On February 11, 2014, the SEC’s Division of Corporation Finance sent a “sweep” letter to exchange-traded note (ETN) issuers. The letter contains 14 items, some of which have application to all structured products, not just ETNs. The letter is the first significant SEC statement about ETNs since the SEC’s Division of Market Regulation issued two Regulation M no-action letters in 2006 and 2007.1
ETNs are inherently more complex, and more difficult to describe simply, than a typical structured note. Due to the effect of the annual fee, and the redemption and call features, the payoff profile of an ETN is difficult to describe succinctly in the up, flat and down scenarios descriptive of many non-ETN structured notes. Consequently, prospectus descriptions of ETNs are often lengthy and use multiple defined terms. Some of the items in the sweep letter address these disclosure issues.
Terms of the Offering
For example, Item 1 of the sweep letter asks issuers to “revise your prospectus supplements, as appropriate, to disclose the material terms of each ETN in a clear, concise and understandable manner,” citing the SEC’s plain-English disclosure requirements.
Item 6 of the sweep letter requests clear disclosure of the redemption value of an ETN. The SEC asks issuers to disclose whether the redemption value is publicly available prior to an investor’s redemption. ETN issuers normally disclose in the prospectus supplement that there is a one-day delay during which a redeeming investor is at risk due to the time period between the investor’s submission of a properly executed redemption request and the calculation of the actual redemption price on the trading day following receipt of the request. Generally, a related risk factor is also included.
Item 7 of the sweep letter relates to disclosure of any applicable fees that may be charged relating to the ETNs. This item mentions index calculation fees, in addition to the normal ETN-related charges, such as annual fees and redemption charges. The Item requests disclosure of the party responsible for payment of each fee, how the fees may change based on the performance of the underlying asset, when the fees are collected and their effect on the redemption amount and the intraday indicative value. Issuers of any structured notes linked to an index (whether or not in ETN form) for which fees are deducted when calculating the index level may consider this guidance related to fee disclosure and, to the extent possible, add an explanation of their effect on the index level and payout at maturity.
Item 2 of the sweep letter requires revisions to prospectus supplements that do not disclose that the issuer may cease or suspend and restart sales of ETNs any time at the issuer’s discretion. This item also requests clear disclosure of the effect of any such actions on liquidity in the secondary market and the addition of appropriate risk factors, if the issuer views such discretion as material.
This comment seems to be a response by the SEC to a few cases where ETNs began to trade away from the value of the underlying reference asset, due to shortages of those ETNs caused by various issuer actions. Due to these types of events, most ETN prospectuses contain clear disclosure of any internal position limits that may cause the issuer to cease ETN issuances and the resulting potential price distortions between the trading value of the ETNs and the value of the underlying asset, as reflected in the indicative value. ETN issuers generally disclose that they may not sell the full principal amount of the ETNs listed on the cover of the prospectus supplement, and may suspend and resume sales of the ETNs at any time, with appropriate risk factor disclosure relating to the effect of those actions on trading prices. Issuers should be wary of suspending and resuming ETN issuances, even for good reasons, as the optics may be negative.
Issuers of ETNs are regularly “creating,” or issuing, new ETNs, and reselling ETNs that have been previously redeemed or repurchased by the issuer’s affiliated broker-dealer. Due to the ongoing creations, the “distribution” of the ETNs, for purposes of Regulation M, does not end until the ETN is called or matures. The affiliated broker-dealers of ETN issuers engage in market-making activities in the ETNs, constantly purchasing and selling ETNs in the market. Normally, redemptions by the issuer and market-making bids and purchases by the affiliated broker-dealer would raise questions under Regulation M.
In order to address these Regulation M issues, in 2006, Barclays Bank plc received the iPath Letter from the SEC’s Division of Market Regulation, under which the SEC staff granted relief from Rules 102 and 101 for the redemption of ETNs by the issuer and the market-making activities of its affiliated broker-dealer. In the iPath Letter, the staff agreed that the availability of real-time pricing information for both the ETNs (due to their NYSE listing) and the underlying reference asset (index levels are publicly available in real time), plus the ability of arbitrageurs to redeem ETNs and purchase new ETNs, would prevent any significant differences between the price of the ETNs and the underlying reference asset.
One of the items of trading information on the iPath ETNs that counsel argued was relevant for reference purposes, and the staff did not disagree, was Barclays’ real-time publication of the ETNs’ intraday indicative value, which is intended to be an approximation of the value of the ETNs and is derived under a formula included in the prospectus supplement. The intraday indicative value is one more piece of information for investors to use to compare against the actual market value of the ETN on the NYSE and the level of the underlying asset when determining whether to hold, redeem or purchase ETNs.
Item 3 of the sweep letter asks issuers to explain the purpose of calculating the indicative value and why it is relevant to investors. The sweep letter requests that issuers avoid presenting the indicative value as a formula, and instead use clear, narrative disclosure.
Requesting disclosure of the market value of the ETNs relative to the initial price to public seems to call for estimated initial value-type disclosure for ETNs. In the sweep letter’s introduction, reference is made to the April 2012 sweep letter “for additional disclosure matters that may be applicable to ETN offerings.” The most significant item in the April 2012 sweep letter was the requirement that issuers include their estimated initial value of their structured products in prospectuses. ETNs, as opposed to unlisted structured products, immediately start trading at their actual resale value on the NYSE. Due to, among other things, the liquidity of ETNs and the easy availability of their actual resale value, ETN issuers have not included estimated initial value in their prospectus supplements.Item 5 requests that, if the indicative value is included in the prospectus supplement, there be a clear explanation of the differences between the indicative value, “the market value of the ETN relative to the initial price to public” and the redemption amount. A relevant risk factor should also be included. Under the iPath Letter, an issuer must include the indicative value. The redemption amount is typically the indicative value minus the stated redemption fee. Most issuers include robust disclosure about the differences between the different value measures and risk factors, disclosing that the trading prices, and the amount that an investor would receive upon redemption or call, may vary substantially from the indicative value.
Item 14 of the sweep letter focuses, once again, on ETN price distortions due to a suspension of issuances or a lack of supply (see Item 2 above). In this item, the SEC specifically points to the iPath Letter and the Deutsche Bank no-action letter and requests an explanation of how an issuer’s purchase of an ETN in response to a holder’s redemption request during a period of price distortion would be in compliance with the Regulation M relief granted in those no-action letters. If an issuer suspends issuance of ETNs, the distribution, for purposes of Regulation M, would be completed, and a redemption of an ETN by the issuer would not violate Regulation M.
In Item 13 of the sweep letter, the SEC requests that issuers disclose short sale activities by broker-dealers and others and how the loans and repurchases will be disclosed, and a confirmation that the issuer will register these transactions under the Securities Act of 1933. Appropriate risk factor disclosure is also requested describing the market effect that short sales and securities lending activities may have on ETN liquidity.
ETN prospectuses normally disclose that dealers (including affiliates of the issuer) may resell an ETN acquired from a holder in a market-making purchase, or pursuant to a redemption, and that they may sell an ETN in covering a short sale transaction. The prospectus will also disclose that it will be deemed to cover any short sales of ETNs by market participants who cover their short position with ETNs borrowed from the issuer or its affiliates.
In the iPath Letter, counsel stated that there would be short sales of ETNs by dealers and exchange specialists to satisfy customer demand. Relief was requested, and received, from two short sale rules, old Rule 10a-1 under the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 200(g) of Regulation SHO under the Exchange Act.
The SEC also questions the practice of using a single prospectus supplement to offer multiple ETNs with different investment profiles. Some ETN issuers will include long and short versions of an ETN with the same underlying asset on one prospectus, or multiple ETNs with different underlying assets on one prospectus. Item 11 of the sweep letter asked issuers to explain why they believe that practices like these are appropriate. Of course, many structured note issuers include multiple notes with the same payoff structure, but different underlying assets of the same type, on one prospectus supplement.
In Item 9 of the sweep letter, the SEC requests disclosure of the number and dollar amount of outstanding ETNs in a series. Most ETN issuers maintain websites on which they publish that information. Their prospectus supplements should make reference to those websites.
The sweep letter also calls on issuers to consider other disclosure items that have been previously raised by the SEC:Familiar Issues
- Disclosing activities that create conflicts of interest between the issuer and its affiliates and ETN purchasers, and the impact of those activities on supply, pricing and the market for ETNs (Item 8);2
- Avoiding security titles that suggest that investors are purchasing anything other than an unsecured debt obligation—use of the word “shares” should be avoided, as should any suggestion that the ETNs are interests in an exchange-traded fund (Item 12); and
- A reminder to comply with Item 508 of Regulation S-K by clearly disclosing the roles of broker-dealers in sales of ETNs. The staff also requests information as to how these broker-dealers satisfy their prospectus delivery obligations for these offerings.
The SEC requests that issuers respond to the sweep letter within 10 business days (February 27, 2014). It is possible that these response letters will be available on the SEC’s website.
Many of the sweep letter’s items reflect the SEC’s ongoing concerns about clear disclosure to investors, particularly in the area of complex products. Most active ETN issuers’ prospectus supplements contain disclosure that is in substantial compliance with the concerns raised by the SEC in the sweep letter.