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.
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.
In proposing the rule, the SEC considered a number of issues, including conditions currently required in existing exemptive orders. These issues include:
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.
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.
The proposed rule would not apply to share class ETFs.
The proposed rule would extend to ETFs structured as master-feeder funds, but those with existing orders would be grandfathered.
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) under the 1940 Act related to fund of funds arrangements involving ETFs.
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.
The SEC requested comments within 60 days after publication in the Federal Register.
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 field for most ETFs and ultimately reduce costs and improve transparency in the market place.