The SEC’s New Exchange-Traded Fund Rule

The Securities and Exchange Commission (SEC) recently adopted Rule 6c-11 under the Investment Company Act of 1940 (the “Act”), which removes the need for most exchange-traded fund (ETF) sponsors to obtain individual exemptive orders and which “levels the playing field” for many ETFs moving forward. The category of ETFs that are eligible to rely on the new rule (“Eligible ETFs”) does not include leveraged or inverse ETFs¹, nontransparent ETFs, ETFs that are structured as unit investment trusts (UITs), and ETFs that are organized as a separate class of a fund issuing multiple classes of shares representing interests in the same portfolio of securities.

The Rule is expected to lower the barriers to entry for Eligible ETFs, as they will no longer need to obtain individual exemptive orders, and removes a competitive disadvantage resulting from some ETF sponsors having older forms of the relief that provided more flexibility with respect to creation and redemption basket construction. The Rule also signals an interest on the part of the SEC to focus on more complex and novel ETF products, such as nontransparent ETFs, which will continue to require individual exemptive orders. The SEC release adopting the Rule (the “Adopting Release”) affirmatively states the SEC’s interest in engaging with ETF sponsors and investors, as well as with other market participants, regarding ETFs that are outside the scope of Rule 6c-11.

Summary of the Final Rule

ETFs have historically applied for, and upon receipt operated pursuant to, individual exemptive relief orders that exempted them from provisions of the Act. The Rule codifies many of those exemptions and uniformly applies the Rule to all Eligible ETFs, eliminating the distinctions between actively managed ETFs, passively managed ETFs that track proprietary indexes (self-indexed ETFs), and passively managed ETFs that track third-party indexes and that currently exist under current exemptive orders. The Adopting Release clarifies that the SEC believes that the existing federal securities laws and the required portfolio transparency under the Rule adequately address any special concerns that self-indexed ETFs present.

• An Eligible ETF must comply with the following conditions to rely on the Rule:
• Post daily portfolio holdings information in a standardized format on the ETF’s website before commencement of trading on the ETF’s primary listing exchange (i.e., full portfolio transparency);
• Adopt written policies and procedures governing the construction of baskets and the process of acceptance of baskets, including additional policies and procedures governing “custom baskets,” if applicable;
• Disclose certain premium, discount and bid-ask spread information on its website; and
• Maintain additional records: (a) copies of all written agreements with authorized participants and (b) information regarding baskets exchanged with authorized participants.

These conditions are based on requirements under existing exemptive orders, but the SEC modified them in certain important respects from those included in the proposed rule, as discussed in more detail below.

Full Portfolio Transparency. Each Eligible ETF must disclose the following information regarding its portfolio holdings, which must be publicly available and free of charge, on its website on each business day: (i) ticker symbol, (ii) CUSIP or other identifier, (iii) description of holding, (iv) quantity of each security or other asset held (e.g., par value for a debt security), and (v) percentage weight of the holding in the portfolio. Consistent with current ETF practices, this information must be posted on the ETF’s website prior to the opening of regular trading on the stock exchange on which an ETF has its primary listing and must be based on the portfolio holdings that will form the basis for the next net asset value (NAV) calculation. In addition, Rule 6c-11 specifically requires that the portfolio holdings be those as of the close of the prior business day. After considering comments, the SEC did not adopt the requirement that the portfolio holdings information be posted prior to the acceptance of any orders by the ETF, thus allowing for the continued use of T-1 orders. Also, the SEC did not include the requirement that the portfolio holdings information comply with Article 12 of Regulation S-X, but instead chose to streamline the required information to a subset of the information required by the listing exchanges’ generic listing standards for actively managed ETFs. This information is not required to be in a standardized format under current exemptive orders.

Basket Construction and Custom Baskets. Adopted as proposed, this condition of Rule 6c-11 requires an Eligible ETF to adopt written policies and procedures regarding the construction of creation and redemption baskets and the process that it will use to accept baskets. The Rule permits all Eligible ETFs to use “custom baskets,” provided specific custom basket policies and procedures are adopted by the ETF, which must include the following:

• Detailed parameters for the construction and acceptance of custom baskets that are in the best interest of the ETF and its shareholders;
• A process for making any changes to or deviating from the adopted parameters; and
• The roles and/or titles of personnel of the ETF’s adviser who would be responsible for reviewing each custom basket for compliance with the parameters.

Under current standard ETF exemptive orders, creation and redemption baskets must reflect the ETF’s portfolio holdings pro rata, subject to certain very limited exceptions. Older exemptive orders, however, provide much greater flexibility to vary the contents of creation and redemption baskets to manage an ETF’s portfolio more efficiently, thus creating an uneven playing field among ETFs. Rule 6c-11 removes this competitive disadvantage by permitting all Eligible ETFs to use custom baskets, provided the requirements above are met.

The Rule defines a creation or redemption “custom basket” as (a) a nonrepresentative selection of the ETF’s portfolio holdings or (b) a representative basket that differs from the initial basket used that day. In the Adopting Release, the SEC acknowledged that there are circumstances in which it could be beneficial for an ETF to use a custom basket (e.g., the ability to substitute a security), and the basket construction conditions (including for custom baskets) are intended to provide Eligible ETFs with the flexibility to address situations in which holding certain securities may be difficult or impossible while also enabling portfolio management to make changes in an efficient manner.

Basket procedures should be designed to maintain the flexibility intended by the Rule, while also addressing the potential for over-reaching by authorized participants. The Adopting Release specifically noted that the following should be included in basket policies and procedures:

• Methodology for the construction of baskets and the process used to accept each basket (including custom baskets);
• Circumstances under which the basket may omit positions that are not operationally feasible to transfer in kind;
• When and how the ETF would use representative sampling;
• How an ETF would replicate changes in its portfolio holdings because of rebalancing or reconstitution of the ETF’s underlying index;
• Approach for testing compliance with policies and procedures and, if applicable, addressing whether the parameters for custom baskets continue to result in custom baskets that are in the best interests of the ETF and its shareholders; and
• Reasonable controls designed to prevent inappropriate differential treatment among authorized participants.

The SEC clarified in the Adopting Release that it believes that the ETF’s investment adviser is in the best position to design and administer the ETF’s custom basket policies and procedures, including parameters for custom baskets that are in the best interests of the ETF and its shareholders, and to determine which of its employees would approve custom baskets for compliance with the parameters. The SEC stated that an adviser may determine that its portfolio management personnel are the appropriate personnel to be responsible for compliance with the custom basket policies and procedures. In such cases, however, the ETF’s compliance policies and procedures under Rule 38a-1 under the Act should provide safeguards against conflicts of interest that could arise. In addition, the ETF’s board of trustees would have oversight over the basket policies and procedures, like other compliance policies and procedures of the ETF, as well as general oversight of the ETF.

Finally, the Adopting Release emphasized that the custom basket policies and procedures may be tailored to each ETF’s investment strategies, risks and types of baskets—i.e., there can be different procedures depending on whether it is a creation or redemption basket or whether there is a cash or security substitution, for example.

As proposed, the Rule would have required the ETF to post one basket that it would exchange that day for creations or redemptions on its website. That is not part of the Rule as adopted. The SEC acknowledged that the utility of a published basket was limited, as market participants have access to the information through the National Securities Clearing Corporation (NSCC) or directly from the ETF. However, certain records as discussed below are required to be maintained.

Additional Website Disclosures. An ETF will be required to disclose certain information that is designed to assist shareholders in making investment and trading decisions. In particular, an ETF will be required to disclose its (a) NAV per share, market price and premium and discount, each as of end of the prior day; (ii) median bid-ask spread information calculated as of the most recent 30-day period; and (iii) historical information regarding premiums and discounts (in both table and line graph format for most recently completed calendar year and most recently completed calendar quarter).

Notably, the definition of “market price” differs from that in current exemptive orders. Rule 6c-11 defines market price as the official closing price of an ETF’s shares or, if it is more accurate, the midpoint of the national best bid and national best offer (“NBBO”) as of the time of calculation of the ETF’s NAV. The Rule also provides for a uniform median bid-ask spread calculation methodology that requires the use of the NBBO. Also, although not required under current exemptive orders, the Rule requires that ETFs trading at a premium or discount greater than two percent for more than seven consecutive trading days will be required to post a discussion of the factors that are reasonably believed to have materially contributed to the occurrence and a statement that the ETF premium or discount was greater than two percent. It will also be required to maintain that information on the ETF’s website for at least one year from the occurrence. As proposed, the Rule would also have required an interactive calculator providing customizable bid-ask spread information to be included on an ETF’s website. ETF sponsors were generally opposed to this proposed requirement, and it was not adopted by the SEC.

Required Records. The Rule requires an ETF to maintain a record of each basket exchanged with an authorized participant, which would include the name of the authorized participant and the following information regarding each holding in the basket: (1) ticker symbol, (2) CUSIP or other identifier, (3) description of holding, (4) quantity of each holding, and (5) percentage weight of each holding, as well as any cash balancing amount. In addition, if applicable, the record must note whether it was a custom basket and must include a statement that the custom basket complied with the ETF’s custom basket policies and procedures. The Rule also requires that an ETF maintain all copies of agreements with its authorized participants. The records must be maintained for at least five years, with the first two in an easily accessible place.

In addition, the SEC addressed the following:

Fund of Funds Relief. Current standard ETF exemptive orders also contain “fund of funds relief” that permits fund of funds structures in excess of the statutory limits in Section 12(d)(1) of the Investment Company Act. This relief will not be rescinded. Those ETFs that do not have this relief and that will rely on Rule 6c-11 will be able to rely on the standard fund of funds relief, provided they comply with the terms and conditions for funds of funds relief in those orders. This relief will be available until a new SEC fund of funds rule is adopted and is effective.

Form N-1A Amendments². The SEC also adopted amendments to Form N-1A to provide for additional information to investors who purchase and sell ETF shares on the secondary market and to remove disclosures, such as creation unit size, from the prospectus. Notably, the SEC did not adopt a requirement to include information in a question-and-answer format in Item 3 of Form N-1A, which would have included hypothetical bid-ask spread examples. Also, ETFs not relying on the Rule will be required to provide similar disclosures regarding median bid-ask spreads and premium and discount information as those ETFs relying on the Rule are required to provide. These amendments are effective on the Rule’s Effective Date (discussed below), and the compliance date is one year from the Effective Date.

Securities Exchange Act of 1934. The Adopting Release clarifies that shares of all ETFs, not just those of Eligible ETFs, are considered “redeemable securities.” As such, all ETFs, including those not operating under the Rule, may rely on Rules 101(c)(4) and 102(d)(4) of Regulation M and Rules 10b-17(c) and 11d1-2 under the Securities Exchange Act of 1934 (the “Exchange Act”) without obtaining individual relief or relying on class relief from those provisions.

The SEC also issued a conditional exemptive order under Section 11(d)(1) of the Exchange Act and Rules 10b-10, 15c-15, 15c-6 and 14e-5 thereunder, to broker-dealers and other market participants. This relief applies only in connection with those ETFs that rely on the Rule. Among other things, the order requires that, except in the case of Rule 14e-5, the ETF meet the diversification requirements applicable to regulated investment companies in Section 851(b)(3)(B) of the Internal Revenue Code. It does not require any minimum creation unit size or value. This relief is effective on the Rule’s Effective Date.

Effect of the Rule on Existing ETF Exemptive Orders

The SEC is rescinding the individual exemptive orders for Eligible ETFs one year after the Rule’s effective date, which is December 23, 2019 (the “Effective Date”). On or after that time, ETF sponsors without individual exemptive orders must rely on the Rule to offer and operate new ETFs, and ETF advisers with existing exemptive relief may choose to operate under the Rule or under their existing orders up until one year after the Effective Date (the “Compliance Date”). On or after the Compliance Date, all Eligible ETFs must rely on the Rule and must comply with the conditions discussed below. In addition, the Adopting Release amends current ETF orders that “automatically expire on the effective date of a rule permitting the operation of ETFs” so that those ETF orders will expire on the Compliance Date. Below is a summary of the impact of the Rule and rescission of current exemptive orders:

Practice Points and Tips

An Eligible ETF that currently has an exemptive order has one year from the Effective Date to comply with the Rule’s conditions. At that time, the SEC will rescind the exemptive relief order under which the Eligible ETF operates. As such, advisers should use the transition period to address the new operational, disclosure and compliance requirements of the Rule. Among other things, we suggest that advisers:

• Review existing basket procedures and develop additional procedures to comply with the Rule, including parameters for custom baskets if the adviser would like flexibility to use custom baskets. The procedures must establish parameters that comply with the Rule and must be appropriately tailored to address circumstances that different funds and strategies may encounter.
• Determine, if applicable, who at the adviser will be responsible for reviewing and approving custom baskets. If the adviser determines that members of the portfolio management team are the appropriate people, appropriate compliance policies and procedures should address any conflicts of interest. Roles and responsibilities should be clearly defined.
• Review, and update if necessary, any website policies and procedures to ensure that the ETF complies with the various website-posting requirements of the Rule. Policies and procedures should clearly state responsibilities for website compliance.
• Develop a process for producing, updating and ensuring the accuracy of the premium and discount and bid-ask spread information provided on the ETF’s website and elsewhere and determine who at the adviser is responsible for such process.
• Review and amend disclosures in the prospectus and SAI to comply with new requirements in Form N-1A, as well as other changes in the ETF’s operations.
• Review, and update if necessary, any recordkeeping policies to ensure that all documents that the Rule requires are retained for the required periods.
• Develop compliance processes for testing that the conditions for reliance on the Rule continue to be satisfied. We expect the SEC staff to include examination of compliance with the conditions as part of its examination process for ETFs once it rescinds the exemptive orders.

¹ As a condition of Rule 6c-11, an ETF may not directly or indirectly seek to provide investment results that are a multiple or inverse of the returns of a securities index over a predetermined amount of time.
² The SEC also adopted similar amendments to Form N-8b-2 used by ETFs organized as UITs.