On June 28, 2018, the SEC issued a proposed new rule under the Investment Company of 1940 (the 1940 Act)— Rule 6c-11—that would permit exchange-traded funds (ETFs) that satisfy certain conditions to launch and operate without first obtaining an individualized exemptive order from the SEC. In connection with proposed Rule 6c-11, the SEC proposed to rescind certain exemptive orders that have been granted to ETFs that could rely on the proposed rule. The SEC also issued proposed amendments that would require additional prospectus and/or website disclosure of information concerning ETF trading costs, including as to bid-ask spreads and premiums and discounts from the ETF’s net asset value. At present, ETFs require specific exemptive relief from various provisions of the 1940 Act to operate. To date the SEC has granted more than 300 such orders, many with inconsistent terms and conditions. According to the proposing release, the proposed rule and amendments are “designed to create a consistent, transparent, and efficient regulatory framework for ETFs and to facilitate greater competition and innovation among ETFs.”
Highlights of the SEC’s ETF rule proposal and amendments are as follows:
- Custom baskets permitted. In order to facilitate efficient ETF operation and, in view of differences in exemptive order terms among ETF sponsors, to level the playing field, Rule 6c-11 would provide flexibility with respect to the use of “custom baskets,” i.e., baskets that are composed of a non-representative selection of the ETF’s portfolio holdings (e.g., baskets that do not reflect a pro rata representation or representative sampling of the ETF’s portfolio holdings), or different baskets used in transactions on the same business day. The proposed rule would provide an ETF with the option of using custom baskets if it has adopted and implemented policies and procedures that “(i) set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, including the process for any revisions to, or deviations from, those parameters; and (ii) specify the titles or roles of the employees of the ETF’s investment adviser who are required to review each custom basket for compliance with those parameters.”
- No distinction between index-based and actively managed ETFs. As part of the effort to simplify the regulatory framework governing ETFs, ETFs that are able to rely on Rule 6c-11 would be subject to the same conditions, regardless of whether the ETF is index-based or actively managed. The SEC stated that it believes index-based and actively managed ETFs that comply with the proposed rule’s conditions function similarly with respect to operational matters, despite different investment objectives or strategies, and do not present significantly different concerns under the provisions of the 1940 Act from which the proposed rule grants relief.
- Full portfolio transparency required. The proposed rule would require an ETF to disclose prominently on its website the portfolio holdings that will form the basis for the next calculation of its net asset value per share. This disclosure must be made each business day before the opening of regular trading on the primary listing exchange of the ETF’s shares and before the ETF starts accepting orders for the purchase or redemption of creation units. In this regard, the SEC is seeking comment on whether it should consider exemptions for ETFs with non-transparent or partially transparent portfolios in connection with the proposed rule.
- Additional disclosure requirements. In addition to the portfolio holdings information, the SEC is proposing to require ETFs to disclose on their websites information regarding a published basket that will apply to orders for the purchase or redemption of creation units each business day, the median bid-ask spread for the ETF’s most recent fiscal year and certain historical information about the extent and frequency of an ETF’s premiums and discounts. In addition, proposed form amendments would require additional specific disclosure regarding ETF trading information and related costs formatted as a series of questions and answers.
- No Intraday Indicative Value requirement. One of the standard conditions currently required for operation of an ETF is dissemination of Intraday Indicative Value (IIV).1 However, the SEC is not proposing to require the dissemination of an ETF’s IIV as a condition of the proposed rule because, as stated in the proposing release, the SEC understands that IIV is no longer used by market participants when conducting arbitrage trading. Moreover, the proposing release notes that “IIV also may not reflect the actual value of an ETF that holds securities that do not trade frequently.” In view of the foregoing, as well as the condition under proposed Rule 6c-11 requiring daily disclosure of portfolio holdings, the SEC stated that it did not believe an IIV requirement would be necessary.
- Effect of proposed Rule 6c-11 on prior exemptive orders. The SEC is proposing to amend and rescind the exemptive relief issued to ETFs that would be permitted to rely on the proposed rule. The proposed rescission of orders would be limited to the portions of an ETF’s exemptive order granting relief with respect to an ETF’s formation and operation.
- Leveraged and inverse ETFs and ETFs organized as UITs or as a share class of an open-end fund not covered by proposed rule. ETFs that seek to provide returns that exceed the performance, or returns that have an inverse relationship to the performance, of a market index by a specified multiple over a fixed period—i.e., leveraged and inverse ETFs—would not be permitted to operate under the proposed rule. Similarly, ETFs organized as unit investment trusts (UIT ETFs) would not be able to rely on the proposed rule; rather, proposed Rule 6c-11 would be available only to ETFs that are organized as open-end funds.2 In addition, ETFs that are structured as a share class of a multiple-class open-end fund would not be included in the scope of the proposed rule.
The SEC requests comment on all aspects of the proposed rule and disclosure amendments, including with respect to, among other things, the scope of the proposed rule (e.g., whether leveraged or inverse ETFs should be covered by the rule) and whether the SEC should create a new registration form specifically designed for ETFs.
Members of Vedder Price’s Investment Services Group plan to publish a detailed analysis of the SEC’s ETF rule proposal and amendments in the near future.
Comments on the proposal and amendments will be due 60 days after the date of publication of the SEC’s proposing release in the Federal Register.
The SEC’s proposing release is available at: https://www.sec.gov/rules/proposed/2018/33-10515.pdf
1 As noted in the proposing release, exchanges, such as NYSE Arca, have their own requirements for dissemination of an ETF’s IIV.
2 Under the SEC’s proposal, UIT ETFs would continue to be regulated pursuant to their exemptive orders, rather than a rule of general applicability. The proposing release noted that the “vast majority of ETFs currently in operation are organized as open-end funds.”
