On September 25, 2019, the SEC adopted Rule 6c-11 (Rule) under the Investment Company Act of 1940, as amended (1940 Act), to modernize the regulatory framework for most exchange-traded funds (ETFs).1 The Rule eliminates the need for ETFs that can operate under its conditions to obtain an exemptive order from the SEC. In a concurrent release, the SEC issued an exemptive order under the Securities Exchange Act of 1934, as amended (1934 Act) providing relief from certain requirements of the 1934 Act and related rules for ETFs that can rely on the Rule.2 The SEC also adopted form amendments that would expand disclosure obligations for all ETFs.
The Rule will become effective 60 days from its publication in the Federal Register. Most ETF exemptive orders granted by the SEC prior to the Rule’s adoption will be automatically rescinded one year after the Rule’s effective date. Therefore, ETFs relying on those orders will be required to comply with the Rule to continue operating as ETFs after the one year period. The Rule’s adopting release (Adopting Release) highlights several notable changes to requirements of the Rule from those in the proposed rule, which arose from industry comments to the proposal.3 These changes are discussed below.
I. Summary of Rule 6c-11
The Rule applies to open-end funds that (i) issue (and redeem) creation units to (and from) authorized participants (APs) in exchange for a basket of securities and other assets (and any cash balancing amount) and (ii) whose shares are listed on a national securities exchange and trade at market-determined prices. Leveraged or inverse ETFs (ETFs that provide returns over a predetermined time period that (A) correspond to the performance of an index by a specified multiple or (B) have an inverse relationship to the performance of the index) are not eligible to rely on the Rule. Likewise, non-transparent ETFs (ETFs that do not disclose portfolio holdings daily), share class ETFs and ETFs that are unit investment trusts are ineligible to rely on the Rule.
An ETF relying on the Rule is required to comply with the following conditions:
- Website Disclosures. The ETF must disclose on its website each business day:
- the estimated cash balancing amount (if any) and summary information about each of its portfolio holdings that will form the basis of the next calculation of current net asset value (NAV) per share, before the opening of regular trading on the primary listing exchange for its shares;
- its NAV per share, market price and premium or discount, as of the end of the prior business day;
- a table showing the number of days its shares traded at a premium or discount during the most recently completed calendar year and the mostly recently completed calendar quarters since that year;
- a line graph showing its share premiums or discounts for the most recently completed calendar year and the most recently completed calendar quarters since that year;
- the ETF’s median bid-ask spread;4 and
- if the ETF’s premium or discount is greater than 2% for more than seven consecutive trading days, a statement of this fact and a discussion of the factors that are reasonably believed to have materially contributed to it.
- T+1 Accounting for Portfolio Holdings. The portfolio holdings included in the ETF’s next NAV calculation must be the ETF’s holdings as of the end of the prior business day.
- Policies and Procedures. The ETF must adopt and implement written policies and procedures for construction of baskets and the process for acceptance of baskets. If the ETF will use a “custom basket”5, then the policies and procedures must set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders. The custom basket procedures must address the process for any revisions to or deviations from the parameters and specify the titles or roles of the employees of the ETF’s adviser who are responsible for reviewing each custom basket for compliance with the parameters.
- Recordkeeping. The ETF is required to maintain copies of all AP agreements and specified records relating to baskets exchanged with APs.
II. Notable Changes from the Proposed Rule
In adopting the Rule, the SEC made certain, notable changes to the proposed rule in response to industry comments:
- Unlike the proposed rule, the required website disclosure of the ETF’s portfolio holdings under the Rule need not comply with the requirements of Regulation S-X. Such compliance would have mandated detailed categorization of investments and identification of fair valued and non-income producing securities.
- Under the proposed rule, website portfolio holdings disclosure would have been required prior to when the ETF accepted creations and redemptions, which effectively would have prohibited “T-1” trades that are typically used by ETFs that invest in foreign markets. In a T-1 trade, an AP places a creation or redemption order with an ETF after the ETF’s NAV has been calculated for that day on the day before the trade would take place (e.g., an order on 4:30 p.m. to create shares in the ETF on the next business day). Under the Rule, such website disclosure is only required each business day prior to the opening of regular trading on the primary listing exchange for the ETF’s shares.
- As proposed, the Rule would have required an ETF on each business day to disclose that day’s basket for transactions with APs. The SEC determined that this requirement was unnecessary given the required daily portfolio holdings disclosure, and potentially problematic given the ability to use custom baskets.
- The time period over which the ETF’s median bid-ask spread is required to be calculated was shortened in the Rule, from the proposed rule, to the most recent 30 days from the prior fiscal year, and such spread need only be disclosed on the ETF’s website (rather than both on its website and in its prospectus).
- The proposed rule would have required hypothetical examples of bid-ask spread costs showing the costs of “round trip” trades and an interactive website “bid-ask spread calculator,” both of which likely would have required ETFs to source extensive historical market data from outside vendors. These proposed requirements were not adopted in the Rule.
III. Termination of Prior Exemptive Orders
One year after the Rule’s effective date, exemptive relief previously granted to ETFs that are eligible to rely on the Rule and relief that permits ETFs to operate in a master-feeder structure that existing ETFs did not rely on as of June 28, 2018 will be rescinded. Exemptive relief for ETFs outside the Rule’s scope (UIT ETFs, non-transparent ETFs, share class ETFs and leveraged/inverse ETFs) will be preserved. Funds-of-funds relief previously issued to existing ETFs will not be rescinded and future ETFs eligible to rely on the Rule will be permitted to rely on this exemptive relief granted to recent ETF applicants in compliance with the conditions of their applications until future SEC rulemaking is concluded.6
IV. Form Amendments and 1934 Act Exemptive Relief
The SEC adopted amendments to Form N-1A (the registration form used by open-end funds) and Form N-8B-2 (the registration form used by UITs) to require ETFs to disclose additional information about transaction costs to buy and sell ETF shares on an exchange. An ETF that does not rely on the Rule has the option of either disclosing the median bid-ask spread for its shares for the past fiscal year in the ETF’s prospectus or, consistent with ETFs that rely on the Rule, disclosing this spread for the past 30 calendar days on its website. ETFs relying on the Rule will have to identify as such on Form N-CEN. The form amendments are effective one year from the Rule’s effective date.
ETFs and broker-dealers (who may be APs) may encounter issues under certain sections of and rules under the 1934 Act with respect to transactions involving the ETF’s shares.7 For example, Rule 14e-5 under the 1934 Act could restrict an AP that is a dealer manager in a tender offer from transacting with an ETF that contains a security that is the subject of the tender offer. The Rule and a related exemptive order provide ETFs that can rely on the Rule and broker-dealers (who may be APs) relief from Rule 14e-5 and certain other sections of and rules under the 1934 Act with respect to transactions involving the ETFs’ shares.
V. S&K Observations
The Rule is welcome relief for the industry and should facilitate further developments in the ETF industry. Both new and existing ETF providers have the same flexibility to use custom baskets. New ETF providers will no longer have to spend the time and expense needed to receive an exemptive order or no-action relief from the SEC to launch new ETFs. Certain changes to the requirements of the Rule (from those proposed) reflect the staff’s consideration of comments received during the comment period and should lessen the burden on ETFs and their service providers. The SEC’s modifications to disclosure requirements for ETF prospectuses in response to industry comments, for example, shows the SEC’s responsiveness to industry concerns about the usefulness and costs of new disclosure requirements.
If you have any questions regarding the matters covered in this alert, please contact Paul M. Miller (202-661-7155, email@example.com), Robert Kurucza (202-661-7195, firstname.lastname@example.org), Christopher D. Carlson (202-661-7165, email@example.com) or Lancelot A. King (202-661-7196, firstname.lastname@example.org).
1 See Final Rule: Exchange Traded Funds, SEC Rel. No. IC-33646 (Sept. 25, 2019), available at https://www.sec.gov/rules/final/2019/33-10695.pdf.
2 The 1934 Act exemptive order is available at: https://www.sec.gov/rules/exorders/2019/34-87110.pdf.
3 Proposed Rule: Exchange-Traded Funds, SEC Rel. No. IC-33140 (June 28, 2018), available at https://www.sec.gov/rules/proposed/2018/33-10515.pdff.
4 This is computed as a percentage rounded to the nearest hundredth using the ETF’s national best bid and offer data as of the end of each 10 second interval during each trading day for the last 30 calendar days.
5 A “custom basket” is a basket that does not reflect a pro-rata representation of the ETF’s portfolio or that differs from the initial basket used on the same business day.
6 A rule was proposed last year on this point. Proposed Rule: Fund of Funds Arrangements, SEC Rel. No. 33-10590 (Dec. 19, 2018), available at https://www.sec.gov/rules/proposed/2018/33-10590.pdf.
7 This includes Section 11(d)(1) of the 1934 Act, Rules 10b-10, 10b-17, 11d1-2, 15c1-5, 15c1-6, and 14e-5 thereunder and Regulation M. The Rule provides ETFs relying on the Rule with exceptions comparable to open-end funds in Regulation M and Rules 10b-17 and 11d1-2 under the 1934 Act, and the release sets forth the SEC’s view that ETFs that do not rely on the Rule are still able to rely on these exceptions.