfy redemptions up to a specified maximum number of calendar days depending upon specific circumstances in the local market, as disclosed in the ETF’s prospectus or SAI. Other than in the disclosed situations, these ETFs satisfy redemptions within seven days.
These ETFs have successfully argued in their exemptive applications that Section 22(e) of the 1940 Act is designed to prevent unreasonable, undisclosed, and unforeseen delays in the payment of redemption proceeds and assert that the requested relief will not lead to the problems that Section 22(e) was designed to prevent. The anticipated delays in the payment of redemption proceeds would occur principally due to local holidays in the foreign market. The ETFs state that the SAI will disclose those local holidays (over the period of at least one year following the date of the SAI) that are expected to prevent the delivery of redemption proceeds in seven days and the maximum number of days needed to deliver redemption proceeds.
5. Relief for Certain Fund-of-ETFs Transactions
Many ETFs have also obtained relief from Section 12(d)(1) of the 1940 Act to permit other investment companies to purchase shares of the ETF in excess of the fund-of-funds limitations imposed under Section 12(d)(1). Section 12(d)(1) generally prohibits an investment company from (i) acquiring more than 3 percent of any other investment company’s outstanding voting securities, (ii) investing more than 5 percent of its total assets in any one investment company, and (iii) investing more than 10 percent of its total assets in investment companies in the aggregate. The exemptive relief obtained by ETFs in this area has generally included a substantial number of conditions that are similar to those to which funds seeking relief to invest in unaffiliated traditional mutual funds have been subject, including a number of conditions designed to limit the influence that an acquiring fund may exercise over a fund that it acquires.
2 Exemptive Relief from the 1940 Act Not Required for ETVs
Because they are not investment companies and are therefore not regulated under the 1940 Act, ETVs are not required to obtain exemptive relief from certain provisions of the 1940 Act. This may give ETVs a speed to market advantage over ETFs because obtaining the exemptive order may be a lengthy process. In addition, not being required to comply with the usual ETF exemptive order conditions has the following implications for ETVs.
1 Relief to Redeem Shares in Large Aggregations Only
ETVs are not prohibited by the 1933 Act or other federal securities laws from issuing shares that are redeemable in creation units only. Of course, corporate issuers generally do not redeem their shares at all, other than through a tender offer or other occasional type of buy-back program.
2 Relief for Shares to Trade at Negotiated Prices
ETVs are not prohibited by the 1933 Act or the 1934 Act from listing their shares on a national exchange for secondary market trading. However, although exemptive relief from the 1940 Act is not required, like ETFs, ETVs must file certain registration forms under the 1934 Act and comply with applicable exchange rules to permit their shares to trade on the exchange.
3 Relief for In-Kind Transactions between an ETV and Certain Affiliates
ETVs are not subject to the affiliated transaction prohibitions of the 1940 Act.
4 Relief to Redeem Shares in More Than Seven Days
ETVs are not subject to the 1940 Act’s prohibitions against suspending the right of redemption, or postponing the date of payment or satisfaction of redemption requests more than seven days after the tender of a security for redemption. Therefore, while as a matter of remaining competitive with other ETFs, ETVs generally have adopted similar redemption procedures, theoretically an ETV would have more flexibility in this regard than an ETF.
ETFs Versus ETVs: Exemptive Relief Under the Securities Exchange Act of 1934
1 ETF Requests for Exemptive Relief
ETF shares are listed on national exchanges and trade in the secondary market. This aspect of ETFs has been viewed as potentially triggering the application of certain provisions of the 1934 Act and rules adopted by the SEC thereunder. Many of these provisions, however, would prove unworkable if applied to ETFs.
The answer to this regulatory conundrum has been to request special exemptions from the SEC to avoid the application of the 1934 Act provisions and rules that would be unworkable. The division of the SEC that administers the 1934 Act is the Division of Trading and Markets (formerly known as the Division of Market Regulation), a different division entirely from the Division of Investment Management that regulates the investment company aspects of ETFs. Because of certain procedural and operational differences between the two divisions and certain other technical considerations, the process through which ETFs have requested relief from the Division of Trading and Markets has been less formal than the exemptive application process followed with respect to the exemptions necessary under the 1940 Act. The procedure for requesting the necessary relief under the 1934 Act has involved submitting letters to two offices of the Division of Trading and Markets — the Office of Chief Counsel and the Office of Trading Practices and Processing — requesting “exemptive, interpretive, or no-action relief” from the 1934 Act provisions and rules.
These letters have typically been framed as follows: in connection with the secondary market trading of an ETF’s shares, the ETF, on behalf of itself, its individual series or portfolios (if any), the primary listing stock exchange and any other exchange through which the ETF’s shares may trade, the ETF’s principal underwriter, and persons or entities engaging in transactions in the ETF’s shares and the purchase and redemptions of creation units, including Authorized Purchasers, requests, as appropriate, from the staff of the Division of Trading and Markets of the SEC, or from the SEC itself, exemptions from, or interpretive or no-action advice regarding, the following provisions and rules of the 1934 Act:
▪ Section 11(d)(1)
▪ Rule 10a-1
▪ Rule 10b-10
▪ Rule 10b-17
▪ Rule 11d1-2
▪ Rule 14e-5
▪ Rule 15c1-5
▪ Rule 15c1-6
▪ Rules 101 and 102 of Regulation M
▪ Rule 200(g) of Regulation SHO.
As is often the case after the SEC staff becomes more familiar with certain types of exemptive relief, the respective offices of the Division of Trading and Markets have granted “class relief” to ETFs that, depending on the nature of a particular ETF, may obviate the need for the ETF to seek its own relief. However, the “class relief” letters have typically included very specific conditions that an ETF must satisfy to be able to rely on the letter, and the letters therefore need to be carefully analyzed for potential applicability. The more unique an ETF and its underlying index, the less likely the ETF may be able to rely on prior class relief letters.
2 ETV Requests for Exemptive Relief
ETVs that have analyzed the potential applicability of the 1934 Act provisions and rules discussed above have in some cases concluded that certain of the provisions and/or rules arguably do not apply and therefore no exemptive relief is necessary. Other provisions and/or rules, on the other hand, may be applicable. In the case of currency and commodity based ETVs, exemptive relief initially was sought from Rule 10a-1, Rule 200(g) of Regulation on SHO, Rules 100 and 102 of Regulation M and Section 11(d)(1) of and Rule 11(d)1-2 of the 1934 Act. The Division of Trading and Markets, after receiving exemptive requests relating to certain currency and commodity-based ETVs, issued class relief letters obviating the necessity to such relief for ETVs whose circumstances were the same as those addressed in those class relief letters. However, as with respect to the letters issued in connection with ETFs, a careful analysis of the application of each of the potentially applicable 1934 Act provisions and rules may need to be undertaken for an ETV in order to justify whether reliance on the class relief letters is warranted or whether separate relief is necessary.
ETFs Versus ETVs: Application of Exchange Listing Standards
Another significant regulatory component of ETF share secondary market trading and exchange listing is the triggering of exchange listing requirements. National exchanges must be authorized by the SEC to list every security traded on the exchange. Exchanges have over time adopted listing standards applicable to classes of securities such as stocks, bonds, and ETF shares. However, as new types of ETFs have been brought to market, listing exchanges have been required to seek new listing authority from the SEC. Such authority must be requested and obtained by the listing exchange’s submitting a formal exemptive application to the Division of Trading and Markets under Rule 19b-4 of the 1934 Act.
Another significant regulatory consequence of secondary-market trading and exchange listing for ETFs is the triggering of exchange listing requirements. As noted, national exchanges must be authorized by the SEC to list securities traded on the exchange. Over time, exchanges have adopted generic listing standards applicable to certain classes of securities such as stocks, bonds, and ETF shares. However, as new types of ETFs have been brought to market, listing exchanges have been required to seek new listing authority from the SEC. To obtain such authority, the exchange must submit a formal application to the Division of Trading and Markets under Rule 19b-4 of the 1934 Act. Through this process, generic ETF listing rules have been put into place. Similar generic listing standards have been developed for ETVs, but listing exchanges are generally required under such standards to submit a 19b-4 application for each new ETV.[15] The 19b-4 application process can be time-consuming and it is therefore important to assess the need to submit a 19b-4 application early on in the process of forming and registering an ETF or ETV.
The structure of a particular ETV may influence the applicability of the relevant exchange’s listing requirements, particularly those imposed in the wake of the passage of the Sarbanes Oxley Act of 2002. In this regard, limited partnerships and passive business organizations, such as certain trusts (both entity forms currently used for ETVs to address tax and other issues) are not subject to the same compliance and governance requirements that apply to listed issuers organized as corporations or limited-liability companies. For example, ETVs that are limited partnerships or passive trusts are not required to have a majority of independent directors on their boards of directors or have nominating or compensation committees.[16] Moreover, ETVs that are passive trusts may be able to take advantage of exceptions from additional governance rules or compliance requirements even as compared to limited partnerships.[17]
ETFs VERSUS ETVs: Structural Considerations
ETFs receive a very significant advantage from being organized and regulated as an investment company under the 1940 Act ─ availability of “Subchapter M” treatment under the Internal Revenue Code. One of the cardinal tenets of any type of investment fund, whether a mutual fund or hedge fund or some other type of collective investment vehicle, is that the fund must provide investors with “pass-through” tax treatment. Otherwise, if the fund is itself taxed, it ends up in the same situation as a corporation that pays income tax on its earnings, and then its shareholders pay taxes on the remaining earnings that the corporation distributes. For various reasons, this type of “double taxation” has never been viewed as workable for collective investment vehicles. Importantly, mutual funds, ETFs, and other types of registered investment companies receive pass-through tax treatment from special provisions under the Internal Revenue Code contained in Subchapter M of the Code.
Because ETVs are not registered investment companies, or “RICS” as they are referred to in industry parlance, they must cast about for other sources of pass-through tax treatment under the Internal Revenue Code. One avenue has been to organize as “master limited partnerships,” since limited partnerships generally receive pass-through tax treatment under the Code. Importantly, however, alternative structures such a master limited partnerships may present certain disadvantages from varying perspectives, including under the federal securities laws.
Specifically, limited partnerships are considered “ineligible issuers” under the SEC’s “securities offering reform rules.” A significant implication of categorization as an “ineligible issuer” under the 1933 Act is the imposition of severe limitations on the ETV’s ability to market its shares, even with respect to what it can say to members of the press. It is not clear why concerns that led the SEC to adopt the “ineligible issuer” restrictions should apply to ETVs organized as limited partnerships, particularly as similar but technically different organizational structures may not trigger “ineligible issuer” status. Additional guidance or exemptive or no-action relief in this regard from the SEC or its staff may be sought by certain ETVs, although it is not clear how receptive the SEC or its staff may be to the plight of such issuers. Even if the staff were sympathetic, they could conceivably prefer to address iniquities created through formal rulemaking rather than individual exemptive or no-action relief.
Another practical implication of choosing a tax structure for an ETV is tax reporting. Limited partnerships, for example, are required to report earnings to investors on “K-1s,” which some fund sponsors may have viewed as unattractive from a marketing standpoint. In this regard, the Treasury Department recently issued guidance on the appropriate tax reporting for certain types of fund structures that may be employed by ETVs. Market participants should be aware that there are other issues that may arise for ETVs that are commodity pools, including taxation on previously unrealized gains in the portfolio when futures contracts held are marked to market at the end of the year.
ETFs VERSUs ETVs: Other Regulatory Considerations
1 Potential Applicability of the Commodities Exchange Act
Regulation of Commodity Pools. ETVs that trade in commodity futures or options, even if this activity is not the predominate activity of the ETV, are commodity pools subject to regulation under the Commodity Exchange Act (“CEA”). As such, they are regulated by the CFTC, a federal agency that has a structure and a mission in the U.S. futures markets akin to that of the SEC in the nation’s securities markets. The CEA regulates commodity pools through requirements imposed upon the commodity pool operator (“CPO”) rather than the pool itself. The CPO is typically the advisor to and manager of the pool and, is responsible for marketing the pool and solicitation of investors, for hiring and managing trading advisors and investment advisers (i.e., commodity trading advisors, or “CTAs”) and for obtaining brokerage services for the pool through futures commission merchants (“FCMs”) and broker-dealers.
The CPO may itself manage the pool’s futures and commodity option transactions or it may retain independent CTAs to do so. CTAs are the commodities market equivalent of securities investment advisers and provide advice about futures transactions (including commodity options) and the futures markets and are also regulated by the CFTC under the CEA. Significant exemptions from CTA registration include a statutory exemption for certain SEC-registered investment advisers whose business does not consist primarily of acting as a CTA and who do not act as a CTA to any fund primarily engaged in futures or commodity options trading, and for a CPO that only advises the pools that it manages.
FCMs are also regulated by the CFTC under the CEA. FCMs are the commodities market equivalent to broker-dealers and are the entities through which the CPO buys and sells commodities futures and options for the pool.
Registration and Record Keeping. CPOs must register with the CFTC, must have its salespersons (“associated persons”) registered, and must meet disclosure, reporting and record keeping requirements. Applicants for registration as a CPO, the applicant’s principals, and associated persons of a CPO must file for registration with the NFA, which is akin to the Financial Industry Regulatory Authority (“FINRA”) in its regulation of futures market participants and processes registration applications pursuant to delegated authority from the CFTC. A CPO applicant and all of its associated persons must also pass the National Commodity Futures Examination (“Series 3” examination) or other applicable proficiency test and must attend statutorily-mandated ethics training. CPOs must also maintain specified books and records at their main business office and make them available for inspection by the CFTC and the United States Department of Justice.
Disclosure. Subject to certain exemptions similar in certain respects to the private placement exemptions under federal securities laws, CPOs are required to deliver to each prospective investor, and file with the NFA and the CFTC, a disclosure document setting forth information about the commodity pool, the CPO, and the CTAs for the pool. For ETVs, this document would also be the prospectus filed with the SEC in connection with the registration of the securities offered by the pool. In addition to information required by the SEC and the FINRA, to meet the CFTC’s disclosure document requirements, the prospectus must also describe the business background of the CPO and its principals; the CPO’s and the pool’s record of performance for itself and other pools managed the CPO; fees to be incurred by the pool; conflicts of interest on the part of the CPO, CTAs, and other commodity professionals who will provide services to the pool; and material legal proceedings against the CPO, the CTA for the pool, and other relevant persons during the past five years.
The NFA may provide comments on the disclosure document and must approve the final disclosure document. In addition to the specific disclosure requirements, CPOs are subject to statutory and regulatory antifraud prohibitions with respect to their operation of a commodity pool.
In addition to the prospectus delivery requirements imposed under federal securities laws, the CPO is required, subject to certain exceptions, to obtain an acknowledgment from each investor that the disclosure document was delivered. CPOs must, absent an exemption, also provide pool participants with an account statement at least quarterly (monthly for pools with net assets exceeding $500,000) and an annual report within ninety calendar days after the end of the pool’s fiscal year. The annual report also must be filed with the CFTC through the NFA.
Pursuant to no-action relief granted by the CFTC staff, ETVs that are commodity pools need not obtain the acknowledgement of receipt of the disclosure document from investors who purchase from the initial purchaser of the pool securities or from other Authorized Purchasers that purchase such securities directly from the pool and resell to the public. In addition, the CFTC staff has also allowed the monthly account statements to be posted by the CPO on the web and that such account statements need not be directly delivered to the investors. (However, to date, similar exemptive relief has not been provided with respect to the obligation to deliver a commodity pool’s annual report to investors.) This relief is conditioned in part on the distributor’s compliance with relevant securities law requirements and the condition that the disclosure document and quarterly reports be made available on the web by the CPO. Reliance on the CFTC staff positions given to particular issuers and other market participants, in some circumstances, has been permitted for other issuers and market participants by the CFTC. Such reliance has been limited to circumstances that essentially mirror those of the original applicant for relief. Whether or not reliance on a particular prior letter is warranted or a separate letter is required may be something a newly-organized ETV would wish to confirm with the CFTC staff.
2 FINRA “Direct Participation Program” Requirements
Under FINRA rules, a “direct participation program” includes a program that provides for flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution. Under FINRA Conduct Rule 2310 (“Rule 2310”) (until recently, Rule 2810), no member or person associated with a member may participate in any manner in any public offering of securities of a “direct participation program” unless documents and information as specified therein related to the offering have been filed with and reviewed by FINRA. FINRA is largely focused on the activity and compensation of its broker-dealer members in the offering. Although FINRA does not have direct jurisdiction over the ETV as an issuer, as a practical matter and as specifically allowed by FINRA in its rules, the ETV, as issuer, is typically involved in assuring compliance with Rule 2310 in order to permit FINRA members to participate in the offering.
The FINRA filing is required no later than one business day after the ETV’s registration statement is filed with the SEC filed with or submitted to the SEC or any state securities commission or other regulatory authority. No sales of securities subject to Rule 2310 may commence unless (i) the documents and information required have been filed and reviewed FINRA and (ii) FINRA has provided an opinion that it has no objections to the proposed offering.
Regulatory Issues Associated with Exchange Traded Notes
ETNs differ structurally from ETFs and ETVs because they are unsecured debt obligations of the issuer. Payment under an ETN is subject to the credit risk of the issuer, as opposed to a share of an ETF or ETV that represents an undivided interest or claim against a pool of underlying assets. Functionally, though, ETNs are designed to trade like ETF and ETV shares in the secondary market by stipulating the return on the ETN as equaling the performance of the underlying index or other specified benchmark. Almost all issuers of ETNs to date have been large banks, which have issued ETNs pursuant to what are essentially medium-term note programs. The notes were issued under an indenture agreement entered into between the bank and a corporate trustee, which permitted the related ETN shares to take on the favorable credit rating of the bank. Today’s credit markets, of course, are in a state of some flux, and the attractiveness of bank obligations, including ETNs, has diminished.
There also may be some tax-related uncertainty associated with ETNs. ETNs are treated for federal income tax purposes as “prepaid forward contracts.” Put simply, investors are taxed only when they sell their ETN shares in the secondary market; until then, any gain is deferred. Moreover, gains or losses upon sale are treated as capital gains (or losses). However, the IRS announced in December 2007 that it and the Department of the Treasury are re-examining the tax treatment of ETNs and have asked for public comment on whether the tax treatment should be modified.[18]
There are particular advantages for a “seasoned issuer” offering ETNs. Specifically, “well-known seasoned issuers” may initially register ETNs on Form S-3 under the 1933 Act and go effective automatically upon filing. This provides certainty and speed to market.
New SEC rules Streamlining ETF Regulation
On March 11, 2008, the SEC published a release (the “Release”) proposing for comment new rules and rule amendments under the 1940 Act that would enable ETFs to register with the SEC and commence operations without obtaining individual exemptive orders from the SEC.[19] In the Release, the SEC also proposed disclosure amendments relating to ETFs and a rule to provide flexibility to traditional mutual funds to invest in ETFs. Comments on the proposal were due by May 19, 2008.
1 Background
As previously discussed, ETFs are registered with the SEC under the 1940 Act as “open-end management investment companies.” ETFs also register their shares with the SEC under the 1933 Act.
Unlike mutual funds, ETFs do not sell or redeem their individual shares at net asset value. Instead, ETFs sell and redeem their shares at NAV only in large blocks called creation units. Brokerage houses or large institutional investors that purchase blocks of ETF shares in creation units generally do so through “in-kind” transactions involving a basket of securities or other assets (“basket assets”) that mirrors the composition of the ETF’s portfolio, plus a small amount of cash to account for the difference between the value of the basket assets and the NAV of the ETF shares. An ETF’s shares are listed on a national stock exchange and can be purchased or sold in the secondary market at market prices, just like shares of stock of any public company. Thus, an ETF is something of a hybrid between a traditional mutual fund and a “closed-end” fund, with creation units of ETF shares being bought and sold from the ETF at NAV like shares of a mutual fund, and smaller amounts of shares being traded at market prices in the secondary market like a closed-end fund.
As previously noted, ETFs have historically been “index-based,” with investment objectives of tracking the performance of a specified index (or the inverse of such performance) (or some other benchmark) by investing in all or a representative sample of the securities of the index. More recently, however, the SEC has begun issuing exemptive relief to “actively managed” ETFs that do not attempt to track the performance of any index.
Because of their unique structure, ETFs must obtain exemptive relief from certain provisions of the 1940 Act. Specifically, an ETF, because it is organized as an open-end fund, generally is required to file an exemptive application requesting an order granting relief from: (i) Sections 2(a)(32) and 5(a)(1) of the 1940 Act so that the ETF may issue shares that are redeemable only in creation units; (ii) Section 22(d) and Rule 22c-1 to permit the purchase and sale of individual ETF shares in the secondary market at negotiated prices; and (iii) Sections 17(a)(1) and (a)(2) to permit in-kind purchases and redemptions of creation units by persons that may be affiliated with the ETF by reason of owning more than 5% of its outstanding securities. ETFs have also generally obtained relief from Section 24(d) of the 1940 Act to permit secondary market sales of ETF shares unaccompanied by a full “statutory” prospectus, provided that a shorter “product description” was provided instead. In addition, many ETFs have obtained relief from Section 12(d)(1) to permit other investment companies to purchase shares of the ETF in excess of the 1940 Act’s fund-of-funds limitations.
3 New SEC Exemptive Rule
Proposed Rule 6c-11 would provide relief to an ETF that complies with the rule’s conditions so that the ETF would not need to file an individual exemptive application and obtain exemptive relief before commencing operations. If adopted, the new rules would make it substantially easier to establish new ETFs, by reducing organizational costs and the time it takes to bring new ETFs to market. Currently, although the time required to obtain routine SEC exemptive orders for ETFs has shortened considerably over the course of the past several years, obtaining an exemptive order for an innovative or novel ETF can still take six to twelve months or more.[20]
1 The Nature of the Relief
Proposed Rule 6c-11 would:
• deem ETF shares to be “redeemable securities” under Section 2(a)(32) of the 1940 Act;
• provide relief from Section 22(d) and Rule 22c-1 to permit purchases and sales of ETF shares in the secondary market at market prices; and
• provide relief from Sections 17(a)(1) and 17(a)(2) to persons who are “affiliated persons” of an ETF solely by reason of holding more than 5 percent of the voting securities to the ETF (and to affiliated persons of such persons) or more than 5 percent of the voting securities of another investment company under common control with the ETF to permit the in-kind deposit and receipt of basket assets.[21]
Notably, the proposed rule would not have provided the prospectus delivery relief from Section 24(d) that ETFs have typically obtained through their individual exemptive orders. The SEC explained that this was because many broker-dealers selling ETF shares in secondary market transactions actually transmit a full prospectus to purchasers, and because the SEC believed that such a prospectus delivery exemption would be unnecessary given its recent summary prospectus proposal.[22] In this regard, the Release stated that, if the SEC were to adopt Rule 6c-11 before the summary prospectus was finalized, it would expect to permit delivery of a product description in lieu of a prospectus pending final approval of the summary prospectus proposal. In fact, the SEC recently adopted the proposed summary prospectus proposed, while Rule 6C-11 has not yet been adopted. The impact of this change in the expected order of events was explained above in Section III.A.2.
2 The Rule’s Conditions
Essentially, in order to rely on the relief that would be provided by proposed Rule 6c-11, an open-end investment company would have to meet the definition of “exchange-traded fund” set forth in the rule.[23] The elements of the ETF definition are as follows:
• Probably the most obvious element of the definition is that an ETF must be approved for listing and trading on a national securities exchange under Section 12 of the 1934 Act.[24]
• The ETF must issue or redeem creation units in exchange for basket assets the current value of which is disseminated on a per share basis by a national securities exchange at regular intervals during the trading day.
• In any sales literature, the ETF must identify itself as an ETF that does not sell or redeem individual shares and explain that investors may purchase or sell individual shares on an exchange.
• Each business day, the ETF must disclose on its Web site the prior day’s NAV and closing market price and the premium or discount of the market price against NAV (as a percentage of NAV).
• The ETF must either (1) disclose each business day on its Web site the identities and weightings of the securities and other assets held by the ETF, or (2) have a stated investment objective of obtaining returns that correspond to those of a specified index, if the index provider discloses on its Web site the identities and weighting of the component securities and other assets of the index.
3 Additional Noteworthy Aspects of the Proposed Rules
The elements of the proposed definition of “ETFs” as discussed above are similar to the express conditions that have typically been included in individual applications for exemptive relief. In addition to the express conditions, however, such applications have generally included extensive factual background on the ETF, and the relative brevity of the proposed rule suggests that much of that background information essentially is irrelevant from the 1940 Act perspective. In addition, the following aspects of the application of the proposed rule may be noteworthy.
• Actively-Managed ETFs. As noted above, the SEC has recently begun granting exemptive orders to ETFs that are not index-based, after seeking comment on such ETFs in a concept release published in 2001.[25] The proposed rule would generally reflect the view there should be no significant difference from a regulatory standpoint between index-based and actively-managed ETFs as long as an actively-managed ETF is willing to comply with the “transparency” conditions of the rule, including by making its holdings public on a daily basis. Of course, the adviser to an actively-managed fund may be reluctant to provide this degree of transparency, because it might provide the market with the ability to divine information about the adviser’s investment strategy. In this regard, the SEC stated in the Release that it will consider individual applications for exemptive relief for actively-managed ETFs that would not satisfy the rule’s transparency conditions.
• Affiliated Index Providers. Historically, index-based ETFs have represented in their exemptive applications that neither they nor their advisers are affiliated with the entity that formulates and calculates the index that the ETF seeks to track (the “index provider”). More recently, the SEC has begun granting exemptive relief to ETFs with affiliated index providers, and proposed Rule 6c-11 would not specify any requirements with respect to the identity of the index provider.
• Intra-Day Value. As noted above, proposed Rule 6c-11 would require that the value of an ETF’s basket assets be disseminated at regular intervals during the trading day; it would not require that these intra-day values be disseminated at any specified interval. The rules of the national securities exchanges, which must be approved by the SEC, establish this frequency, which for most ETFs is every 15 seconds. However, the rule would appear to require that the intra-day value be determined based on the current value of the basket securities, even though exchange rules generally permit more flexibility in the calculation of intra-day values (e.g., use of either the value of the basket assets or the value of ETF’s benchmark index to calculate intra-day values).
• Use of the Term “Mutual Fund.” While the proposed rule would require an ETF to identify itself as an “exchange-traded fund” in sales literature, it would not include the express prohibition on referring to an ETF as a “mutual fund” that was included in the exemptive orders. It is not clear whether the SEC intended to permit referring to an ETF as a mutual fund, or whether it might interpret the requirement to use the term exchange-traded fund to preclude using the term “mutual fund” as well.
• Location of Web Site Information. As noted above, the rule would require most of the required information to be available on the ETF’s Web site, but the intra-day value would be required to be disseminated by the listing exchange, and the index provider could post to its Web site information on the component securities of the relevant index. One might question whether the identity of the party publishing the information or the location of the Web site matters as long as investors can readily access the information and are made aware of how to access it. In this regard, it is unclear whether an ETF could provide a link on its Web site to all of the required information on the listing exchange’s or some other entity’s Web site.
4. Impact of the New Rules on Existing ETFs
In the Release, the SEC proposes to amend existing ETF orders so that they more closely reflect the proposed rule by eliminating the prospectus delivery exemptions, which would effectively require existing ETFs to comply with the disclosure changes discussed immediately below. The Release states that, in other respects, the proposed rule would provide more flexibility than the outstanding exemptive orders; therefore, the SEC expects that most, if not all, ETFs would rely on the rule instead of any order they had previously obtained.
C. New Disclosure Requirements for ETFs
As noted, the Release also included amendments to Form N-1A, the form on which open-end investment companies register under the 1940 Act and register their shares under the 1933 Act. As also discussed, the SEC recently adopted certain disclosure-related rules, while Rule 6c-11 is still pending. The disclosure requirements adopted applicable to ETFs are discussed above in Section III.A.2.
D. The Fund-of-ETFs Exemption
As noted above, ETFs have obtained relief from Section 12(d)(1) to permit other investment companies to purchase shares of the ETF in excess of the fund-of-funds limitations of that section. The exemptive relief granted by the SEC has been conditioned on a number of conditions that are similar to those to which funds seeking relief to invest in unaffiliated traditional mutual funds have been subject, including a number of conditions designed to limit the influence that an acquiring fund may exercise over a fund that it acquires. In response to industry input that some of those conditions are unnecessary in the context of a fund-of-ETFs, the SEC has proposed a new rule, Rule 12d1-4 under the 1940 Act, that would provide a fund-of-ETFs exemption with conditions substantially less burdensome than those that have heretofore been included in Section 12(d)(1) exemptive orders for both funds-of-funds and funds-of-ETFs.
Specifically, the conditions of proposed Rule 12d1-4 are as follows:
• No acquiring fund or any of its investment advisers or depositors, and any company controlling, controlled by or under common control with the acquiring fund or any of its investment advisers or depositors, may control an underlying ETF, individually or in the aggregate.[26]
• An acquiring fund may not redeem ETF shares, and instead must sell its shares in the secondary market. The SEC stated in the Release that this would prevent an acquiring fund from threatening large-scale redemptions as a means of coercing an ETF. However, one might question whether such coercion might be possible through the threat of large-scale secondary market sales, as such sales might result in creation unit redemptions.
• Any sales charges and service fees charged in connection with the purchase, sale or redemption of securities issued by the acquiring fund must not exceed the limits for funds-of-funds set forth in Rule 2830(d)(3) of FINRA Conduct Rules.[27]
• An underlying ETF may not make investments in other investment companies in excess of the Section 12(d)(1) limits (i.e., funds-of-ETFs-of-funds are not permitted).
E. Competitive Issues Relating to the Impact of the New Rules on ETVs
and ETNs
The viability of the summary prospectus for the ETF industry and the benefits it promises are contingent upon its use by ETFs. The rule conditions delivery of the summary prospectus on the availability of the full prospectus on a Web site. For larger, more-established mutual fund companies, the maintenance of such a Web site is not an issue and they may decide to transition to the less-costly summary prospectus. Certain sponsors of ETFs, however, may not find it practicable to devote the necessary resources to construct and maintain a Web site that will meet the requirements of the rule, and it is unlikely that the broker-dealers selling ETFs in the secondary market would assume this responsibility. This factor could limit the ability of some smaller companies sponsoring ETFs to use summary prospectuses. This, in turn, could hinder the marketability of their product.
Within the ETF industry itself, competitive issues may arise between traditional ETFs, ETVs, and ETNs. ETVs and ETNs do not use Form N-1A and, as a result, would not be impacted by the new SEC disclosure rules and will not be eligible to use the summary prospectus. The question then becomes whether such exchange-traded products will be disadvantaged by the lack of a similar short-form document. (Although some exchange-traded products currently may be able to use a Product Description, for a number of reasons, many may continue to use the full statutory prospectus.) In time, broker-dealers may gravitate to those products for which there is a short, user-friendly summary prospectus. This could have implications that may alter the competitive balance among exchange-traded products.
The proposed ETF exemptive rules, if adopted, may cause an additional shift in the competitive balance existing in the exchange-traded product industry today. As discussed above, absent an applicable exemption, shares of ETVs, like those of ETFs, are required to be registered under the 1933 Act and trading of the shares in the secondary market is regulated under the 1934 Act. ETVs are not required to register under the 1940 Act, but this aspect of federal ETV regulation has proved a mixed blessing. On the one hand, ETVs have not been required to run the 1940 Act exemption gauntlet. On the other, the fact that ETVs are not regulated, investment companies have subjected product sponsors to a unique set of regulatory challenges under the federal securities laws, as well as federal tax laws.
This competitive calculus could change if the proposed exemptive rules are adopted ETVs would no longer enjoy a competitive advantage over ETFs resulting from ETFs having to obtain exemptive relief; at the same time, ETVs would continue to be subject to the unique regulatory issues resulting from not being regulated under the 1940 Act. This same result would appear to obtain with respect to ETNs.
F. Prognosis for New ETF Rules
The lack of adoption of Rule 6c-11, an exemptive rule widely supported by the industry, has been somewhat of a mystery. When the SEC proposes an exemptive rule supported by industry proponents but then subsequently fails to adopt it, industry observers sometimes question whether additional concerns have developed within the agency that may have caused it to rethink the propriety of the rule, or at least certain aspects of the rule.
In the case of Rule 6c-11, it is possible that certain criticism leveled at the SEC relating to some leveraged and inverse ETFs may be causing a re-evaluation of the rule. One possible concern could be the use of derivatives by these and other ETFs against a backdrop of governmental concern generally about derivative financial instruments. In this regard, although Rule 6c-11 would not prohibit the use of derivatives, at least one recently-issued notice for an exemptive order granted in connection with an actively-managed ETF notes that the ETF represented that neither the “initial fund” nor any “future funds” would invest in options contracts, futures contracts, or swap agreements. This appears to be a relatively recent development.[28]
In any case, a recent speech by a senior SEC official noted that the SEC will consider Rule 6c-11 in the coming year, but did not connote any sense of urgency in such consideration.[29]
Conclusion
ETFs, ETVs, and ETNs share the same common goal ─ to provide investors with transparent and liquid exposure to underlying investments in which they would not otherwise have the financial resources to invest, whether that be a particular basket of stocks, currencies, crude oil, or other commodities or precious metals. As ETFs, ETVs, and ETNs begin to proliferate, fund sponsors are realizing that simplicity and expense ratios are critical factors in a fund’s success. The regulatory maze governing these products is a very real challenge to a product’s success and its profitability. A multidisciplinary legal approach is a critical factor in successfully navigating the maze.
W. Thomas Conner
Sutherland Asbill & Brennan LLP
Washington, DC
thomas.conner@
202-383-0590
-----------------------
© 2009 Sutherland Asbill & Brennan LLP. All Rights Reserved.
This conference outline is intended for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making a decision or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland Asbill & Brennan and the recipient.
The author would like to express his gratitude to his colleague Eric Freed, who contributed to this outline.
[1] “Exchange-Traded Funds, Volume 1, The Professional’s Pocket Guide,” Powershares Corporate Library, December 2006.
[2] See 2008 Investment Company Fact Book, available at .
[3] See The growth spurt may be over, Financial Adviser, the Financial Times Ltd (June 12, 2008).
[4] See Some ETFs Fall Short on Pricing, The Wall Street Journal (Nov. 21, 2008).
[5] The first ETFs were organized and registered as “unit investment trusts” or “UITs,” but because that structure is not currently used this outline does not discuss the UIT structure and applicable regulatory constructs. Additionally, when discussing registration and other provisions of the federal securities laws applicable to ETFs, ETVs and ETNs, this outline does not attempt to address certain regulatory exemptions that may otherwise apply.
[6] See SEC, CFTC Approve Trading of Futures and Options Contracts on Gold ETF, SEC Press Release (June 3, 2008).
[7] Fund Shareholder Reports and Quarterly Portfolio Disclosure, Inv. Co. Act. Rel. No. IC-26372 (Feb. 27, 2004) (adopting Form N-Q for quarterly disclosure of mutual funds portfolio holdings).
[8] For reasons that will become apparent, this outline refers to commodity-based ETFs as “exchange traded vehicles” or “ETVs” because they are not investment companies required to register under the 1940 Act.
[9] Over the course of the past year, the United States Commodities Funds (USCF) organization has brought a series of additional petroleum-based ETVs to market.
[10] See Section 5(b) of the 1933 Act.
[11] See Section 24(d) of the 1940 Act. Section 24(d) makes inapplicable the prospectus delivery exception provided by Section 4(3) of the 1933 Act that otherwise is generally available to dealers of securities in the secondary market.
[12] Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Inv. Co. Act Rel. No. IC-28584 (2009). The amendments require that a summary section be added at the beginning of each mutual fund prospectus that contains specified information presented in “plain English” and in a standardized order. The SEC also adopted a new rule that permits this summary to be used on a stand-alone basis as a “summary prospectus,” if the full statutory prospectus is made available on a Web site and will be provided to an investor upon request. The purpose of the amendments is to make information that is critical to investors’ investment decisions readily available, while harnessing the potential of the Internet to make more-detailed information available to those investors who may care to review it.
[13] As noted, the proposed ETF rules would codify the type of exemptive relief traditionally provided to ETFs, but would not provide prospectus delivery relief from Section 24(d), and likely because of these changes, recent exemptive orders granted by the SEC do not permit ETFs to provide “Product Descriptions” instead of full statutory prospectuses to secondary market purchasers. If the SEC rescinds the relief already provided to ETFs in this regard when the proposed ETF rules are adopted, the summary prospectus would be the only option available to ETFs to deliver a disclosure document shorter then the full prospectus.
[14] The registration and updating requirements under the 1933 Act are considerably simpler for ETVs that have achieved “well-known seasoned issuers,” or “WKSI,” status and can therefore register their shares on Form S-3. A discussion of S-3 registration procedures is beyond the scope of this outline.
[15] See, e.g., Commentary .04 under NYSE Arca Rule 8.201.
[16] See NYSE Arca Rules 5.3 and 5.3(k); see also NYSE Listed Company Manual 303A.00.
[17] See NYSE Arca Rules 5.3 and 5.3(k) (corporations, limited-liability companies, and limited partnerships are required to have an audit committee with three independent directors but passive business organizations are not); see also NYSE Listed Company Manual 303A.00.
[18] Internal Revenue Bulletin 2008-2 (Jan. 14, 2008).
[19] “Exchange-Traded Funds,” Investment Company Act Release No. 28193, File No. S7-07-08. See also Sutherland Asbill & Brennan LLP Legal Alert: SEC Proposes New ETF Rules That Would Enhance Speed to Market (March 11, 2008).
[20] As noted, ETFs typically also need relief from various provisions of and rules under the 1934 Act. The staff of the SEC’s Division of Trading and Markets has issued a number of letters granting class-based relief from those provisions and rules to ETFs meeting the conditions of such letters. See Willkie Farr & Gallagher, LLP (Apr. 9, 2007); PowerShares Exchange-Traded Fund Trust (Oct. 24, 2006); Derivative Products Committee of the Securities Industry Association (Nov. 21, 2005). If an ETF does not meet such conditions, however, a separate no-action request may be necessary. A detailed discussion of these letters and the 1934 Act provisions and rules is beyond the scope of this outline.
[21] The proposed rule would also provide relief from Section 22(e) of the 1940 Act so that an ETF would be able to delay delivery of a foreign security that is part of the basket assets applicable to a redemption request if: (i) a foreign holiday prevents timely delivery; (ii) the ETF discloses in its registration statement the holidays that it expects may prevent timely delivery and the maximum number of days that it anticipates it will need to make delivery; and (iii) the foreign securities are delivered no later than 12 calendar days after the tender of the ETF shares for redemption.
[22] While the SEC did not explain why broker-dealers have not relied on the Section 24(d) relief in practice (and requested comments if its understanding in that regard is correct), there may be some reason to believe that (1) some broker-dealers are uncomfortable relying on the relief in light of certain provisions of the 1933 Act that might require prospectus delivery notwithstanding the relief from Section 24(d), and (2) prospectus fulfillment facilities have difficulty accommodating the delivery of different ETF documents in different circumstances.
[23] Some of the first ETFs were organized not as open-end investment companies, but as unit investment trusts. Because essentially all ETFs organized recently have been structured as open-end companies, the SEC did not propose to make the rule applicable to unit investment trusts.
[24]Listing standard provisions for ETFs and ETVs are discussed above in Section VI.
[25] Actively Managed Exchange Traded Funds, Investment Company Act Rel. No. 25258 (Nov. 11, 2001), File No. S7-20-01.
[26] Section 2(a)(9) of the 1940 Act establishes a presumption that any person who owns beneficially, either directly or through one or more controlled companies, more than 25 percent of the voting securities of a company controls such company.
[27] [28]!S´ÅProposed Rule 12d1-4 would also provide that, with respect to an insurance company separate account that invests in an acquiring fund: (i) the acquiring fund and underlying ETF may not charge a sales load; (ii) any asset-based sales charge (as defined in the FINRA rules) or service fees is charged only by the acquiring fund or the ETF, but not both; and (iii) the fees associated with the variable insurance contract that invests in the acquiring fund and the sales charges and service fees charged by the acquiring fund and underlying ETF, in the aggregate, must be reasonable in relation to the services rendered, the expenses expected to be incurred and, with respect to the variable insurance contract, the risks assumed by the insurance company.
[29] See Pacific Investment Management Company LLC and PIMCO ETF Trust, Notice of Application (Oct. 20, 2009).
[30] “Remarks Before the ICI 2009 Securities Law Developments Conference,” Washington, D.C. (Andrew J. Donohue, Director, Division of Investment Management).
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