On September 26, 2019, the Securities and Exchange Commission (the SEC) adopted a final rule under the Investment Company Act of 1940 (the “Investment Company Act”) that will enable most exchange-traded funds (“ETFs”) to operate without an exemptive order, subject to various conditions (“Rule 6c-11”). Among other things, Rule 6c-11 will rescind certain exemptive orders that it issued previously to ETFs and ETF sponsors, replace those orders with a standard ETF framework and establish new disclosure requirements for ETFs that rely on the rule.
Here, we summarize the highlights of Rule 6c-11 and also summarize the new disclosure requirements that will apply to ETFs.
On October 24, 2019, the Federal Register published Rule 6c-11, which will become effective December 23, 2019. The compliance date for the amendments to Form N-1A is December 22, 2020, one year following the effective date.
Rescission of Prior Exemptive Orders
Rule 6c-11 rescinds, one year after its effective date, portions of certain ETF exemptive orders that granted relief related to ETF formation and operation. In turn, Rule 6c-11 provides ETFs that fall within its scope exemptive relief from the Investment Company Act that is commensurate with the relief granted by the SEC’s prior exemptive orders.
Treatment of ETF Shares as “Redeemable Securities”
The SEC’s exemptive orders provided a specialized understanding of ETFs that fit their operations but varied from the otherwise strict definitions of “redeemable security” and “open-end company,” as defined in Section 2(a)(32) and Section 5(a)(1) of the Investment Company Act. Rule 6c-11 codifies this approach by defining an ETF to mean a registered open management company (a) that issues (and redeems) creation units to (and from) authorized participants in exchange for a basket and a cash balancing amount, if any, and (b) whose shares are listed on a national securities exchange and traded at market-determined prices. This definition effectively accepts ETFs as a version of “open-end” funds permitted to issue “redeemable securities” (redeemable on demand but only in connection with the creation unit process).
In addition, the rules under the Securities Exchange Act of 1934 (the “Exchange Act”) that apply to transactions in redeemable securities issued by an open-end fund will apply to ETFs relying on Rule 6c-11. Thus, shares issued by all ETFs (i.e. those that rely on Rule 6c-11 and those that cannot) will be eligible for the “redeemable securities” exceptions in Rules 101(c)(4) and 102(d)(4) of Regulation M and Rule 10b-17(c) under the Exchange Act in connection with secondary market transactions in ETF shares and the creation or redemption of creation units. ETFs relying on Rule 6c-11 similarly will qualify for the “registered open-end investment company” exemption in Rule 11d1-2 under the Exchange Act.
ETFs that cannot Rely on the Rule
ETFs structured as unit investment trusts (UITs) cannot rely on the rule and must continue to rely on an exemptive order. Similarly, Rule 6c-11 includes a condition that excludes leveraged and inverse ETFs. These types of ETFs may not rely on the rule, and will instead continue to rely on exemptive orders.
Trading of ETF Shares at Market-Determined Prices
ETFs that register under the Investment Company Act normally obtain exemptions from Section 22(d) and Rule 22c-1, which prohibit selling redeemable securities at prices other than those described in the prospectus or based on the net assets value (the NAV). Consistent with the SEC’s prior exemptive orders, Rule 6c-11 will codify those same exemptions, enabling secondary market trading of ETF shares at market-determined prices.
Rule 6c-11 will exempt ETFs from the restrictions contained in sections 17(a)(1) and (a)(2) of the Investment Company Act regarding the deposit and receipt of baskets by a person who is an affiliated person of an ETF (or who is an affiliated person of such a person) solely by reason of: (i) holding with the power to vote 5% or more of an ETF’s shares; or (ii) holding with the power to vote 5% or more of any investment company that is an affiliated person of the ETF. This relief is again consistent with the relief that the SEC has granted to ETFs under prior exemptive orders.
Additional Time for Delivering Redemption Proceeds
Rule 6c-11 will exempt ETFs from the redemption requirements of Section 22(e) of the Investment Company Act, allowing ETFs to delay satisfaction of a redemption request for more than seven days in the case of certain foreign investments for which a local market holiday or extended delivery cycles of another jurisdiction make timely delivery unfeasible. Pursuant to this exemption, an ETF must deliver foreign investments as soon as practicable, but in no event later than 15 days after the tender to the ETF. Rule 6c-11 does not provide a sunset provision to limit the relief from Section 22(e) to 10 years from the rule’s effective date, as was contemplated when the rule was proposed.
Other Key Provisions
Index-Based ETFs Versus Actively Managed ETFs
The rule eliminates the distinction between index-based ETFs and actively managed ETFs for purposes of regulation. The rule also does not include additional conditions relating to index-based ETFs with affiliated index providers (self-indexed ETFs).
The rule will require ETFs to adopt and implement written policies and procedures governing the construction of all basket assets (meaning the portfolio of assets that will underlie a creation unit’s creation or redemption) and the process that the ETFs will use for acceptance of basket assets.
In a departure from current practices, ETFs that rely on the rule would be permitted the flexibility to use “custom baskets” when creating creation units and redemption units, provided they comply with established procedures.
Custom baskets include baskets that do not reflect (i) pro rata representation of the ETF’s portfolio holdings, (ii) a representative sampling of the ETF’s portfolio holdings or (iii) changes due to rebalancing or reconstitution of the ETF’s securities market index, if applicable. Moreover, if an EFT uses different baskets in transactions on the same business day, each basket after the initial basket would be a custom basket.
Policies and procedures maintained for ETFs that use custom baskets must:
- Set detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, including the process for any revisions to or deviations from those parameters, and
- Specify the titles or roles of employees of the ETF’s investment adviser who are required to review each custom basket for compliance with those parameters.
Registration Statement and Website Disclosures
The rule makes a variety of changes to how specific matters for an ETF are addressed in its disclosures. The chart at the end of this alert compares the rule’s disclosure requirements with existing requirements for ETFs.
Going forward, ETFs should evaluate their compliance policies, as well as disclosures in ETF prospectuses and statements of additional information to ensure that they are appropriate when Rule 6c-11 becomes fully effective. The following chart summarizes some of the disclosure requirements mandated by Rule 6c-11.