Since shares of exchange traded funds (ETF Shares) are continuously offered and are also traded in secondary markets, various issues arise under the Securities Exchange Act of 1934. Issues also arise under the Securities Exchange Act because most ETF Shares are purchased and redeemed in-kind. We have noted some confusion over some obligations under the Securities Exchange Act for ETF Shares, particularly with regard to Section 13 and Section 16 compliance. What follows is a brief summary of issues under the Securities Exchange Act that are applicable to ETF Shares. It does not provide comprehensive advice or identify each rule, regulation, document or action that an exchange traded fund (ETF) should consider in addressing issues under the Securities Exchange Act.
Available No-Action Relief
The SEC has granted no-action relief to ETFs with respect to compliance with Section 13(d) and Section 16 of the Securities Exchange Act, and has indicated that ETFs no longer need to submit requests for no-action relief unless novel or unusual issues are present. See Select Sector SPDR Trust, No-Action Letter (publicly available May 6, 1999), and PDR Services Corporation, No-Action Letter (publicly available December 14, 1998).
The SEC has issued generic no-action relief that obviates the need for index ETFs to obtain their own no-action relief for items related to Regulation M, tender offers, broker confirmations, margin, disclosure of broker relationships, and advance notice of corporate actions, as discussed below. See The American Stock Exchange, No-Action Letter (publicly available August 17, 2001). In addition, the SEC has consistently granted equivalent no-action relief to ETFs that are not tied to an index, and has indicated that such ETFs no longer need to submit requests for no-action relief with respect to broker confirmations, margin, and disclosure of broker relationships unless novel or unusual issues are present. See WisdomTree Trust, No-Action Letter (publicly available May 9, 2008).
Specific Securities Exchange Act Issues
Sections 13(d) and 16(a). Section 13(d) requires beneficial owners of more than five percent of an issuer’s outstanding securities to file reports with the SEC. Section 16(a) requires each officer, director, and beneficial owner of more than 10 percent of a public company’s outstanding shares (insiders) to file reports with the SEC disclosing the number of shares beneficially owned, and reports regarding changes in ownership. The SEC has granted no-action relief to ETFs with respect to the reporting obligations under Sections 13(d) and 16(a) to the effect that: (1) owners of more than five percent of the ETF Shares are not required to file reports under Section 13(d); and (2) insiders are not required to file reports under Section 16(a).
The no-action relief with respect to sections 13(d) and 16(a) is based primarily on representations that the ETF Shares trade at prices that do not deviate materially from NAV. The letters caution, in this regard, that if the ETFs Shares begin to trade at prices that materially deviate from NAV, the no-action relief would no longer be available.
Regulation M. Regulation M is intended to limit the activities of those persons who have a readily identifiable incentive to manipulate the market during an offering. Regulation M exempts from its application redeemable securities issued by an open-end management investment company, and an ETF is an open-end management investment company. However, because of the limited redeemability of ETF Shares, it is not clear that the exemption for open-end investment companies is applicable to ETFs. As a result, ETFs have sought, and the SEC has been willing to grant, no-action positions confirming that:
- Persons who may be deemed to be participating in a distribution of ETF Shares may bid for or purchase such ETF Shares during their participation in such distribution
- The receipt of securities comprising the basket of securities received in connection with the redemption of ETF Shares does 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
- ETFs may redeem ETF Shares during the continuous offering of such ETF Shares.
Tender Offers. Rule 14e-5, among other things, 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. Rule 14e-5 could be read as restricting the ability of a dealer manager of a tender offer for a particular security included in the ETF’s portfolio from purchasing and redeeming ETF Shares during the offer period. That would be the case to the extent that purchases and redemptions of ETF Shares are viewed as an indirect purchase or sale of the security subject to the tender offer. To obviate concerns in this regard, ETFs have sought, and the SEC has been willing to grant, exemptive relief from Rule 14e-5 to permit dealer-managers of tender offers of securities comprising the basket of securities tendered or received in connection with a purchase or redemption of ETF Shares to purchase and redeem ETF Shares during the pendency of the offer.
Broker Confirmations. 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 completion of the transaction. The confirmation must contain certain specified information, including the identity, price, and number of shares or units (or principal amount) of the security purchased or sold.
Compliance with Rule 10b-10 would be extremely burdensome to the extent that all of its requirements were viewed as applicable to all securities comprising the basket of securities tendered or received in connection with a purchase or redemption of ETF Shares. For this reason, ETFs have sought, and the SEC has been willing to grant, exemptive relief to permit broker-dealers to omit information respecting the identity, price and number of shares of each individual security tendered or received. The SEC has been willing to grant such relief conditioned upon the representation that the confirmation furnished by the broker-dealer to its customer will state that all information required by Rule 10b-10 will be furnished upon request and all such requests will be fulfilled in a timely manner.
Margin. Pursuant to Section 11(d)(1) of the Securities Exchange Act, 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 30 days. 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 be viewed as applicable to ETFs. To obviate this concern, ETFs have sought and obtained no-action relief from the SEC to permit 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. The SEC has also extended this relief to broker-dealers who transact directly with the ETF. In both cases, the relief is subject to the condition that the broker-dealer not receive, from the ETF or an affiliated person of the ETF, any payment, compensation, or other economic incentive to promote the shares of the ETF.
ETFs have also received confirmation that ETF Shares may be treated by broker-dealers as shares issued by an open-end investment company and therefore, pursuant to Rule 11d1-2 of the Securities Exchange Act, broker-dealers are able to 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.
Disclosure of Broker Relationships. A broker-dealer is required, under Rule 15c1-5 under the Securities Exchange Act, to disclose to its customers any control relationship between the broker-dealer and the issuer of the security being purchased or sold. Similarly, a broker-dealer that effects a transaction with a customer in connection with any distribution in which the broker-dealer is interested, is required, under Rule 15c1-16 under the Securities Exchange Act, to disclose to its customer the existence of such interest. ETFs have obtained no-action relief from the SEC to confirm that the foregoing rules do not require disclosure of a broker-dealer’s relationship with any issuer of a security held in the ETF’s portfolio.
Advance Notice of Corporate Actions. Rule 10b-17 requires a public company to give advance notice of certain specified actions (for example, dividends, stock splits, rights offerings). Paragraph (c) of the Rule, however, states that the Rule does not apply to redeemable securities issued by open-end investment companies. However, because of the limited redeemability of ETF Shares, it is not clear that the exemption for open-end investment companies is applicable. As a result, ETFs have sought, and the SEC has been willing to grant, no-action positions confirming that this exemption applies to ETFs.