Growth in the ETP industry has led the SEC to seek public comment on a variety of topics related to the listing and trading of ETP shares.
On June 12, the US Securities and Exchange Commission (SEC) issued a release (the Release) requesting comment on topics related to the listing and trading of exchange-traded products (ETPs) on national securities exchanges and sales of ETPs by broker-dealers, including in their capacity as “authorized participants” that transact directly with ETPs.[1] The Release focuses solely on issues under the Securities Exchange Act of 1934 (Exchange Act), including exemptive and no-action relief and listing standards thereunder, and sets forth 53 total questions (some with subparts) for public response. The Release follows recent public comments by SEC Commissioner Kara Stein on ETPs and alternative investment products,[2] as well as the recently issued order that instituted proceedings to determine whether to approve or disapprove a rule proposal by NYSE Arca, Inc. to adopt generic listing standards for actively managed exchange-traded funds, which we discussed in a previous LawFlash.[3]
Noting that there has been tremendous growth in the number, aggregate market capitalization, and variety of ETPs in recent years,[4] and that there has been a corresponding increase in the number and complexity of requests by issuers for exemptive relief under the Exchange Act to allow shares of ETPs to be offered for sale on exchanges, the SEC is requesting comment on a number of areas. Specifically, the SEC has requested comment on (i) arbitrage mechanisms and market pricing for ETPs; (ii) exemptive and no-action relief related to trading ETPs; (iii) securities exchange listing standards for ETPs; and (iv) broker-dealer sales practices and investors’ understanding of the nature and use of ETPs.
In this LawFlash, we provide a brief overview of each of these topics and the information that the SEC appears interested in obtaining.
Arbitrage Mechanisms and Market Pricing of ETPs
Because ETPs trade at intra-day market prices rather than the ETP’s end-of-day net asset value (NAV), in granting exemptive or no-action relief under the Exchange Act, the SEC typically relies on representations made by ETP issuers regarding the continuing existence of arbitrage pricing mechanisms designed to ensure that the secondary market prices of ETP shares do not vary substantially from NAV. The SEC has found that, in practice, the deviation between the daily closing price of ETP shares and NAV has been relatively small, though some types of ETPs (such as ETPs based on international indices) have experienced relatively higher deviations.[5]
The SEC is seeking comment on “all aspects of the arbitrage mechanism for ETPs, including the nature, extent, and potential causes of premiums and discounts” on ETP secondary market pricing. For example, the SEC is requesting input on the characteristics of an ETP that facilitate or hinder the alignment of secondary market share prices with such ETP’s NAV, and the circumstances under which the ETP share prices may not track NAV. The SEC is also seeking comment on the trading of ETPs that invest in less-liquid assets, particularly during periods of market stress. In its questions, the SEC seems to be very interested in drilling down on the particular ETP characteristics that result in arbitrage pricing mechanisms working better for some ETPs than others, how institutional investors measure intraday prices of ETP portfolios, the circumstances under which an ETP might suspend creations and under which an ETP (other than an ETF) might suspend redemptions, and whether alternative methods exist to ensure that secondary market prices do not vary substantially from NAV. The SEC is also interested in learning more about exchange-traded notes (ETNs) and arbitrage opportunities tied to trading of ETNs.
Exemptive Relief and No-Action Positions under the Exchange Act
The trading of ETP shares on an exchange generally requires that the issuer obtain exemptive or no-action relief from a number of provisions of, or rules promulgated under, the Exchange Act. In general, this relief is needed because the continuous nature of the distribution of ETP securities presents conflicts under certain trading and market regulations that predate ETPs as a product type. The SEC has addressed these issues through the issuance of a series of “class letters” or, in some cases, issuer-specific relief.[6] The SEC is requesting comment relating to the exemptive and no-action relief it has granted under these provisions of the Exchange Act.
For example, Rules 101 and 102 of Regulation M generally prohibit distribution participants, issuers, selling security holders, and their affiliated purchasers from purchasing, bidding for, or attempting to induce others to purchase or bid for covered securities during the restricted period of a distribution of securities.[7] Because ETPs are generally regarded as being in continuous distribution, absent relief, the purchase of ETP shares in open market transactions by an authorized participant would violate these rules. The SEC has granted relief with respect to these rules based on an ETP issuer’s representations that the ETP arbitrage mechanism makes it difficult to manipulate distributions of ETP shares and that the ETP’s characteristics will mitigate against the types of abuses that Regulation M is intended to address. In the Release, the SEC is requesting comments on approaches for preventing manipulation of a distribution of ETP shares by persons who may have an incentive to do so.
The SEC is also requesting comment on the conditions and criteria to be considered by the SEC staff pertaining to ETPs’ exemptive and no-action relief issued in connection with Section 11(d)(1) of the Exchange Act and Rule 11d1-2 thereunder, and Exchange Act Rules 10b-10, 14e-5, 15c1-5, and 15c1-6. For example, the SEC is requesting input on the frequency with which investors request detailed confirmation information in creation and redemption transactions as provided for in the SEC’s exemptions and no-action positions under Rule 10b-10, whether ETP investors use and benefit from this information, and whether different conditions could achieve the purposes of Rule 10b-10 at less cost or burden to broker-dealers.
The current landscape for exemptive and no-action relief under these provisions of the Exchange Act is a complicated patchwork that has evolved over time as various types of new ETPs have come to market. Further, because many of these issues are not “front and center” for the ETPs themselves, but instead directly affect the broker-dealers and market makers that transact in shares of ETPs, there is a range of market practice with respect to the level of detail that ETP complexes provide to these issues. Comments provided by the market in response to the Release are expected to provide additional color on market practices that could lead to a more uniform approach on these issues.
Exchange Listing Standards
Under the Exchange Act, before ETP shares can be listed and traded on a national securities exchange, that exchange must have SEC-approved initial and continued listing standards that permit listing of that type or class of ETP.[8] The listing standards can be generic (permitting an exchange to list and trade specific ETPs without filing a product-specific proposed rule change with the SEC) or non-generic (which require the exchange to file, and the SEC to approve, a proposed rule change that is specific to that ETP).[9] The latter process, depending on the structure and strategy of the ETP at issue, can take months to gain regulatory approval (and approval may be denied) and consequently may be a deterrent to product innovation in the marketplace.
The SEC is requesting comment on whether the dual obligations of the exchanges and the SEC in determining whether the proposed listing and trading of shares of an ETP is consistent with the Exchange Act are complementary or whether they overlap. The SEC is also requesting comment on whether current exchange listing standards are effective given the increasing complexity of ETP investment strategies. For example, the SEC is seeking input on whether the exchange listing standards adequately address the use of non-exchange-listed derivatives and of leverage.
Broker-Dealer Sales Practices and Investor Understanding and Use of ETPs
Under regulations imposed by federal law and self-regulatory organizations, broker-dealers have several duties when dealing with their customers and when recommending the purchase or sale of securities by their customers.[10] These include making suitable recommendations, engaging in fair and balanced communications with the public, disclosing conflicts of interest, and receiving fair compensation both in agency and principal transactions.
The SEC is requesting comment on how investors use ETPs and the ways in which ETPs are recommended or sold to investors, particularly retail investors. In this regard, the SEC is seeking input on the extent to which individual investors buy or sell complex ETPs based on a broker-dealer’s recommendation, whether individual investors understand the nature and operation of such ETPs, and how broker-dealers meet their obligations when recommending ETPs to customers.[11] Last, the SEC is seeking input on the role investment advisers play in the purchase or sale of ETPs.
Conclusion
The inquiry into these issues indicates that the SEC and its Staff, particularly within the Division of Trading and Markets, is thinking through a number of issues about ETPs as a trading tool and considering how the influx of these new products (and variations of these new products) affects the markets and retail investors. Market participants may want to take this opportunity to more fully inform the SEC about these issues, which could result in more practical guidance or rulemaking down the road.
Comments should be submitted to the SEC by August 17, 2015. We will continue to monitor developments in this area and provide updates as necessary.
[1]. Request for Comment on Exchange-Traded Products, Securities Exchange Act Release No. 34-75165 (June 12, 2015), 80 FR 34729 (June 17, 2015) (the Release). For purposes of the Release, the SEC defines “ETPs” to collectively refer to exchange-traded funds (ETFs) that are registered as investment companies under the Investment Company Act of 1940 (1940 Act), pooled vehicles structured as trusts or partnerships that do not invest primarily in securities and are therefore not registered under the 1940 Act, and exchange-traded notes (ETNs) issued by financial institutions.
[2]. Stein, Dissenting Statement Regarding the Commission’s Order Approving a Proposed Rule Change to Adopt New Rule 5713 and List Paired Class Shares Issued by AccuShares Commodities Trust I (Feb. 23, 2015), available here; see also See Richard F. Morris, John J. O’Brien, Jeremy Esperon, “SEC Considers Active ETF Listing Standards, Approves Paired Class ETP” (Mar. 19, 2015), available here.
[3]. See W. John McGuire, Richard F. Morris, John J. O’Brien, and Jeremy Esperon, “Update on Proposed Listing Standards for ETFs” (June 15, 2015).
[4]. The Release provides significant detail on the historic growth of ETPs as a product, noting that the first ETP began trading on January 22, 1993, and as of December 31, 2014, there were 1,664 US-listed ETPs with an aggregate market capitalization in excess of $2 trillion. The SEC also points out that from 2006 to 2013, an average of more than 160 ETPs came to market per year and that the aggregate market capitalization has doubled since 2009. See Release, supra note 1 at 3-4.
[5]. With respect to ETFs investing in non-US securities, it is worth noting, however, that timing differences between the close of local market trading and the time the ETP’s NAV is calculated (typically 4:00 pm ET) are a major factor in these differences.
[6]. See, e.g., Letter from James A. Brigagliano, Assistant Director, Division of Market Regulation, to Claire P. McGrath, Vice President and Special Counsel, The American Stock Exchange, re: Exemptive Relief for Exchange Traded Index Funds (Aug. 17, 2001), available here; Letter from Josephine Tao, Division of Trading and Markets, Securities and Exchange Commission, to W. John McGuire, Morgan, Lewis & Bockius LLP, re: AdvisorShares Trust Actively-Managed ETF WCM/BNY Mellon Focused Growth ADR (June 18, 2010), available here; Letter from Joseph Furey, Division of Trading and Markets, Securities and Exchange Commission, to W. John McGuire, Morgan, Lewis & Bockius LLP, re: AdvisorShares Madrona & Meidell ETFs (June 16, 2011) (providing conditional staff no-action relief to ETFs whose portfolios consist of other diversified ETFs), available here.
[7]. 17 CFR 242.101 and 242.102.
[8]. 15 U.S.C. 78s(b) and 17 CFR 240.19b-4.
[9]. 15 U.S.C. 78s(b).
[10]. See, e.g., Exchange Act Section 15(c) and FINRA Rule 2111.
[11]. SEC Commission Kara Stein recently noted that FINRA has brought a number of cases against brokers involving the sale of leveraged and inverse ETFs to retail customers. See Stein, Dissenting Statement, supra note 2. In response to this string of enforcement actions, the industry has adopted a disclosure-based regime that regulators have not opposed.
