Authored by Ethan Corey
On September 25, 2019, the Securities and Exchange Commission (SEC) adopted a new rule under the Investment Company Act of 1940 (1940 Act) as well as amendments to registration forms and data collection forms.1 New rule 6c-11 under the 1940 Act is intended to enable most transparent exchange-traded funds (ETFs), whether passive or actively managed, to operate without the need to obtain an individual exemptive order from the SEC. Amendments to Forms N-1A and N-8B-2 under the 1940 Act are intended to provide useful information to investors who purchase ETF shares in secondary market transactions. Amendments to Form N-CEN under the 1940 Act are intended to facilitate the SEC’s ability to monitor ETFs’ reliance on rule 6c-11.
If an ETF that has already obtained an exemptive order from the SEC can rely upon the rule, its exemptive order will be rescinded effective December 22, 2020, except to the extent that it received relief to purchase other funds or sell its own shares to other funds in excess of the limits found in the 1940 Act. The SEC intends to eliminate variations that have arisen among exemptive orders, so that similarly situated ETFs will be subject to the same set of rules.
Scope of ETFs Covered by Rule 6c-11
Rule 6c-11 does not cover every ETF. Non-transparent actively managed ETFs must continue to obtain individual exemptive orders. In addition, certain categories of transparent ETFs must obtain individual exemptive orders:
- ETFs Organized as Unit Investment Trusts: Existing unit investment trust (UIT) ETFs will continue to rely upon their existing exemptive orders; any new UITs must obtain their own exemptive relief.
- Leveraged/Inverse ETFs: ETFs that seek to provide leveraged or inverse investment returns over a predetermined period of time are intended to be short-term trading tools for sophisticated investors and serve a different investment purpose than most other ETFs. The SEC also intends to consider these funds’ use of derivatives in the context of its general evaluation of funds that use leverage. However, the SEC has recently proposed to amend Rule 6c-11 to encompass these ETFs.
- Share Class ETFs: An ETF structured as a separate share class of a fund that issues multiple classes of shares cannot operate in reliance on rule 6c-11. It must obtain separate exemptive relief.
- Master-Feeder ETFs: An ETF structured as a feeder that invests in a master cannot operate in reliance on rule 6c-11. It must obtain separate exemptive relief.
Great, So It Looks Like My ETF Can Rely Upon the Rule.
What Relief Does the Rule Give the ETF?
- Custom Baskets. The rule gives ETFs the ability to reserve the right to use custom baskets – baskets that contain a non-representative selection of an ETF’s portfolio holdings, or a basket used in a transaction on a business day that differs from the initial basket used.
- ETF Shares Are Treated as “Redeemable Securities”.
- How is That Different From The Old Exemptive Orders? The exemptive orders provided exemptions from the definition of “redeemable securities”.
- What are the Practical Consequences of the Shift?
- 1940 Act sections and rules that apply to mutual funds will apply to ETFs relying on the rule and to ETFs registered as management investment companies that continue to rely upon exemptive orders.
- Securities Exchange Act of 1934 (Exchange Act) rules (and rule exceptions) that apply to transactions in redeemable securities issued by a mutual fund will apply to ETFs relying on the rule and to ETFs registered as management investment companies that continue to rely upon exemptive orders.
- Related Exemptive Relief and Interpretations Under the Exchange Act. The SEC issued an exemptive order that harmonizes certain related relief under the Exchange Act. In particular, the order provides exemptive relief to broker-dealers and other persons from certain requirements under the Exchange Act with respect to ETFs relying on rule 6c-11.
- Trading of ETF Shares at Market-Determined Prices. Consistent with existing exemptive relief, the rule permits secondary market trading of ETF shares at market-determined prices. The SEC indicated that it is satisfied that the arbitrage mechanism has operated effectively to minimize the deviation between an ETF’s market price per share and its net asset value per share.
- Affiliated Transactions. The rule grants relief to enable authorized participants or other market participants that become affiliates of an ETF by virtue of holding 5% or more of the ETF’s outstanding securities or 5% or more of the outstanding securities of an affiliate of the ETF to continue to make in-kind purchases or redeem in-kind from the ETF.
- Additional Time for Delivering Redemption Proceeds. The rule grants relief to ETFs to delay meeting a redemption request in the case of certain foreign investments when a local market holiday or the extended delivery cycles of the foreign market make timely delivery impracticable – but only to the extent that additional time for settlement is actually required. Although the proposing release would have required a foreign investment not to have an established U.S. public trading market in order to qualify for the relief, the adopting release does not.
Conditions for Reliance on Rule 6c-11
Some of the more significant changes from the conditions that have developed under the existing exemptive orders are that ETFs are no longer required to disseminate intraday indicative values and have more flexibility with respect to the use of custom baskets as compared to more recent exemptive orders. Each condition is discussed in more detail below:
- Continuous Issuance/Redemption of Creation Units To/From Authorized Persons: The SEC stated that any authorized person (AP) of an ETF – a member or participant of a clearing agency registered with the Commission that has a written agreement with the ETF or one of its service providers that allows it to place orders for the purchase and redemption of creation units – must be able to exchange baskets and (if necessary) a cash balancing amount with the ETF for creation units. Creation unit, in turn, is defined as a specified number of ETF shares that the ETF will issue to (or redeem from) an AP in exchange for the deposit (or delivery) of a basket and a cash balancing amount (if any).
- Listing on a National Securities Exchange. One element of the definition of an exchange-traded fund requires that the fund’s shares: (i) be listed on a national securities exchange; and (ii) be traded at market determined prices. If an ETF ceases to be listed on an exchange, it loses its eligibility to rely upon rule 6c-11 – it must meet individual redemption requests as required by section 22(e) of the 1940 Act or liquidate.
- Intraday Indicative Value (‘‘IIV’’). Unlike the SEC’s exemptive orders, an ETF does not need to disseminate an intraday estimate of its NAV per share in order to rely upon the rule.
- Portfolio Holdings Disclosure. Rule 6c–11 will require an ETF to disclose prominently on its website, publicly available and free of charge, the portfolio holdings that will form the basis for each calculation of NAV per share.
- Timing of Portfolio Holdings Disclosure. Rule 6c–11 will require website disclosure of an ETF’s portfolio holdings on each business day before the opening of regular trading on the primary listing exchange of the ETF’s shares. However, an ETF may accept orders for the purchase or redemption of creation units before it discloses its portfolio holdings – this is intended to enable ETFs to accept creation and redemption orders shortly after the U.S. market closes (so-called “T–1 orders”).
- Presentation of Portfolio Holdings Disclosure. An ETF must disclose the ticker, CUSIP or other identifier (where applicable) of each holding, and provide a description of each holding.
- ETFs holding debt securities should include the security’s name, maturity date, coupon rate, and effective date, where applicable.
- The SEC encouraged ETFs, when disclosing the quantity of a security or other asset held, to use the measure typically associated with quantifying the particular security or asset, such as number of shares for equity securities, par value for debt securities, number of units for securities, such as UITs, that are measured in units, and dollar value for cash.
- The SEC encouraged ETFs to disclose this information on their websites.
- Portfolio Holdings That Will Form the Basis for the ETF’s NAV Calculation. Rule 6c–11 will not require ETFs to disclose intraday changes in portfolio holdings. The rule requires ETFs to disclose only those changes that would affect the portfolio composition serving as a basis for NAV calculation.
- The rule will require ETFs that rely upon the rule to adopt and implement written policies and procedures regarding:
- how baskets are constructed; and
- the process the ETF will employ in accepting baskets.
- Custom Baskets. If an ETF reserves the ability to use custom baskets,it must adopt written policies and procedures that:
- 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
- specify the titles or roles of employees of the ETF’s investment adviser who are required to review each custom basket for compliance with those parameters.
- Website Disclosure. An ETF relying upon the rule must disclose the following items of information on its website:
- NAV per share, market price, and premium or discount, each as of the end of the prior business day;
- A table and chart showing the number of days the ETF’s shares traded at a premium or discount during the most recently completed calendar year and calendar quarters of the current year;
- For ETFs with a premium or discount greater than 2% for more than seven consecutive trading days, disclosure that the premium or discount was greater than 2%, along with a discussion of the factors that are reasonably believed to have materially contributed to the premium or discount; and
- Median bid-ask spread over the most recent thirty calendar days.
- Marketing. Unlike the exemptive orders, the rule does not require ETFs to disclose in sales literature that shares are not individually redeemable or that investors may sell individual shares through a broker on a national securities exchange.
Rule 6c-11 will require ETFs relying upon the rule to maintain records of:
- agreements with each AP allowing the AP to purchase or redeem creation units; and
- the following items of information for each basket exchanged with an AP:
- ticker symbol, CUSIP or other identifier, description of holding, quantity of each holding, and percentage weight of each holding composing the basket exchanged for creation units;
- if applicable, an identification of the basket as a ‘‘custom basket’’ and a record stating that the custom basket complies with the ETF’s custom basket policies and procedures;
- cash balancing amounts (if any); and
- the identity of the AP conducting the transaction
Fund of Funds Relief
The rule will not supersede fund of funds relief granted in prior orders (relief to purchase or sell shares of other funds in excess of the limits in Section 12(d)(1) of the 1940 Act). However, a new fund relying on the rule will not enjoy the fund of funds relief in prior orders, so the SEC is granting temporary relief to new funds that parallels its most recent fund of funds exemptive relief, until it adopts a new fund of funds exemptive rule (a new rule has been proposed).
Disclosure Amendments – Form N-1A and Form N-8B-2
The amendments to Form N1A and Form N–8B–2 are intended to provide investors who purchase ETF shares in secondary market transactions with tailored information regarding ETFs, including information regarding costs associated with an investment in ETFs. The amendments to Form N–1A will:
- require new disclosure regarding ETF trading and associated costs, including bid-ask spreads;
- require ETFs that do not rely upon rule 6c–11 to disclose median bid-ask spread information on their websites or in their prospectuses; and
- exclude ETFs that provide premium/discount disclosures in accordance with rule 6c–11 from the premium and discount disclosure requirements in the form.
The disclosure amendments to Form N-8B-2, which is used by UIT ETFs, largely track those for Form N-1A.
Form N–CEN will require ETFs to report whether they are relying on rule 6c–11, to assist the SEC in determining which ETFs are relying on rule 6c–11.
While Rule 6c-11 continues to leave significant segments of the ETF universe outside its scope, it nonetheless brings a welcome degree of uniformity to ETF sponsors. The playing field for ETFs should be more level once the rule takes effect on December 23, 2019, and there should be even further uniformity once the compliance date for the form amendments of December 22, 2020 occurs. Perhaps more importantly, Rule 6c-11 will make the process of bringing a new ETF to market more predictable, as ETF sponsors will no longer be subject to the vagaries and idiosyncrasies of the exemptive application process. This should encourage the launching of new transparent ETFs, while freeing SEC staff resources to focus on exemptive applications filed by more esoteric or cutting-edge ETFs.
1Exchange-Traded Funds, Investment Company Act Rel. No. 33646 (Sept. 25, 2019), 84 FR 57162 (Oct. 24, 2019) (Adopting Release).