In March 2008, the Securities and Exchange Commission ("SEC") proposed new rules under the Investment Company Act of 1940 (the "40 Act") that would exempt exchange-traded funds ("ETFs") from certain provisions of the 40 Act as well as certain SEC rules, and would allow investment companies to more freely invest in ETFs than is currently allowed under the 40 Act. The SEC also proposed an amendment to Form N-1A (the registration form used by open-end management investment companies to offer and register their securities) to promote more useful information for investors trading ETF shares.

The new rules are intended to facilitate ETFs' activities and allow investors to take better advantage of ETFs' investment opportunities. Specifically, the proposed rules are designed to eliminate unnecessary regulatory applications that are currently required for ETFs to perform their regular functions, and to promote greater competition and innovation among them.

Regulation Under the 40 Act

The 40 Act lists specific requirements (or prohibitions) that fund sponsors must follow rather than stressing full disclosure, which is the focus of other U.S. securities regulation. The 40 Act was a direct reaction to the extensive range of management and marketing abuses in the investment company industry during the 1920s and 1930s.1 Consequently, the 40 Act is focused on direct regulation and is based on the principle that investment advisors are fiduciaries who bear specific responsibilities.

Among the provisions of the 40 Act are a number of structural and operating requirements for investment companies that are not consistent with ETF operations. Congress, however, provided the SEC with blanket authority to grant specific exemptions from the 40 Act. This blanket authority permits ETFs to be approved by exemption. Although Congress granted broad exemption power to the SEC, such exemptions cause considerable delay between the date a request for exemption is filed and the date exemptive relief is granted.

The 40 Act requirements and prohibitions are quite specific. As a consequence, an ETF needs a large number of exemptions from securities legislation to perform such acts as creating and redeeming baskets and shares (in-kind and only in large blocks), and permitting individual shares to be traded at market prices on an organized securities market. Although some exemptions depend upon the issuer, the exchange, or specific authorized participant, certain basic exemptions are necessary for all ETF launches.

Proposed Rule 6c-11

The SEC's proposed rule 6c-11 is designed to allow ETFs to enter the market and perform daily activities more easily by codifying the exemptions that are typically granted when an ETF is formed. The SEC has seen that certain prohibitions are unnecessary as they relate to ETFs and do more to slow the inevitable formation of ETFs than they do to protect investors.

Exemptive Relief – As stated above, the structure of ETFs has forced their sponsors to request certain basic exemptions to allow their funds to operate after formation. Proposed rule 6c-11 specifically provides for relief through the following common exemptions, which are unique to ETFs:

  • Issuance of "Redeemable Securities": Individual ETF shares are not redeemable securities and are not bought back by the fund at their daily net asset value ("NAV").2 Currently, ETFs must apply for exemption to be permitted to redeem shares only in creation unit aggregations. Proposed rule 6c-11 would deem an individual equity security issued by an ETF to be a "redeemable security," even though ETF shares are issued and redeemed only in creation unit aggregations. This provision would permit an ETF to register with the SEC as an open-end fund, which the Act defines as an investment company that issues redeemable securities.
  • Trading of ETF Shares at Negotiated Prices: The 40 Act prohibits a dealer from selling a redeemable security that is being offered currently to the public by or through an underwriter, except at a current public offering price described in the fund prospectus. ETF shares are both traded on the secondary market and offered through an underwriter. Therefore, ETFs are currently required to obtain an exemption because ETF shares trade in the secondary market at current market prices, and not at the current offering price described in the fund prospectus or based on the NAV of the fund itself at the close of each trading day. The proposed rule would exempt a dealer in ETF shares from the 40 Act prohibitions regarding purchases, sales and repurchases of ETF shares in secondary market transactions at current market prices.
  • In-Kind Transactions between ETFs and Certain Affiliates: Purchases and redemptions of ETF creation units are typically in-kind rather than cash transactions. Because of the 40 Act's self-dealing prohibitions, an affiliated person of a registered investment company is generally prohibited from selling any security to or purchasing any security from the fund. As a matter of course, an exemption is now required to allow these affiliates to participate. The proposed rule, however, would allow such ETF affiliates to purchase and redeem creation units through in-kind transactions because such affiliates are not treated differently from non-affiliates when engaging in purchases and redemptions of creation units. Therefore, there is no opportunity for these affiliated persons to effect a transaction detrimental to the other ETF shareholders.
  • Additional Time for Delivering Redemption Proceeds: A registered open-end investment company is generally prohibited from delaying the right of redemption more than seven days after the tender of a security. This prohibition has caused problems for some ETFs that track foreign indexes because of local market delivery cycles for transferring foreign securities to redeeming investors and local market holiday schedules. Under the proposed rule, ETFs would be exempt from the prohibition and allowed 12 calendar days to satisfy the redemption if they disclose the foreign holidays expected to prevent timely delivery of, and the maximum number of days anticipated to deliver, the foreign securities.
  • Actively Managed ETFs: Upon application, proposed rule 6c-11 would provide an exemption for an actively managed ETF that discloses on its Internet website each business day the identities and weightings of the component securities and other assets held by the ETF, while the security holders of the ETF would still have the advantage of the typical 15-second intervals of intraday values. This rule is intended to help promote actively managed ETFs with fully transparent portfolios.

Disclosure Amendments – To promote fair and honest securities markets, the securities laws require significant disclosure by securities issuers to their potential investors. Among other requirements, the 40 Act requires certain disclosure, such as the continuous delivery of prospectuses to investors in open-end funds, including ETFs, which perpetually offer their securities to the public.

In its proposed rules, the SEC makes several amendments to Form N-1A to accommodate its use by ETFs and meet the needs of all investors who purchase shares in secondary market transactions, rather than financial institutions purchasing creation units directly from the ETF.

Organization as an Open-end Investment Company

Proposed rule 6c-11 would be available only to ETFs organized as open-end funds. The SEC believes that ETF sponsors prefer the open-end fund structure because it allows greater investment flexibility (including flexibility in reinvesting dividends received on portfolio investments).

Conditions

The SEC provides for certain additional conditions under which the ETF must conduct its business to take advantage of the exemptions that the proposed rule would provide. First, for each business day, the fund must clearly disclose the composition of the securities and assets held by the fund or state that it has an investment objective of obtaining returns corresponding to the returns of a specified securities index. While the exchange on which the fund's shares are traded typically provides a regular intraday value of such shares at 15-second intervals,3 such an arrangement is not required. The proposed rule would, however, require the shares to be listed on a national securities exchange that provides such Intraday Value. In addition, the ETF must not advertise as an open-end fund or mutual fund, and must explain that the shares are not individually redeemable in order to prevent retail investors from confusing ETFs with traditional mutual funds.

Footnotes

1 Congress concluded that disclosure was not an adequate remedy or deterrent for the abuses uncovered.

2 A redemption feature is necessary because the sale of the shares into the secondary market mimics the redemption feature at the investor level.

3 This value is commonly known as the "Intraday Value."

Appendix

Introduction to ETFs

ETFs offer public investors an undivided interest in a pool of securities and other assets, and thus are similar in many ways to traditional mutual funds, except that ETF shares can be bought and sold throughout the day on an exchange through a broker-dealer. ETF shares represent an undivided interest in the asset portfolio held by the fund, and ETFs are organized either as open-end investment companies1 or unit investment trusts.

To form an ETF, a market maker, specialist or large institutional investor becomes a fund's authorized participant (who may in some cases also be the sponsor) by signing a participation agreement with a sponsor. The authorized participant then transfers to the ETF a predefined "basket" of securities that mirror the ETF's portfolio in exchange for shares of a creation unit2 of the ETF, typically between 10,000 and 1 million (but most commonly 50,000) ETF shares.

The individual ETF shares making up the creation unit are registered and traded on a national exchange. Investors cannot redeem individual shares with the ETF directly and may only trade such shares through the exchange at their market value. Large institutional investors, however, may call for in-kind redemption3 at the NAV of a creation unit, but only if such investor holds the number of ETF shares that comprises a whole creation unit.4

Index-Based ETFs – The earliest ETFs, which were first developed in the early 1990s, were pegged to a specific index on a publicly traded securities exchange.5 These funds continue to exist in many forms, holding a portfolio that reflects an index or segment of an index, such as the S&P 500 (commonly referred to as "SPDRS"), the Dow Jones Industrial Average (known as "DIAMONDS"), and the NASDAQ 100 Index (called the "NASDAQ 100 Trust"). Today, however, ETFs have evolved to track the performance of a wide variety of other indexes, foreign and domestic, that may be created specifically for a particular ETF (e.g., commodities, such as precious metals). The ETFs' intended business strategy is to provide returns corresponding to the price and dividend yield of the specific index with which they are associated.

Each exchange on which the ETF shares are listed typically discloses an approximation of the current value of the basket on a per-share basis at 15-second intervals throughout the day, i.e., the Intraday Value, and indexbased ETFs also disseminate the current value of the relevant index. Such disclosure is intended to allow investors to determine the NAV of an ETF's creation units at practically any moment throughout the trading day, and decide whether to purchase or redeem creation units, based on the relative values of the ETF shares in the secondary market and the securities contained in the ETF's portfolio.

Actively Managed ETFs – Actively managed ETFs are formed and operate in the same manner as index-based ETFs. However, unlike index-based ETFs, an actively managed ETF does not seek to track the return of a particular index (e.g., S&P 500). Instead, the ETF's investment adviser, like an adviser to any traditional actively managed mutual fund, generally selects securities consistent with the ETF's investment objectives and policies without regard to a corresponding index.

Footnotes

1 An open-end investment company is defined as an investment company that issues redeemable securities. See 15 U.S.C. 80a-5(a)(1).

2 A creation unit is a set of shares or securities that make up one unit of a fund held by the trust underlying the ETF. One creation unit is the denomination of underlying assets that can be redeemed for a certain number of ETF shares.

3 Direct redemption with the ETF may only be made through in-kind redemptions, and not in exchange for cash.

4 Any investor holding the requisite number of ETF shares may redeem those shares with the ETF directly. An individual, however, would rarely have the ability to hold the number of ETF shares required to have the right to redeem.

5 The funds discussed above are "investment companies" (as defined in the 40 Act) because they issue securities and are, or propose to be, primarily engaged in the business of investing in securities, rather than in commodities. Although other types of ETFs invest in commodities, such commodities-based ETFs do not meet the definition of an investment company, and therefore are not subject to the SEC's proposed rule.

This article is presented for informational purposes only and is not intended to constitute legal advice.