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Nov 26, 2019

A Summary: Changes to Exemptive Relief and Disclosure Requirements under the New ETF Rule

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On September 26, 2019, the Securities and Exchange Commission (the SEC) adopted a final rule under the Investment Company Act of 1940 (the “Investment Company Act”) that will enable most exchange-traded funds (“ETFs”) to operate without an exemptive order, subject to various conditions (“Rule 6c-11”).[1] Among other things, Rule 6c-11 will rescind certain exemptive orders that it issued previously to ETFs and ETF sponsors, replace those orders with a standard ETF framework and establish new disclosure requirements for ETFs that rely on the rule.

Here, we summarize the highlights of Rule 6c-11 and also summarize the new disclosure requirements that will apply to ETFs.[2]

On October 24, 2019, the Federal Register published Rule 6c-11, which will become effective December 23, 2019. The compliance date for the amendments to Form N-1A is December 22, 2020, one year following the effective date.

Rescission of Prior Exemptive Orders

Rule 6c-11 rescinds, one year after its effective date, portions of certain ETF exemptive orders that granted relief related to ETF formation and operation. In turn, Rule 6c-11 provides ETFs that fall within its scope exemptive relief from the Investment Company Act that is commensurate with the relief granted by the SEC’s prior exemptive orders.

Treatment of ETF Shares as “Redeemable Securities”

The SEC’s exemptive orders provided a specialized understanding of ETFs that fit their operations but varied from the otherwise strict definitions of “redeemable security” and “open-end company,” as defined in Section 2(a)(32) and Section 5(a)(1) of the Investment Company Act. Rule 6c-11 codifies this approach by defining an ETF to mean a registered open management company (a) that issues (and redeems) creation units to (and from) authorized participants in exchange for a basket and a cash balancing amount, if any, and (b) whose shares are listed on a national securities exchange and traded at market-determined prices. This definition effectively accepts ETFs as a version of “open-end” funds permitted to issue “redeemable securities” (redeemable on demand but only in connection with the creation unit process).

In addition, the rules under the Securities Exchange Act of 1934 (the “Exchange Act”) that apply to transactions in redeemable securities issued by an open-end fund will apply to ETFs relying on Rule 6c-11. Thus, shares issued by all ETFs (i.e. those that rely on Rule 6c-11 and those that cannot) will be eligible for the “redeemable securities” exceptions in Rules 101(c)(4) and 102(d)(4) of Regulation M and Rule 10b-17(c) under the Exchange Act in connection with secondary market transactions in ETF shares and the creation or redemption of creation units. ETFs relying on Rule 6c-11 similarly will qualify for the “registered open-end investment company” exemption in Rule 11d1-2 under the Exchange Act.

ETFs that cannot Rely on the Rule

ETFs structured as unit investment trusts (UITs) cannot rely on the rule and must continue to rely on an exemptive order. Similarly, Rule 6c-11 includes a condition that excludes leveraged and inverse ETFs. These types of ETFs may not rely on the rule, and will instead continue to rely on exemptive orders.

Trading of ETF Shares at Market-Determined Prices

ETFs that register under the Investment Company Act normally obtain exemptions from Section 22(d) and Rule 22c-1, which prohibit selling redeemable securities at prices other than those described in the prospectus or based on the net assets value (the NAV). Consistent with the SEC’s prior exemptive orders, Rule 6c-11 will codify those same exemptions, enabling secondary market trading of ETF shares at market-determined prices.

Affiliated Transactions

Rule 6c-11 will exempt ETFs from the restrictions contained in sections 17(a)(1) and (a)(2) of the Investment Company Act regarding the deposit and receipt of baskets by a person who is an affiliated person of an ETF (or who is an affiliated person of such a person) solely by reason of: (i) holding with the power to vote 5% or more of an ETF’s shares; or (ii) holding with the power to vote 5% or more of any investment company that is an affiliated person of the ETF. This relief is again consistent with the relief that the SEC has granted to ETFs under prior exemptive orders.

Additional Time for Delivering Redemption Proceeds

Rule 6c-11 will exempt ETFs from the redemption requirements of Section 22(e) of the Investment Company Act, allowing ETFs to delay satisfaction of a redemption request for more than seven days in the case of certain foreign investments for which a local market holiday or extended delivery cycles of another jurisdiction make timely delivery unfeasible. Pursuant to this exemption, an ETF must deliver foreign investments as soon as practicable, but in no event later than 15 days after the tender to the ETF. Rule 6c-11 does not provide a sunset provision to limit the relief from Section 22(e) to 10 years from the rule’s effective date, as was contemplated when the rule was proposed.

Other Key Provisions

Index-Based ETFs Versus Actively Managed ETFs

The rule eliminates the distinction between index-based ETFs and actively managed ETFs for purposes of regulation. The rule also does not include additional conditions relating to index-based ETFs with affiliated index providers (self-indexed ETFs).

Baskets

The rule will require ETFs to adopt and implement written policies and procedures governing the construction of all basket assets (meaning the portfolio of assets that will underlie a creation unit’s creation or redemption) and the process that the ETFs will use for acceptance of basket assets.

In a departure from current practices, ETFs that rely on the rule would be permitted the flexibility to use “custom baskets” when creating creation units and redemption units, provided they comply with established procedures.

Custom baskets include baskets that do not reflect (i) pro rata representation of the ETF’s portfolio holdings, (ii) a representative sampling of the ETF’s portfolio holdings or (iii) changes due to rebalancing or reconstitution of the ETF’s securities market index, if applicable. Moreover, if an EFT uses different baskets in transactions on the same business day, each basket after the initial basket would be a custom basket.

Policies and procedures maintained for ETFs that use custom baskets must:

  • Set 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.

Registration Statement and Website Disclosures

The rule makes a variety of changes to how specific matters for an ETF are addressed in its disclosures. The chart at the end of this alert compares the rule’s disclosure requirements with existing requirements for ETFs.

Our Take

Going forward, ETFs should evaluate their compliance policies, as well as disclosures in ETF prospectuses and statements of additional information to ensure that they are appropriate when Rule 6c-11 becomes fully effective. The following chart summarizes some of the disclosure requirements mandated by Rule 6c-11.

SUMMARY OF AMENDMENTS TO FORM N-1A AND ETF WEBSITE DISCLOSURE

EFFECTIVE DATE: DECEMBER 23, 2019
COMPLIANCE DATE: DECEMBER 22, 2020

 

CURRENT PROVISIONS

AMENDMENTS

AMENDMENT DETAILS

Item 3

Currently, this item requires disclosure indicating only that the table describes fees and expenses investors may pay if they buy and hold shares of the fund.

Addition of “Selling”.
Adds the term “selling” to current narrative disclosure requirements to clarify that the fees and expenses reflected in the expense table may be higher for investors if they buy, hold, and sell shares of the fund.

 

Item 3

 

Fee Disclosure.
Adds a requirement to include a statement that investors may be subject to other fees not reflected in the table, such as brokerage commissions and fees to financial intermediaries.

 

Item 6

 

Expense Disclosure.
Requires an ETF to provide narrative disclosure identifying specific costs associated with buying and selling ETF shares and directing investors to its website for additional information.

Permits an ETF to use formats other than Q&As to present the required information.
Moves the narrative disclosures regarding trading costs to Item 6 of Form N-1A, which provides investors with information regarding the purchase and sale of fund shares.
Requires an ETF to state that an investor may incur costs attributable to the bid-ask spread.
Requires that an ETF’s summary prospectus or summary section cross-reference the ETF’s website.

Items 6, 11 and 27

Website Disclosure Requirements.
Rule 6c-11 will require the following information to be disclosed publicly and prominently on the ETF’s website:

NAV per share, market price and premium or discount, each as of the end of the prior business day;

a line graph showing ETF share premiums or discounts for the most recently completed calendar year and the most recently completed calendar quarters since that year (or the life of the ETF, if shorter);

a table showing the number of days the ETF’s shares traded at a premium or discount during the most recently completed calendar year and the most recently completed calendar quarters since that year (or the life of the ETF, if shorter);

information regarding persistent (i.e. more than seven consecutive trading days) premium or discount of greater than 2%; and

median bid-ask spread over the most recent thirty calendar days.

Median Bid-Ask Spread Disclosure.
ETF relying on rule 6c-11:
Are required to disclose only median bid-ask spread on its website.

 

ETF not relying on rule 6c-11:
Are required to provide the ETF’s median bid-ask spread for its most recent fiscal year in its prospectus; or
Are required to comply with the bid-ask spread website disclosure requirements under rule 6c-11 (i.e. an ETF must disclose its median bid-ask spread for the most recent thirty calendar days on its website).

Adopts a lookback period of the ETF’s most recent fiscal year for the prospectus bid-ask spread disclosure requirement.

Items 6, 11 and 27 Website Disclosure Requirements.

Rule 6c-11 will require the following information to be disclosed publicly and prominently on the ETF’s website:

NAV per share, market price and premium or discount, each as of the end of the prior business day;

a line graph showing ETF share premiums or discounts for the most recently completed calendar year and the most recently completed calendar quarters since that year (or the life of the ETF, if shorter);

a table showing the number of days the ETF’s shares traded at a premium or discount during the most recently completed calendar year and the most recently completed calendar quarters since that year (or the life of the ETF, if shorter);

information regarding persistent (i.e. more than seven consecutive trading days) premium or discount of greater than 2%; and

median bid-ask spread over the most recent thirty calendar days.
Median Bid-Ask Spread Disclosure.
ETF relying on rule 6c-11:
Are required to disclose only the median bid-ask spread on its website.

ETF not relying on rule 6c-11:
Are required to provide the ETF’s median bid-ask spread for its most recent fiscal year in its prospectus; or
Are required to comply with the bid-ask spread website disclosure requirements under rule 6c-11 (i.e. an ETF must disclose its median bid-ask spread for the most recent thirty calendar days on its website).

Adopts a lookback period of the ETF’s most recent fiscal year for the prospectus bid-ask spread disclosure requirement.

Items 11 and 27

Item 11(g)(2) currently requires an ETF to provide a table showing the number of days the market price of the ETF’s shares was greater/less than the ETF’s NAV per share (i.e. premium/discount) for the most recently completed calendar year.
Item 27(b)(7)(iv) currently requires an ETF to include a table with premium/discount information for the five most recently completed fiscal years in its annual reports.
ETFs are currently permitted to omit both disclosures by providing the premium/discount information required in Item 11(g)(2) on their websites.

Premium and Discount Disclosure.
ETFs relying on rule 6c-11:
Are excluded from premium and discount requirements in Items 11(g)(2) and 27(b)(7)(iv).
ETFs not relying on rule 6c-11:
Are required to include premium and discount information required in Items 11(g)(2) and 27(b)(7)(iv) in both the prospectus and annual report, unless it chooses to comply with certain website disclosure requirements under rule 6c-11.

 

Item 6

Currently, this item requires an ETF to specify the number of shares it will issue or redeem in exchange for the deposit or delivery of basket assets.

No Disclosure of Creation Unit Size.
Removes the requirement that an ETF specify the number of shares it will issue or redeem in exchange for the deposit or delivery of basket assets.

 

Items 6 and 11

Item 6(c)(ii) currently requires an ETF issuing shares in creation units of less than 25,000 to disclose the information required by Items 6(a) and (b).
Items 6(a) and (b) require a fund to (1) disclose the minimum initial or subsequent investment requirements; (2) disclose that the shares are redeemable; and (3) describe the procedures for redeeming shares.
Item 11(g)(1) currently provides that an ETF may omit information required by Items 11(a)(2), (b) and (c) if the ETF issues or redeems shares in creation units of not less than 25,000 shares each.
Item 11(a) requires a fund to disclose when calculations of NAV are made and that the price at which a purchase or redemption is effected is based on the next calculation of NAV after the order is placed.
Items 11(b) and (c) require a fund to describe the procedures used when purchasing and redeeming the fund’s shares.

No Specific Disclosure for Smaller Creation Units.
Eliminates disclosure requirements that apply only to ETFs with creation unit sizes of less than 25,000 shares.

 

   

Footnotes

[1]   Investment Company Act Rel. No. 33646, Final Rule – Exchange Traded Funds.
[2]  Read our previous alerts on this topic:

Authors and Contributors

John Adams

Partner

Investment Funds

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+44 20 7655 5740

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Jay G. Baris

Partner

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Lorna Xin Chen

Partner

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John (Sean) Finley

Partner

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+1 212 848 4346

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Laura Friedrich

Partner

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+1 212 848 7411

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Nathan Greene

Partner

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+1 212 848 4668

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Paul Schreiber

Of Counsel

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Thomas Majewski

Counsel

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Sean Murphy

Counsel

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Ted Randolph

Counsel

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Matthew Kutner

Associate

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