Earlier today (June 28, 2018), at an open meeting of the U.S. Securities and Exchange Commission (SEC) (Meeting), the SEC unanimously voted to issue a proposed rule and form amendments (Proposal) that would allow certain exchange-traded funds (ETFs) to operate without exemptive relief and would expand the disclosure requirements for all ETFs.
Since 1993, ETFs have operated in reliance on individual exemptive orders from the SEC, creating what Commissioners Kara Stein and Michael Piwowar described as a “patchwork quilt” of regulation. In 2008, the SEC proposed a new rule that would have permitted certain ETFs to operate without an exemptive order, but the proposal was not adopted after the financial crisis led the SEC to shift its focus.
Scope of Proposed Rule 6c-11 and Impact on Existing Exemptive Relief
Proposed Rule 6c-11 would create a framework for ETFs that are organized as open-end management investment companies (funds) and satisfy certain standardized conditions to operate under the Investment Company Act of 1940 (1940 Act), without first obtaining individual exemptive relief from the SEC. ETFs ineligible to rely on proposed Rule 6c-11 would include: (i) ETFs organized as unit investment trusts (UITs); (ii) ETFs structured as share classes of multi-class funds; and (iii) leveraged or inverse ETFs.
For ETFs eligible to rely on proposed Rule 6c-11, the Proposal would rescind existing exemptive relief. In addition, the Proposal also contemplates rescission of existing exemptive relief permitting ETFs to operate in a master-feeder structure. The SEC’s “fact sheet” relating to the Proposal notes that ETFs that currently utilize a master-feeder structure would be grandfathered in, but that ETF sponsors would be prevented from establishing any new master-feeder arrangements.
The Proposal does not contemplate rescission of existing exemptive relief permitting certain investments in an ETF in excess of the limits set forth in Section 12(d)(1) of the 1940 Act, subject to certain conditions.
Notable Differences from Existing Exemptive Relief
Proposed Rule 6c-11 includes standardized conditions that do not distinguish between index-based and actively-managed ETFs, and differ in certain ways from current exemptive relief. Notably, proposed Rule 6c-11 would require an ETF to disclose its holdings on its website on a daily basis. Under current exemptive relief, an ETF that seeks to track a third-party index (except a 130/30 or long/short index) is not required to post holdings daily.
Proposed Rule 6c-11 would also afford ETFs flexibility to use “custom baskets,” or baskets used for creation and redemption transactions that (i) do not correspond pro rata to the ETF’s portfolio holdings, or (ii) are not the same as those used for other creation and redemption transactions that day. While certain older exemptive orders provide flexibility with respect to custom baskets, newer exemptive relief generally requires ETFs to use baskets that correspond pro rata to their holdings, with limited exceptions.
In order to utilize custom baskets under proposed Rule 6c-11, an ETF would be required to adopt written policies and procedures describing in detail the circumstances under which custom baskets would be utilized in the best interests of the ETF and its shareholders, and implement certain recordkeeping requirements related to custom basket transactions. Commissioner Piwowar noted at the Meeting that “this proposal sets forth a principles-based approach, allowing funds to use custom creation/redemption baskets, which should substantially level the playing field for old and new entrants in this market.”
The Proposal would expand the disclosure requirements for all ETFs by amending Form N-1A (the registration form used by ETFs structured as open-end funds) and Form N-8B-2 (the registration form used by ETFs structured as UITs) to require the inclusion of more ETF-specific information designed for investors that buy and sell ETF shares in the secondary market. Importantly, the new disclosure requirements under Form N-1A would apply to all ETFs using that Form, even those ETFs not relying on proposed Rule 6c-11.
The Proposal would also implement certain requirements relating to ETF website disclosure, including a new requirement to disclose information relating to bid-ask spreads. The enhanced website disclosure would be designed to provide an ETF’s investors with more insight into the efficiency of its arbitrage process.
The comment period for the Proposal will be 60 days after publication in the Federal Register. A copy of the SEC’s “fact sheet” that relates to the Proposal is available here and a copy of the proposing release is available here.