The U.S. Securities and Exchange Commission adopted a new rule under the Investment Company Act of 1940 that will allow exchange-traded funds that satisfy certain standardized conditions to operate without first obtaining individual exemptive relief.1 At the same time, the SEC adopted related form amendments and issued conditional exemptive relief from certain provisions of the Securities Exchange Act of 1934 with respect to transactions in shares of ETFs that rely on the rule.2 Taken together, the Commission actions simplify and modernize the regulatory framework governing ETFs and provide ETFs greater operational flexibility than exists under exemptive relief issued in recent years.
Despite the popularity of the ETF product structure, ETFs currently operate pursuant to individual exemptive orders, the terms of which have varied over time. Rule 6c-11 under the 1940 Act (ETF Rule) and the related form amendments (Form Amendments) according to the SEC, are “designed to create a consistent, transparent, and efficient regulatory framework for ETFs … and to facilitate greater competition and innovation among ETFs.” Key features of the SEC rulemaking and related actions include the following:
- Custom Baskets. ETFs that rely on the ETF Rule are permitted to use “custom baskets” (creation and redemption baskets that do not correspond pro rata to holdings or that differ from other baskets used that business day) provided that they adopt certain policies and procedures that address, in detail, the use of such custom baskets.
- Daily Holdings Disclosure. The ETF Rule eliminates distinctions that exist between index-based and actively managed ETFs under existing exemptive relief. Accordingly, all ETFs (whether index-based or actively managed) that rely on the ETF Rule are required to disclose their portfolio holdings on a daily basis.
- Classification of ETF Shares as “Redeemable Securities”. Existing exemptive orders provide exemptions from certain definitions to permit ETFs to redeem shares in creation unit aggregations, rather than on an individual basis. The ETF Rule instead classifies shares of ETFs as “redeemable securities,” making certain Exchange Act rule exceptions available to such ETFs. Significantly, the Adopting Release provides that shares of all ETFs, whether or not they rely on the ETF Rule, are considered “redeemable securities” for purposes of relying on these exceptions.
- Bid-Ask Spread Disclosures. Although required bid-ask disclosure is not as extensive as originally proposed, an ETF that relies on the ETF Rule is required to disclose its median bid-ask spread over the past 30 days on its website. In addition, the Form Amendments require certain narrative disclosure regarding trading costs, as well as prospectus or website disclosure of median bid-ask spread information by ETFs that do not rely on the ETF Rule.
- Rescission of Exemptive Relief. Existing exemptive relief relating to ETFs eligible to rely on the ETF Rule (Eligible ETFs) will be rescinded one year after the effective date of the rule. However, the ETF Rule does not rescind existing exemptive relief for ETFs that are ineligible to rely on the ETF Rule, nor does it rescind exemptive relief contained in ETF exemptive orders permitting certain investments in an ETF in excess of the limits set forth in Section 12(d)(1) of the 1940 Act (Fund of Funds Relief). Notably, the Adopting Release provides that ETFs that rely on the ETF Rule and do not have Fund of Funds Relief may enter into fund of funds arrangements in accordance with the conditions of recent ETF exemptive orders, until the effective date of a new SEC rule permitting registered funds to invest in other funds in excess of the Section 12(d)(1) limits (including Rule 12d1-4, if adopted).
- Exchange Act Relief. As noted above, classification of ETF shares as redeemable securities automatically makes certain exceptions from Exchange Act rules available to ETFs. In addition, the SEC issued conditional exemptive relief from certain provisions of the Exchange Act to broker-dealers and other market participants engaged in certain transactions with respect to shares of ETFs relying on the ETF Rule (Exchange Act Relief). This relief is largely provided currently in a series of “class letters” and is subject to conditions that could have limited the flexibility otherwise afforded by the ETF Rule. The Exchange Act Relief eliminates certain conditions of existing relief and further harmonizes the regulatory framework for ETFs. However, unlike the SEC’s interpretation of “redeemable securities,” the Exchange Act Relief extends only to ETFs that rely on the ETF Rule.
The ETF Rule, the Form Amendments and the Exchange Act Relief will become effective 60 days after publication in the Federal Register. As existing exemptive relief for Eligible ETFs will be rescinded one year from that date, such ETFs will need to come into compliance with the ETF Rule by that time. The compliance date for the Form Amendments is one year following their effective date.
Footnotes
1) See Exchange-Traded Funds, SEC Rel. No. IC-33646 (Sept. 25, 2019) (Adopting Release).
2) See SEC Rel. No. 34-87110 (Sept. 25, 2019).
