Exchange Traded Funds (ETFs) and Exchange Traded Notes …



From PLI’s Course Handbook

Nuts and Bolts of Financial Products 2009

#18678

8

Exchange traded Funds and Exchange traded notes

Paul J. McElroy

Sullivan & Cromwell LLP

Submitted by:

Robert S. Risoleo

Sullivan & Cromwell LLP

Copyright © 2008

All Rights Reserved

EXCHANGE TRADED FUNDS

AND EXCHANGE TRADED NOTES

Paul J. McElroy

December 18, 2008

Copyright © 2008

All Rights Reserved

Biographical Information

Program Title: Nuts & Bolts of Financial Products 2009

Name: Paul J. McElroy

Position or Title: Special Counsel

Firm or Place of Business: Sullivan & Cromwell LLP

Address: 1701 Pennsylvania Ave., NW, Washington, DC 20006

Phone: 202-956-7550

Fax: 202-293-6330

E-Mail: mcelroyp@

Primary Areas of Practice: Investment Management, Securities

Law School: Columbus School of Law, Catholic University of America

Work History: Associate, Sullivan & Cromwell LLP, 1988-96; Special Counsel, Sullivan & Cromwell LLP, 1997-Present

Exchange Traded Funds

and Exchange Traded Notes

I. Exchange Traded Funds – “ETFs”

A. Introduction

1. ETFs offer investors an exchange-listed and -traded security that represents an undivided interest in a pool of securities and other assets.

2. ETFs share many characteristics with traditional mutual funds, in light of their “open-end” structure, providing certain market participants an opportunity (albeit limited) to purchase newly issued shares from the ETF issuer at net asset value (NAV) and to have the ETF issuer redeem shares at NAV.

3. ETFs also share characteristics with closed-end funds, in that ETF shares can be purchased and sold by all investors through a broker-dealer throughout the trading day at negotiated prices on an exchange or over the counter.

4. Hybrid structure of ETFs, combining features of mutual funds and closed-end funds, affords ETFs certain advantages over both kinds of traditional funds: ETFs possess intra-day liquidity (which mutual funds lack), and ETF shares generally trade in the secondary market at prices that closely correlate to their NAV (in contrast to most closed-end funds). Investors may sell ETFs short, and write options and set market, limit and stop-loss orders on them.

5. Many ETFs, due to their essentially passive investment management and their clearance and settlement through DTC, have low expense ratios and transfer agency costs and achieve certain tax efficiencies as compared to traditional mutual funds.

B. Basic Structures and Classifications of ETFs

1. ETFs Registered under the 1940 Act vs. Commodity ETFs

a. Predominant form of ETF is an issuer of securities that meets the definition of “investment company” under the Investment Company Act of 1940 by engaging primarily in the business of investing in securities.

i. required to register under the 1940 Act and generally are subject to regulation by that Act and the rules thereunder

ii. by nature of their “hybrid” characteristics, ETFs that register under the 1940 Act require exemptions from certain provisions of the 1940 Act in order to operate and offer their shares to the public

iii. in 2008, SEC proposed for comment rules that would codify the 1940 Act exemptive orders that have been issued to certain kinds of ETFs, but has not yet promulgated any final rule

b. Certain other issuers, also referred to as exchange-traded funds or ETFs, invest primarily in commodities or commodity-based instruments (“commodity ETFs”), and therefore do not constitute investment companies and do not register under the 1940 Act.

i. while commodity ETFs share many characteristics with ETFs that are investment companies, they are not subject to regulation under the 1940 Act

ii. commodity ETFs may be subject other regulation to which investment company ETFs are not (e.g., regulation under the Commodity Exchange Act)

c. Unless otherwise specified, references in this outline to “ETFs” refer only to ETFs that are registered investment companies and not to commodity ETFs.

2. Organizational Form

a. ETFs organized as Unit Investment Trusts (UITs)

i. organized under a trust agreement or similar instrument

ii. have a trustee but no board of directors

iii. are only passive, index-based vehicles; never actively managed

iv. fixed portfolio; invest only on a “full replication” basis (see B.3. below)

b. ETFs organized as Open-End Management Companies

i. usually organized in the manner of a typical mutual fund complex, i.e., as a corporation (or business trust), with a board of directors, that issues several series of shares, each of which represents a separate pool of assets and is offered as a separate ETF

ii. at least one ETF sponsor has received SEC exemptive relief to organize each ETF as a class of shares of a multi-class mutual fund

iii. in contrast to UITs, have greater flexibility in respect of, e.g., portfolio management, investment of dividends, lending of portfolio securities and creation of rule 12b-1 plans (for payment of distribution expenses out of funds assets)

iv. may invest using full replication or portfolio sampling strategy if index-based (see B.3. below), or may be actively managed (see B.4. below)

3. Index-Based ETFs

a. Predominant form of ETFs in the marketplace – attempts to obtain returns that correspond to those of a specified underlying securities index either by replicating or sampling the component securities of the index.

b. Full replication vs. portfolio sampling

i. full replication strategy – ETF invests in every component security of its underlying index, in substantially the same proportions as in the index. ETFs organized as UITs are limited to investing on a full replication basis

ii. portfolio sampling strategy – in light of practical difficulties or substantial costs involved in holding every security in an underlying index, ETF uses a sampling strategy pursuant to which it invests in some but not all of the index’s component securities – those securities in which the ETF invests are intended, in the aggregate, to reflect the underlying index’s capitalization, industry and fundamental investment characteristics, and to perform like the index.

iii. sampling ETFs may acquire a subset of the component securities of the underlying index and, in some cases, certain securities and other financial instruments that are not included in the index but the inclusion of which in the ETF’s portfolio is intended to help track the performance of the index

c. Underlying indices used by index-based ETFs

i. equity indices

ii. fixed income indices

iii. broad-based indices

iv. narrow indices, e.g., industry, segment or sector-based

v. international indices

vi. “enhanced” or customized indices, in some circumstances created primarily for use by the ETF

d. Use of derivative instruments – in an attempt to achieve results that are leveraged or inverse relative to its underlying index, a small minority of index-based ETFs utilize various derivative instruments in lieu of or in addition to investing in component securities of the index.

4. Actively Managed ETFs

a. For the first time in 2008, SEC issued exemptive orders permitting several actively managed ETFs.

b. Unlike index-based ETFs, an actively managed ETF does not seek to track the return of a particular index.

c. Like a traditional actively managed mutual fund, an actively managed ETF’s investment adviser selects portfolio securities consistent with the ETF’s investment objectives and policies without regard to a corresponding index.

d. In light of certain operational differences in comparison with index-based ETFs, SEC has had to impose some conditions to the granting of exemptive relief for actively managed ETFs that are not present in the exemption granted to index-based ETFs (see C.3.b.ii. below).

C. Operation of ETFs

1. Listing and Trading of Individual ETF shares

a. ETFs register offerings and sales of their shares under the Securities Act of 1933 (e.g., ETFs organized as open-end management companies file on form N-1A).

b. ETFs list their shares for trading under the Securities Exchange Act of 1934.

i. index-based ETF is permitted to list if it meets the exchange’s “generic listing requirements” (including, among other things, having an underlying index that exceeds specified minimum numbers of index components and that does not exceed specified maximum weightings of individual index components and of the top five most heavily weighted components – those minimums and maximums vary depending on whether the index components are U.S. securities, non-U.S. securities or a combination)

ii. for index-based ETFs and actively managed ETFs that do not meet the generic listing requirements, the exchange must file with SEC an application under rule 19b-4 of the 1934 Act for a rule change necessary to allow the ETF to be listed by the exchange

c. As with any listed security, investors may trade ETF shares on the exchange or over the counter throughout the trading day at market prices.

2. Issuance and Redemption of ETF shares only in “Creation Units”

a. In contrast to mutual funds, ETFs do not sell or redeem their individual shares at NAV.

b. Financial institutions (typically, those broker-dealers that have entered into an agreement with the ETF to serve as “authorized participants”) may purchase or redeem ETF shares directly from the ETF at a price based on the NAV next computed after the receipt of the order to purchase or redeem.

i. such purchases and redemptions are permitted only for transactions in large blocks of ETF shares called “creation units”

ii. creation units vary from ETF to ETF but typically consist of aggregations 25,000 to 100,000 shares per unit

c. Issuances of creation units

i. authorized participant that purchases a creation unit of ETF shares deposits with the ETF a “purchase basket” of specified securities and other assets identified by the ETF that day, and then receives the creation unit in return for those assets

ii. the purchase basket generally reflects the contents of the ETF’s portfolio and is equal in value to the aggregate NAV of the ETF shares in the creation unit

iii. after purchasing a creation unit, authorized participant may hold the ETF shares, or sell some or all in secondary market transactions

d. Redemptions of creation units

i. redemption process is the reverse of the purchase process

ii. authorized participant has acquired the number of ETF shares that comprise at least one creation unit in primary issuances of creation units by the ETF or in secondary market transactions on an exchange or over the counter

iii. authorized participant tenders for redemption the creation unit of ETF shares, and the ETF redeems the creation unit in exchange for a “redemption basket” of securities and other assets identified by the ETF that is equal to the aggregate NAV of the ETF shares in the creation unit

e. In-kind vs. “cash in lieu”

i. for most ETFs, purchase and redemption transactions occur on an “in-kind” basis – ETF shares are issued or redeemed in exchange for a basket of specified securities and other assets

ii. in certain circumstances, ETFs may allow or may specify that cash be substituted for certain specified securities in the basket of assets exchanged for creation units of ETF shares

iii. in addition, a small minority of ETFs – e.g., those that primarily hold financial instruments in their portfolios with limited transferability, or that hold foreign securities subject to local law restrictions on transferability – do not issue or redeem creation units on an in-kind basis, but instead issue and redeem only on a cash basis

3. Effect of Arbitrage Opportunities and Transparency on ETF Share Prices

a. The ability of financial institutions to purchase and redeem creation units at each day’s NAV creates arbitrage opportunities that are thought to contribute to keeping the market price of ETF shares near the NAV per share of the ETF.

b. Portfolio transparency

i. an index-based ETF is required to publish each day the identities of the securities in the purchase and redemption baskets, which serve as a general representation of the index-based ETF’s aggregate portfolio (index-based ETFs are not required to publish their aggregate portfolios)

ii. the actively managed ETFs operating under the recent exemptive orders approved by SEC are required to publish each day the securities and other assets in its aggregate portfolio

c. Index transparency – not all indices are published free of charge or everyday – terms on which and frequency with which an index provider publishes information may further enhance the perceived transparency of index-based ETFs.

d. Intraday value – as a condition to listing, the exchange on which ETF shares are listed (or designated publisher) discloses an approximation of the current value of the ETF’s basket on a per share basis, typically at 15 second intervals throughout the trading day and, for index-based ETFs, disseminates the current value of the relevant index.

e. Closing price / NAV deviation – for ETFs that track domestic indices, e.g., ETF sponsors and market participants have reported average deviations between the daily closing price and the daily NAV of generally less than 2%.

D. Exemptions Enabling or Supporting ETF Operation and Trading

1. 1940 Act Exemptions

a. Issuance of “redeemable securities” – permits ETFs to register as open-end investment companies (or as UITs), notwithstanding that ETFs redeem only creation units rather than individual ETF shares, contrary to the definition of “redeemable security” under section 2(a)(32).

b. Trading of ETF shares at prices other than NAV

i. section 22(d) prohibits a dealer from selling redeemable securities of a registered investment company in a public offering or through an underwriter except at a current offering price described in the prospectus; rule 22c1 requires a dealer to sell, redeem or repurchase redeemable securities of a registered investment company only at a price based on NAV

ii. SEC exemption permits the secondary market trading of ETF shares at current, negotiated market prices rather than at NAV, notwithstanding these provisions

c. In-kind transactions between ETFs and certain affiliates

i. section 17(a) generally prohibits an affiliated person of a registered investment company, or an affiliated person of such a person, from selling any security to or purchasing any security from the company

ii. section 2(a)(3) defines “affiliated person” to include, among others, any person directly or indirectly owning, controlling or holding with power to vote 5% or more of the outstanding voting securities of the other person, and any person directly or indirectly controlling, controlled by or under common control with the other person (a control relationship is presumed where one person owns more than 25% of another person’s voting securities)

iii. in-kind purchases and redemptions of ETF creation units by affiliated persons of ETFs would fall within the prohibitions of section 17(a)

iv. SEC provides a partial exemption from section 17(a) to the extent necessary to permit in-kind purchases and redemptions of ETF creation units by (a) persons who are affiliated persons of an ETF solely by virtue of holding with the power to vote 5% or more, or more than 25%, of the outstanding shares of the ETF (“first-tier affiliates”) and (b) affiliated persons of first-tier affiliates who are not otherwise affiliated with the ETF, and persons who are affiliated persons of an ETF solely by virtue of holding with the power to vote 5% or more, or more than 25%, of the outstanding voting securities of other registered investment companies (or series thereof) advised by the ETF’s investment advisor (“second-tier affiliates”)

d. Extension of time to deliver redemption proceeds

i. section 22(e) prohibits, among other things, a registered investment company from postponing the date of satisfaction of redemption requests more than seven days after the tender of a security for redemption

ii. local market delivery cycles for transferring certain foreign securities, coupled with local market holiday schedules, cause some ETFs that track indices contain foreign securities to be unable to deliver redemption proceeds within seven days

iii. SEC provides partial exemption from section 22(e) for such ETFs, allowing the delivery of redemption proceeds beyond seven days, up to a specified maximum number of calendar days, depending upon specific circumstances in the relevant local markets

e. ETFs organized as UITs have been granted an additional exemption permitting the payment, out of ETF assets, of certain marketing and other expenses incurred by the sponsor, notwithstanding prohibitions of such payments in section 26(a)(2)(c).

f. Investments in ETF shares by other investment companies

i. because ETF shares are shares of a registered investment company, the limitations under the 1940 Act on the ownership of shares of one investment company by another investment company ordinarily apply to ETF shares

ii. under section 12(d)(1)(A) – (a) an investment company (registered or unregistered) may own no more than 3% of the shares of an ETF; (b) shares of any one ETF may have an aggregate value of no more than 5% of the value of the total assets of an acquiring investment company; and (c) securities issued by investment companies (including ETFs) may have an aggregate value of no more than 10% of the value of the total assets of an acquiring investment company

iii. under section 12(d)(1)(B) – an ETF or a broker-dealer is prohibited from selling any security issued by the ETF to any other investment company (registered or unregistered) if, after the sale, the acquiring investment company would (a) together with companies and investment companies it controls, own more than three percent of the acquired ETF’s voting securities, or (b) together with other investment companies (and companies they control) own more than 10% of the acquired ETF’s voting securities

iv. SEC has granted to some ETFs exemptions for the acquisitions and sales of the shares of those ETFs in excess of the section 12(d)(1) limitations, subject to compliance with certain conditions (including, among other things, there being no control of the ETF, no undue influence over ETF services or transactions and no layering of investment company fees as a result of such acquisitions or sales)

g. Future series relief – since 2000, SEC has provided ETF sponsors relief for any ETFs created in the future in connection with their exemptive orders, in order that new ETFs may be introduced provided they meet the terms and conditions contained in the exemptive orders.

h. Proposed rules

i. proposed rule 6c-11 (and, with respect to exemptions from section 12(d)(1) exemptions, proposed rule 12d1-4) would codify substantially all of the 1940 Act exemptions heretofore granted by SEC order, with the exception of (a) relief granted to ETFs organized as UITs and (b) prospectus delivery relief (see D.2.b. below)

ii. as proposed, rule 6c-11 would apply to both index-based and actively managed ETFs meeting the conditions of the rule, but would not apply to ETFs organized as UITs

iii. compared to the conditions to relief contained in existing SEC orders, the conditions to relief in the proposed rules 6c-11 and 12d1-4 contain some additions, deletions and modifications – SEC is now considering public comments received on the proposals

2. 1934 Act “Trading Rules” Relief

a. Because ETF shares are continuously offer and are also traded in the secondary market, various issues with regard to ETF trading arise under the 1934 Act. For the benefit of broker-dealers that trade ETF shares, the staff of SEC Division of Trading and Markets has granted certain no-action and interpretive relief under several provisions of the 1934 Act and the rules and regulations thereunder.

b. Over the years, this relief has been published in various letters, some taking the form of “generic class relief” made available in respect of all ETFs sharing stated characteristics and meeting stated conditions, and others addressing identified ETFs which, in light of particular structural or operational features, fall outside the scope of the generic letters (e.g., actively managed ETFs).

c. Regulation M

i. regulation M is intended to prevent manipulation of the price of a security during the course of a distribution of that security: rule 101 thereof prohibits a distribution participant, in connection with a distribution of securities, from bidding for or purchasing from or attempting to purchase or induce any person to bid for or purchase such security; rule 102 thereof prohibits issuers, selling security holders, or any affiliated purchaser of such person from bidding for, purchasing, or attempting to induce any person to bid for or purchase a covered security during the applicable restricted period in connection with a distribution of securities effected by or on behalf of an issuer or selling security holder

ii. broker-dealers who engage in creation and redemption transactions of creation units of ETF shares could be deemed to be “distribution participants” within the meaning of regulation M

iii. staff has confirmed that the exception in rule 101(c)(4), with respect to purchases and redemptions of shares of open-end investment companies and UITs, applies to transactions in ETF shares – thereby permitting persons who may be deemed to be participating in a distribution of ETF shares to bid for or purchase shares during their participation in such distribution

iv. staff also has confirmed the interpretation of rule 101 that the redemption of creation units of ETF shares and the receipt of baskets in exchange therefor by a participant in a distribution of ETF shares would not constitute an “attempt to induce any person to bid for or purchase a covered security, during the applicable restricted period” within the meaning of regulation M

v. staff also has confirmed that that ETFs are excepted under rule 102(d)(4), with respect to shares of open-end investment companies and UITs, and thus are permitted to redeem creation units of shares during the continuous offering of the ETF shares

d. Content of confirmations

i. rule 10b-10 requires a broker-dealer who effects a transaction on behalf of a customer to provide the customer a written confirmation at or before the completion of the transaction, containing certain specified information

ii. compliance with the rule would be extremely burdensome if its requirements were applicable to all securities comprising the basket of securities tendered or redeemed in connection with a purchase or redemption of a creation unit of ETF shares

iii. staff has granted relief permitting broker-dealers to omit information in the creation/redemption transaction confirm regarding the identity, price and number of shares of each individual portfolio security being tendered or received, subject to the conditions that (a) the confirm states that all information required by rule 10b-10 with regard to each individual portfolio security will be furnished to the customer upon request and (ii) all such requests for information be filled in a timely manner

c. Notices of corporate actions

i. rule 10b-17 requires a public company to give advance notice of certain specified corporate actions (e.g., dividends, stock splits, rights offerings)

ii. staff has confirmed that the exception to the application of this rule that is available to redeemable securities issued by open-end investment companies also applies to ETFs

d. Margin

i. under section 11(d)(1) and rule 11d1-2, a broker-dealer generally may not extend credit in connection with the purchase of any security that is part of a new issue if the broker-dealer was a member of the selling syndicate within the prior thirty days

ii. because ETFs are continuously offered as well as traded in the secondary market, the restrictions on margin in connection with purchases in a public offering could by viewed as applicable to ETFs

iii. staff has granted no-action relief permitting margin credit to be extended, in connection with the purchase of ETF shares on an exchange, by broker-dealers who engage exclusively in secondary market transactions in ETF shares

iv. this relief had not been available to broker-dealers that create ETF shares, or that otherwise participate in the distribution of ETF shares as members of a selling syndicate or group (i.e., relief unavailable to ETF authorized participants)

vi. in 2005, staff extended no-action relief to permit broker-dealers to extend or maintain or arrange for the extension or maintenance of credit to or for customers on the shares of certain qualifying ETFs for which such broker-dealers are authorized participants, subject to the conditions that (a) neither the broker-dealer, nor any natural person associated therewith, directly or indirectly receives from the ETF complex any payment, compensation or other economic incentive to promote or sell the shares of the ETF to persons outside the ETF complex (other than non-cash compensation permitted under certain FINRA rules) and (b) the broker-dealer does not extend, maintain or arrange for the extension or maintenance of credit to or for a customer on shares of the ETF before thirty days have passed from the date that the ETF’s shares initially commence trading (except as otherwise permitted pursuant to rule 11d1-1)

vii. staff has also confirmed that broker-dealers may treat ETF shares as shares issued by an open-end investment company and therefore may extend credit or maintain or arrange for the extension or maintenance of credit on ETF shares that have been owned for more than 30 days by the persons to whom credit is to be provided

e. Tender and exchange offers

i. rule 14e-5 prohibits a person who makes a cash tender offer or exchange offer for an equity security from purchasing, directly or indirectly, such security other than pursuant to the offer

ii. as applied to ETFs, the rule could be read as restricting the ability of a dealer manager of a tender offer or exchange offer for a particular security included in the ETF’s portfolio from purchasing and redeeming ETF shares during the offer period

iii. staff has granted exemptive relief to permit dealer-managers to purchase and redeem ETF shares during the pendency of the tender offer or exchange offer

iv. staff also has taken a no-action position with respect to a broker-dealer, acting as a dealer-manager of a tender offer for a component security of an ETF, that purchases such securities in the secondary market for the purpose of tendering them to purchase a creation unit of ETF shares, if such purchases are effected as adjustments to such a basket in the ordinary course of business as a result of a change in the composition of the relevant index and are not effected for the purpose of facilitating such tender offer

f. Disclosure of control relationships

i. under rule 15c1-5, a broker-dealer is required to disclose to its customers any control relationship between the broker-dealer and the issuer of the security being purchased or sold, and under rule 15c1-6, a broker-dealer that effects a transaction with a customer in connection with any distribution in which the broker-dealer is interested, is required to disclose the existence of such interest

ii. staff has confirmed that these rules do not require disclosure of a broker-dealer’s relationship with any issuer of a security held by an ETF

3. 1934 Act Ownership Reporting Relief

a. Section 13(d) requires beneficial owners of more than 5% of an issuer’s outstanding securities to file reports with SEC, and section 16(a) requires each officer, director and beneficial owner of more than 10% of a public company’s outstanding shares (“insiders”) to file reports with SEC disclosing the number of shares beneficially owned, and reports regarding changes in ownership.

b. Staff has granted relief to the effect that (i) owners of more than 5% of the ETF shares are not required to file reports under Section 13(d) and (ii) insiders are not required to file reports under Section 16(a).

c. Section 13 and 16 relief is conditioned upon the ETF’s shares generally trading at prices that do not materially deviate from NAV

E. Selected Legal and Compliance Issues

1. 1940 Act – Transactions with Affiliates

a. Except for the narrow exemption from section 17(a) for in-kind purchase and redemption transactions by persons deemed first-tier or second-tier affiliates generally by reason of 5% ETF share ownership, the transaction prohibitions and limitations contained in section 17 generally apply to ETFs and their affiliates.

b. Principal transactions (section 17(a))

i. a first- or second-tier affiliate, acting as principal, generally is prohibited from selling securities or other property to an ETF, or purchasing securities or other property from an ETF, or from borrowing money or other property from an ETF

ii. an ETF affiliate is thus prohibited from engaging with the ETF in securities lending transactions, portfolio securities transactions other than in-kind purchase and redemption transactions (e.g., “rebalancings” of an ETF’s portfolio securities) and foreign currency transactions

c. Joint transactions (section 17(d))

i. section 17(d) generally prohibits any affiliate, acting as principal, from effecting any transaction in which the registered investment company is a joint or a joint and several participant with the affiliate in contravention of any SEC rules

ii. section 17(d) and rule 17d-1 thereunder have been construed very broadly by SEC as a “catch-all” for many transactions not expressly prohibited by section 17(a) and not obviously prohibited by section 17(d) – thus, transactions “involving” in the broadest sense registered investment companies (including ETFs) and their affiliates may be caught by section 17(d)

d. Agency transactions (section 17(e))

i. an affiliate, when purchasing or selling any property as agent to or for a registered investment company, may not accept from any source any compensation (other than regular salary or wages), except in the course of the person's business as an underwriter or broker

ii. an affiliate, when acting as broker in connection with the sale of securities to or by a registered investment company, may not receive from any source a commission, fee, or other remuneration for effecting such transaction that exceeds (A) usual and customary broker’s commission if the sale is effected on a securities exchange, or (B) 2% of the sales price if the sale is effected in connection with a secondary distribution of such securities, or (C) 1% of the purchase or sale price in all other cases, unless SEC by rule, regulation or order permits a larger commission

2. 1933 Act and 1940 Act – Prospectus Delivery

a. Section 5(b)(2) of the 1933 Act makes it unlawful to carry, or caused to be carried, through interstate commerce, any security for the purpose of sale or delivery after sale unless accompanied or preceded by a statutory prospectus.

b. Although section 4(3) of the 1933 Act excepts certain transactions by dealers from the provisions of Section 5, section 24(d) of the 1940 Act disallows such exemption for transactions in redeemable securities issued by a UIT or open-end company, if any other security of the same class is currently being offered or sold by the issuer by or through an underwriter in a public distribution.

c. Because ETF shares are issued by UITs or open-end companies and are continually in distribution, a statutory prospectus generally is required to be delivered prior to or at the time of the confirmations of each secondary market sale involving a dealer.

d. Limited exceptions

i. purchases of ETF shares by an investor who has previously been delivered a prospectus (until such prospectus is supplemented or otherwise updated)

ii. unsolicited brokers’ transactions in ETF shares (pursuant to Section 4(4) of the 1933 Act)

iii. under rule 153 under the 1933 Act, the prospectus delivery obligation owed to an exchange member in connection with a sale on the exchange is satisfied by the fact that the ETF prospectus is available at the exchange upon request

e. SEC has granted exemptive relief from section 24(d) to some ETFs pursuant to which, in lieu of a prospectus, ETF investors may receive, in connection with certain secondary market transactions in ETF shares, a short-form “product description”, intended to briefly describe the ETF’s important features.

f. SEC prospectus delivery relief does not cover (a) the requirement to deliver a prospectus to those investors who purchase creation units of ETF shares from the ETF or (b) the requirement that an underwriter or distribution participant of ETF shares deliver a prospectus – thus, a broker-dealer may be deemed a statutory underwriter, and prospectus delivery would be required, if the broker-dealer purchases creation units from an ETF and then sells some or all of the ETF shares comprising such creation units directly to its customers, or if it chooses to couple the creation of a supply of new ETF shares with an active selling effort involving solicitation of secondary market demand for those ETF shares.

g. The relief granted is of little or no utility to broker-dealers who are authorized participants, because it is inapplicable to creation unit transactions and because of the compliance difficulty in distinguishing secondary market transactions that do not involve a distribution of ETF shares from those that may.

h. Also, because broker-dealers are still required to deliver “something”, the compliance burden is not appreciably diminished.

i. Consequently, few broker-dealers seek to avail themselves of the prospectus delivery relief, and few ETF sponsors still produce the short-form product descriptions for this purpose.

j. In light of industry practice and other factors, SEC’s ETF rule proposal does not include a section 24(d) exemption and, further, SEC has proposed to amend previously issued exemptive orders to eliminate the section 24(d) exemptions and require all ETFs to satisfy their statutory prospectus delivery requirements.

3. U.S. Taxation

a. ETFs are regulated investment companies for tax purposes, and so must comply with the diversification and distribution requirements of Subchapter M of the Internal Revenue Code.

b. Diversification

i. at least 50% of the market value of the ETF’s total assets must be represented by cash items, U.S. government securities, securities of other regulated investment companies and other securities, with such other securities limited for purposes of this calculation in respect of any one issuer to an amount not greater than 5% of the value of the ETF’s assets and not greater than 10% of the outstanding voting securities of such issuer

ii. not more than 25% of the value of its total assets may be invested in the securities of any one issuer, or of two or more issuers that are controlled by the ETF and that are engaged in the same or similar trades or businesses or related trades or businesses (other than U.S. government securities or the securities of other regulated investment companies)

b. Distribution

i. ETF portfolio securities generate current income that is actually received by the ETF – ETFs generally must distribute at least 90% of their annual income to its shareholders

ii. ETF shareholders may choose either to receive their share of the income as a current distribution or to reinvest it – if they choose to reinvest, they are deemed to have received a distribution and reinvested that distribution in the ETF

II. Exchange Traded Notes – “ETNs”

A. Introduction

1. ETNs offer investors an exchange-listed and -traded debt security, the value of which fluctuates in relation to the performance of an underlying securities index, commodity index or currency index (or, in some cases, a specified basket of or single commodity or currency).

2. ETNs bear many similarities to ETFs, in that they may be purchased and sold by investors at negotiated prices on an exchange or over the counter, and may be tendered to the issuer for redemption, albeit only in large aggregations, at a price that corresponds generally to their intrinsic value.

3. In contrast to ETFs, ETNs are senior, unsecured debt obligations subject to the credit and solvency of their issuer, and they provide no ownership right or interest in any underlying assets notwithstanding their use of an index or specified basket as a referent.

B. Core Features and Operation of ETNs

1. Typical Features

a. ETNs are debt securities, the valuation of which is derivative of the value of the underlying index (or basket) to which it is linked, subject to any applicable fees.

b. ETNs typically are non-interest-bearing and non-principal protected and have long maturities (e.g., thirty years from original issuance).

c. If ETNs are held to maturity –

i. in accordance with the terms of the ETN, at maturity, ETN holders would receive a cash payment equal to the principal amount of the ETNs, multiplied by the applicable “index factor”, less any applicable investor fee

ii. an index factor on any given day is typically the ratio of the closing value of the relevant index on that day over the closing value of that index on the original pricing date of the ETNs

iii. the investor fee is typically a stated percentage per annum, multiplied by the principal amount of the ETNs, multiplied by the index factor, calculated daily

d. If ETNs are to be disposed of prior to maturity –

i. ETNs may be sold (or purchased) throughout the trading day on the exchange or over the counter at current negotiated prices

ii. alternatively, ETNs may be tendered for redemption, typically on at least a weekly basis, in large minimum amounts of ETNs specified by the issuer in the terms of the ETN – upon such redemption, the redeeming holder would receive a cash payment equal to the principal amount of the ETNs being redeemed, multiplied by the applicable index factor, and less any applicable investor fee and/or redemption fee

2. Listing and Trading of ETNs

a. ETN issuers register offerings and sales of ETNs under the 1933 Act on a continuous or delayed basis, typically on a WKSI shelf registration statement.

b. ETNs are listed for trading under the 1934 Act, typically pursuant to the exchange’s generic listing criteria for ETNs, including –

i. maturity is from one year to 30 years

ii. nonconvertible debt of the issuer

iii. payment at maturity is not based on a multiple of the negative performance of the underlying index (although payment at maturity may be linked to a multiple of the positive performance of the underlying index)

iv. redeemable at least once weekly (in order to waive the otherwise applicable minimum 400 holder requirement)

v. aggregate principal amount meets specified minimum

vi. underlying index or other referent meets certain additional exchange requirements, such as capitalization and pricing information

c. Dissemination of trading information – in order to avoid an exchange halt in ETN trading, intraday “indicative values” meant to approximate the economic value of each ETN are required to be calculated and published every 15 seconds throughout the trading day – in addition, ETN issuer typically undertakes to calculate and publish the closing indicative value on its website each trading day.

3. Issuance and Redemption

a. ETN issuer typically issues ETNs initially – and may “re-open” an ETN issuance from time to time – in amounts greater than it intends initially to sell to the public at the time of issuance, thereby creating “inventory” for the continuous offering of the ETNs to the public.

b. ETN holders may redeem ETNs generally on at least a weekly basis so long as at least a large minimum number of ETNs are redeemed (e.g., 50,000 ETNs for an ETN with a $50 principal amount) – to satisfy this minimum redemption amount, broker-dealers and certain other financial intermediaries are permitted to “bundle” an investor’s ETNs with those of other redeeming investors.

4. Effect of Arbitrage Opportunities and Transparency on ETN Prices

a. ETN issuers represent that the value of the ETN’s underlying index or other referent on any day generally will affect the market price of the ETNs more than any other factor.

b. ETN issuers state that as a result of the potential arbitrage opportunities inherent in the structure of ETNs, assuming that the redemption feature functions as intended, ETNs are not expected to trade at a material discount or premium to the value of the relevant underlying indices or other referents.

c. The dissemination of the “indicative value” of the ETF throughout the trading day and at the closing of each trading day, coupled with the dissemination of current information about an ETN’s underlying index or other referent, are claimed to contribute favorably to the price transparency of ETNs in the secondary market.

C. Exemptions Facilitating ETN Trading

1. The issuers of ETNs are not investment companies and are not subject to regulation under the 1940 Act – therefore, ETN issuers are not required to obtain the extensive set of exemptions that ETFs must obtain.

2. On behalf of themselves and ETN market participants, ETN issuers obtain a portion of the same relief obtained for ETFs in respect of certain of the “trading rules” under the 1934 Act – viz., under regulation M and section 11(d)(1).

a. Regulation M

i. as discussed above, rules 101 and 102 of regulation M generally prohibit a “distribution participant”, and the issuer or a selling security holder, respectively, in connection with a distribution of securities, from bidding for or purchasing or from attempting to induce any person to bid for or purchase, a "covered security" during the applicable restricted period

ii. broker-dealers who engage in bids for or purchases of ETNs, including redemptions of ETNs, could be deemed to be “distribution participants” within the meaning of regulation M

iii. on the basis of ETN issuer representations in no-action requests, particularly that ETNs are redeemable on at least a weekly basis and that the secondary market price of the ETNs should not vary substantially from the value of the relevant underlying indices, the staff of SEC Division of Trading and Markets has confirmed that it will not recommend enforcement action (a) under rule 101, thus permitting persons who may be deemed to be participating in a distribution of ETNs to bid for or purchase ETNs during their participation in such distribution, or (b) under rule 102, thus permitting the ETN issuer and affiliated purchasers to redeem ETNs

b. Margin

i. as discussed above, under section 11(d)(1), a broker-dealer generally may not extend credit in connection with the purchase of any security that is part of a new issue if the broker-dealer was a member of the selling syndicate within the prior thirty days

ii. rule 11d1-2 provides an exemption for section 11(d)(1) for a security issued by a registered open-end investment company or unit investment trust with respect to transactions by a broker-dealer who extends credit on such security, provided the person to whom credit has been extended has owned the security for more than 30 days

iii. although an ETN issuer is not a registered open-end investment company or unit investment trust, in view of the substantial similarity between ETNs and ETFs, ETN issuers have requested the same relief afforded by rule 11d1-2 to ETFs and other registered open-end investment companies

iv. staff has confirmed that broker-dealers may treat ETNs as shares issued by an open-end investment company and therefore may extend credit or maintain or arrange for the extension or maintenance of credit on ETNs that have been owned for more than 30 days by the persons to whom credit is to be provided

D. U.S. Taxation

1. Holder of an ETN holds only a contract with the issuer to receive a payment at a future date based on the level of the underlying index or other referent – in contrast to ETFs, ETN holder has no ownership interest in the assets that comprise the underlying referent and does not actually receive dividends, interest or other current income on underlying referent assets, and only receives payment at maturity. Also, ETN issuer is not required to own the referent assets underlying the ETN, and consequently may receive no current income with respect to those assets.

2. ETN disclosure documents generally provide that ETN holders should treat the ETNs for federal tax purposes as a cash-settled pre-paid contract with respect to the underlying index or other referent and that, if the ETNS are so treated, the holder should recognize capital gain or loss upon the sale, redemption or maturity of the ETNs in an amount equal to the difference between the amount received at such time and the holder’s tax basis in the ETNs.

3. Exception: pursuant to IRS ruling 2008-1, certain financial instruments linked directly to the value of a foreign currency – including single currency ETNs – should be treated like debt for federal tax purposes.

4. ETN disclosure documents caution that the U.S federal income tax consequences of investments in ETNs are uncertain, and that the IRS and the U.S. Treasury are actively considering the tax treatment of instruments such as ETNs and may in the future assert alternate tax treatment.

III. Summary: Principal Similarities and Differences between ETFs and ETNs

A. Legal and Operational

1. Organizational form of issuer

ETF: corporation or business trust (UITs are trusts)

ETN: corporation

2. Character of security

ETF: equity – an undivided interest in a pool of assets

ETN: debt – senior, unsecured

3. Term of security

ETF: if a corporation, perpetual; if a trust, long term

ETN: typically 30 years

4. Registration

ETF: ETF shares – 1933 Act, 1934 Act; ETF issuer – 1940 Act

ETN: 1933 Act, 1934 Act

5. Disclosure document

ETF: prospectus (part of registration statement, usually on Form N-1A)

ETN: prospectus supplement (to MTN prospectus supplement and debt shelf prospectus, part of shelf registration statement on Form S-3)

6. Regulation

ETF: substantial regulation under 1940 Act

ETN: not regulated under 1940 Act

7. Regulatory relief necessary

ETF: exemptive order under 1940 Act; no-action relief under 1934 Act

ETN: no-action relief under 1934 Act

8. Exchange listing

ETF: pursuant to generic listing criteria (or one-off 19b-4 order)

ETN: pursuant to generic listing criteria (or one-off 19b-4 order)

9. Principal service providers

ETF: sponsor (typically investment advisor), administrator, distributor, custodian, independent accountant, legal, index provider/ calculator, exchange, market participants (authorized participants, other broker-dealers)

ETN: indenture trustee, underwriter, independent accountant, legal, index provider/ calculator, exchange, market participants

10. Portfolio assets

ETF: generally, all or portion of securities/assets in underlying index

ETN: none (although issuer may hedge with securities, derivatives, etc.)

11. Portfolio management

ETF: index-based – limited to achieving index performance;

actively managed – pursuant to stated investment objectives

ETN: none

12. Issuance of securities

ETF: continuous, in creation units, generally for in-kind deposit at NAV

ETN: from time to time (and sometimes reopened), at negotiated prices

13. Redemption of securities

ETF: daily, in creation units, generally for in-kind proceeds at NAV

ETN: at least once weekly, in large aggregations, for cash, based on current value of index factor and less applicable fees

14. Clearance and settlement

ETF: book-entry through facilities of DTC

ETN: book-entry through facilities of DTC

15. Voting rights

ETF: if open-end form, yes; if UIT form, generally none

ETN: none

16. Taxation

ETF: taxation as a RIC

ETN: with certain exceptions, treatment as a cash-settled prepaid contract (although subject to change by IRS and U.S. Treasury)

B. Economic

1. Liquidity

ETF: intraday over exchange or OTC at market prices; redemption of creation units at least once daily at NAV

ETN: intraday over exchange or OTC at market prices; redemption of large blocks at least once weekly based on index factor

2. Recourse

ETF: assets in portfolio

ETN: credit of the issuer

3. Principal risk

ETF: market risk only

ETN: market risk and issuer credit risk

4. Arbitrage

ETF: NAV purchase/redemption mechanism, secondary market

ETN: redemption mechanism, purchases out of inventory, secondary market

5. Price transparency

ETF: intraday published indicative value; published index/basket information

ETN: intraday published indicative value; published index/basket information

6. Distributions

ETF: yes; received or reinvested

ETN: none

7. Fees and expenses

ETF: asset-based expense ratio; issuance/redemption fees; brokerage

ETN: investor fee; redemption fees; brokerage

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