SEC’s Proposed Rule 6c-11 Would Level the ETF Playing Field

The Securities and Exchange Commission on June 28, 2018 proposed a long-anticipated rule that would allow most exchange-traded funds (ETFs) to operate and come to market without applying for individual exemptive orders. If adopted as proposed, rule 6c-11 would amend and rescind the exemptive relief issued to ETFs that would be permitted to rely on the proposed rule.

The SEC carved out leveraged ETFs from the exemptive rule proposal. That is, ETFs that seek, directly or indirectly, to provide returns that exceed the performance of a market index by a specified multiple or to provide returns that have an inverse relationship to the performance of a market index (“negative-beta” ETFs) could not rely on the exemptive rule, and would continue to rely on existing orders.

Background

ETFs currently cannot legally operate under the Investment Company Act of 1940 (the 1940 Act) without an SEC order exempting them from certain provisions of the 1940 Act. Among other things, ETFs can issue and redeem shares only in transactions with “authorized participants” and then only in large units called “creation units.” Retail investors can only buy and sell their shares on a securities exchange at the market price, which would violate the 1940 Act requirement that they be able to redeem their shares directly with the fund at the next-determined net asset value.

The SEC issued its first exemptive order for an ETF in 1992. Since then, the SEC has issued more than 300 exemptive orders to registered ETFs that now have approximately $3.4 trillion in total net assets, representing approximately 15% of the total net assets of registered investment companies.

The SEC first proposed rule 6c-11 in 2008 just prior to the global financial crisis, which caused the SEC to redirect its resources to more pressing matters. Over the next decade, the size and complexity of ETFs grew, leading to more variations in the hundreds of ETF exemptive orders it issued.

Conditions

In proposing the rule, the SEC considered a number of issues, including conditions currently required in existing exemptive orders. These issues include:

• Issuance and redemption of shares. ETFs must issue (and redeem) creation units to (and from) authorized participants in exchange for baskets and a cash balancing amount (if any).
• Listing on a national securities exchange. ETFs must list their shares on a national securities exchange, where the shares are traded at market-determined prices. Exchange-listing is one of the fundamental characteristics that distinguishes an ETF from other types of open-end funds (and UITs) and is one reason that ETFs need certain exemptions from the 1940 Act and the rules thereunder.
• Intraday indicative value. Exchange listing standards now require ETFs to maintain an intraday estimate of an ETF’s NAV per share (an “intraday indicative value” or “IIV”) and to widely disseminate the IIV at least every 15 seconds during regular trading hours (60 seconds for international ETFs). The published IIV allows investors to determine whether and to what extent the ETF’s shares are trading at a premium or discount. The SEC did not propose to require the dissemination of an ETF’s IIV as a condition of the proposed rule, because market makers typically calculate their own IIVs.
• Portfolio holdings. The SEC relies on the existence of an arbitrage mechanism to keep the market prices of ETF shares at or close to the NAV per share of the ETF. Effective arbitrage requires daily portfolio transparency, which provides authorized participants and other market participants the ability to value the ETF’s portfolio intraday. For this reason, the rule would require an ETF to disclose on its website its portfolio holdings each day before the market opens and before it starts accepting orders for purchase and redemption of creation units. Portfolio transparency allows authorized participants to assess whether arbitrage opportunities exist and to hedge the ETF’s portfolio. Hedging is important because market makers generally trade to provide liquidity, balance supply and demand, and profit from arbitrage opportunities (without necessarily seeking to profit from taking a directional position in a security).
• Baskets. The rule would require ETFs to adopt and implement written policies and procedures governing the construction of baskets and the process that would be used for the acceptance of baskets. The rule would require ETFs to post on their websites information regarding a published basket at the beginning of each business day, as well as the estimated cash balancing amount if any.

  The proposed rule would define “custom baskets” as (i) baskets that are composed of a non-representative selection of the exchange-traded fund’s portfolio holdings; or (ii) different baskets used in transactions on the same business day. ETFs could create “custom baskets” if they adopt additional written policies and procedures concerning their use and acceptance.

• Website disclosure. The rule would contain a condition requiring ETFs to disclose certain information on their websites.
  • Daily NAV, market price, and premiums and discounts. ETFs would be required to post on their websites, on each business day, the ETF’s current NAV per share, market price and premium or discount, each as of the end of the prior business day, to provide a “snapshot” of the difference between an ETF’s NAV per share and market price on a daily basis.
  • Bid-ask spread disclosures. The SEC would amend Form N-1A to require an ETF to disclose information regarding bid-ask spreads on its website and in its prospectus. Specifically, an ETF would be required to disclose the median bid-ask spread for the ETF’s most recent fiscal year.
  • Historical information regarding premiums and discounts. The SEC also proposes to require that ETFs disclose on their websites historical information about the extent and frequency of an ETF’s premiums and discounts. Specifically, an ETF would be required to post on its website both a table and line graph showing the ETF’s premiums and discounts for the most recently completed calendar year and the most recently completed calendar quarters of the current year. Alternatively, for new ETFs that do not yet have this information, the proposed rule would require the ETF to post this information for the life of the fund.

• Marketing. The SEC is not requiring a condition currently contained in exemptive orders that require an ETF to explain that, among other things, individuals can only buy and sell shares on a national securities exchange, because ETFs are now widely known and accepted in the marketplace.

Leveraged ETFs

Although the rule would not distinguish between actively managed ETFs and index-based ETFs in general, the rule would not apply to leveraged or inverse ETFs.

“We do not believe it is appropriate to permit additional leveraged ETF sponsors to form leveraged ETFs and operate under our proposed rule at this time,” the SEC said. Accordingly, it proposed a condition that would prevent leveraged and inverse ETFs from relying on proposed rule 6c-11.

For example, the proposed rule would not apply to ETFs that attempt to circumvent the leverage prohibition by tracking an index that itself provides leverage by embedding leverage or inverse leverage in the underlying index. The SEC indicated, however, that it does not intend to rescind the order of any existing leveraged ETF. In effect, the rule proposal extends the current moratorium on new leveraged and inverse ETF orders imposed by the SEC’s staff.

Share Class ETFs

The proposed rule would not apply to share class ETFs.

Master-Feeder ETFs

The proposed rule would extend to ETFs structured as master-feeder funds, but those with existing orders would be grandfathered.

Effect of Proposed Rule 6c-11 on Prior Orders

The SEC would amend and rescind orders that it issued to ETFs that can rely on the new rule. However, the SEC would limit its rescission of orders specifically to the portions of an ETF’s exemptive order that grant relief related to the formation and operation of an ETF and, with the exception of certain master-feeder relief discussed above, would not rescind the relief from section 12(d)(1) and sections 17(a)(1) and (a)(2)345 under the 1940 Act related to fund of funds arrangements involving ETFs.

Amendments to Form N-1A

The SEC proposes to amend certain disclosure requirements of Form N-1A to tailor them specifically to ETFs. For example, ETFs would be required to disclose bid-ask information in their prospectuses, which is a feature particular to ETFs.

Comments

The SEC requested comments within 60 days after publication in the Federal Register.

Our Take

Proposed rule 6c-11, long in coming, may remove a barrier to entry for new ETFs because it would eliminate the potentially long and costly application process. It would create a level playing for most ETFs and ultimately reduce costs and improve transparency in the market place.