March 2008
Bulletin 08-055
SEC Proposes New Rule 6c-11 Under the Investment
Company Act of 1940 to Create Certain Exemptions for
Exchange-Traded Securities
If you have questions or would
like additional information on the
material covered in this Bulletin,
please contact one of the authors:
Gustavo A. Pauta
(New York)
+1 212 549 0380
[email protected]
Gerard S. DiFiore
(New York)
+1 212 549 0396
[email protected]
Chad Michael Dickerson
(New York)
+1 212 549 0342
[email protected]
…or the Reed Smith attorney
with whom you regularly work
In March 2008, the Securities and Exchange Commission (“SEC”) proposed new
rules under the Investment Company Act of 1940 (the “40 Act”) that would exempt
exchange-traded funds (“ETFs”) from certain provisions of the 40 Act as well as
certain SEC rules, and would allow investment companies to more freely invest in
ETFs than is currently allowed under the 40 Act. The SEC also proposed an
amendment to Form N-1A (the registration form used by open-end management
investment companies to offer and register their securities) to promote more useful
information for investors trading ETF shares.
The new rules are intended to facilitate ETFs’ activities and allow investors to take
better advantage of ETFs’ investment opportunities. Specifically, the proposed rules
are designed to eliminate unnecessary regulatory applications that are currently
required for ETFs to perform their regular functions, and to promote greater
competition and innovation among them.
Regulation Under the 40 Act
The 40 Act lists specific requirements (or prohibitions) that fund sponsors must
follow rather than stressing full disclosure, which is the focus of other U.S. securities
regulation. The 40 Act was a direct reaction to the extensive range of management
and marketing abuses in the investment company industry during the 1920s and
1930s.1 Consequently, the 40 Act is focused on direct regulation and is based on
the principle that investment advisors are fiduciaries who bear specific
responsibilities.
Among the provisions of the 40 Act are a number of structural and operating
requirements for investment companies that are not consistent with ETF operations.
Congress, however, provided the SEC with blanket authority to grant specific
exemptions from the 40 Act. This blanket authority permits ETFs to be approved by
exemption. Although Congress granted broad exemption power to the SEC, such
exemptions cause considerable delay between the date a request for
NEW YORK
exemption is filed and the date exemptive relief is granted.
The 40 Act requirements and prohibitions are quite specific. As a
consequence, an ETF needs a large number of exemptions from
securities legislation to perform such acts as creating and redeeming
baskets and shares (in-kind and only in large blocks), and permitting
individual shares to be traded at market prices on an organized
securities market. Although some exemptions depend upon the
issuer, the exchange, or specific authorized participant, certain basic
exemptions are necessary for all ETF launches.
This bulletin is presented for informational purposes and is not intended to constitute legal advice.
© Reed Smith LLP 2008. All Rights Reserved.
“Reed Smith” refers to Reed Smith LLP, a limited liability partnership formed in the state of Delaware.
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Client Bulletin 08-055
Proposed Rule 6c-11
The SEC’s proposed rule 6c-11 is designed to allow ETFs to enter the market and perform daily activities more
easily by codifying the exemptions that are typically granted when an ETF is formed. The SEC has seen that
certain prohibitions are unnecessary as they relate to ETFs and do more to slow the inevitable formation of ETFs
than they do to protect investors.
Exemptive Relief – As stated above, the structure of ETFs has forced their sponsors to request certain basic
exemptions to allow their funds to operate after formation. Proposed rule 6c-11 specifically provides for relief
through the following common exemptions, which are unique to ETFs:
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Issuance of “Redeemable Securities”: Individual ETF shares are not redeemable securities and are not
bought back by the fund at their daily net asset value (“NAV”).2 Currently, ETFs must apply for
exemption to be permitted to redeem shares only in creation unit aggregations. Proposed rule 6c-11
would deem an individual equity security issued by an ETF to be a “redeemable security,” even though
ETF shares are issued and redeemed only in creation unit aggregations. This provision would permit
an ETF to register with the SEC as an open-end fund, which the Act defines as an investment company
that issues redeemable securities.
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Trading of ETF Shares at Negotiated Prices: The 40 Act prohibits a dealer from selling a redeemable
security that is being offered currently to the public by or through an underwriter, except at a current
public offering price described in the fund prospectus. ETF shares are both traded on the secondary
market and offered through an underwriter. Therefore, ETFs are currently required to obtain an
exemption because ETF shares trade in the secondary market at current market prices, and not at the
current offering price described in the fund prospectus or based on the NAV of the fund itself at the
close of each trading day. The proposed rule would exempt a dealer in ETF shares from the 40 Act
prohibitions regarding purchases, sales and repurchases of ETF shares in secondary market
transactions at current market prices.
ƒ
In-Kind Transactions between ETFs and Certain Affiliates: Purchases and redemptions of ETF creation
units are typically in-kind rather than cash transactions. Because of the 40 Act’s self-dealing
prohibitions, an affiliated person of a registered investment company is generally prohibited from
selling any security to or purchasing any security from the fund. As a matter of course, an exemption
is now required to allow these affiliates to participate. The proposed rule, however, would allow such
ETF affiliates to purchase and redeem creation units through in-kind transactions because such
affiliates are not treated differently from non-affiliates when engaging in purchases and redemptions of
creation units. Therefore, there is no opportunity for these affiliated persons to effect a transaction
detrimental to the other ETF shareholders.
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Additional Time for Delivering Redemption Proceeds: A registered open-end investment company is
generally prohibited from delaying the right of redemption more than seven days after the tender of a
security. This prohibition has caused problems for some ETFs that track foreign indexes because of
local market delivery cycles for transferring foreign securities to redeeming investors and local market
holiday schedules. Under the proposed rule, ETFs would be exempt from the prohibition and allowed
12 calendar days to satisfy the redemption if they disclose the foreign holidays expected to prevent
timely delivery of, and the maximum number of days anticipated to deliver, the foreign securities.
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Actively Managed ETFs: Upon application, proposed rule 6c-11 would provide an exemption for an
actively managed ETF that discloses on its Internet website each business day the identities and
weightings of the component securities and other assets held by the ETF, while the security holders of
the ETF would still have the advantage of the typical 15-second intervals of intraday values. This rule
is intended to help promote actively managed ETFs with fully transparent portfolios.
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Client Bulletin 08-055
Disclosure Amendments – To promote fair and honest securities markets, the securities laws require significant
disclosure by securities issuers to their potential investors. Among other requirements, the 40 Act requires
certain disclosure, such as the continuous delivery of prospectuses to investors in open-end funds, including
ETFs, which perpetually offer their securities to the public.
In its proposed rules, the SEC makes several amendments to Form N-1A to accommodate its use by ETFs and
meet the needs of all investors who purchase shares in secondary market transactions, rather than financial
institutions purchasing creation units directly from the ETF.
Organization as an Open-end Investment Company
Proposed rule 6c-11 would be available only to ETFs organized as open-end funds. The SEC believes that ETF
sponsors prefer the open-end fund structure because it allows greater investment flexibility (including flexibility
in reinvesting dividends received on portfolio investments).
Conditions
The SEC provides for certain additional conditions under which the ETF must conduct its business to take
advantage of the exemptions that the proposed rule would provide. First, for each business day, the fund must
clearly disclose the composition of the securities and assets held by the fund or state that it has an investment
objective of obtaining returns corresponding to the returns of a specified securities index. While the exchange
on which the fund’s shares are traded typically provides a regular intraday value of such shares at 15-second
intervals,3 such an arrangement is not required. The proposed rule would, however, require the shares to be
listed on a national securities exchange that provides such Intraday Value. In addition, the ETF must not
advertise as an open-end fund or mutual fund, and must explain that the shares are not individually redeemable
in order to prevent retail investors from confusing ETFs with traditional mutual funds.
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1
Congress concluded that disclosure was not an adequate remedy or deterrent for the abuses uncovered.
2
A redemption feature is necessary because the sale of the shares into the secondary market mimics the redemption feature at the investor level.
3
This value is commonly known as the “Intraday Value.”
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Client Bulletin 08-055
Appendix
Introduction to ETFs
ETFs offer public investors an undivided interest in a pool of securities and other assets, and thus are similar in
many ways to traditional mutual funds, except that ETF shares can be bought and sold throughout the day on an
exchange through a broker-dealer. ETF shares represent an undivided interest in the asset portfolio held by the
fund, and ETFs are organized either as open-end investment companies1 or unit investment trusts.
To form an ETF, a market maker, specialist or large institutional investor becomes a fund’s authorized
participant (who may in some cases also be the sponsor) by signing a participation agreement with a sponsor.
The authorized participant then transfers to the ETF a predefined “basket” of securities that mirror the ETF’s
portfolio in exchange for shares of a creation unit2 of the ETF, typically between 10,000 and 1 million (but most
commonly 50,000) ETF shares.
The individual ETF shares making up the creation unit are registered and traded on a national exchange.
Investors cannot redeem individual shares with the ETF directly and may only trade such shares through the
exchange at their market value. Large institutional investors, however, may call for in-kind redemption3 at the
NAV of a creation unit, but only if such investor holds the number of ETF shares that comprises a whole creation
unit.4
Index-Based ETFs – The earliest ETFs, which were first developed in the early 1990s, were pegged to a specific
index on a publicly traded securities exchange.5 These funds continue to exist in many forms, holding a
portfolio that reflects an index or segment of an index, such as the S&P 500 (commonly referred to as “SPDRS”),
the Dow Jones Industrial Average (known as “DIAMONDS”), and the NASDAQ 100 Index (called the “NASDAQ
100 Trust”). Today, however, ETFs have evolved to track the performance of a wide variety of other indexes,
foreign and domestic, that may be created specifically for a particular ETF (e.g., commodities, such as precious
metals). The ETFs’ intended business strategy is to provide returns corresponding to the price and dividend
yield of the specific index with which they are associated.
Each exchange on which the ETF shares are listed typically discloses an approximation of the current value of
the basket on a per-share basis at 15-second intervals throughout the day, i.e., the Intraday Value, and indexbased ETFs also disseminate the current value of the relevant index. Such disclosure is intended to allow
investors to determine the NAV of an ETF’s creation units at practically any moment throughout the trading day,
and decide whether to purchase or redeem creation units, based on the relative values of the ETF shares in the
secondary market and the securities contained in the ETF’s portfolio.
Actively Managed ETFs – Actively managed ETFs are formed and operate in the same manner as index-based
ETFs. However, unlike index-based ETFs, an actively managed ETF does not seek to track the return of a
particular index (e.g., S&P 500). Instead, the ETF’s investment adviser, like an adviser to any traditional actively
managed mutual fund, generally selects securities consistent with the ETF’s investment objectives and policies
without regard to a corresponding index.
1
An open-end investment company is defined as an investment company that issues redeemable securities. See 15 U.S.C. 80a-5(a)(1).
2
A creation unit is a set of shares or securities that make up one unit of a fund held by the trust underlying the ETF. One creation unit
is the denomination of underlying assets that can be redeemed for a certain number of ETF shares.
3
Direct redemption with the ETF may only be made through in-kind redemptions, and not in exchange for cash.
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Client Bulletin 08-055
4
Any investor holding the requisite number of ETF shares may redeem those shares with the ETF directly. An individual, however,
would rarely have the ability to hold the number of ETF shares required to have the right to redeem.
5
The funds discussed above are “investment companies” (as defined in the 40 Act) because they issue securities and are, or propose to
be, primarily engaged in the business of investing in securities, rather than in commodities. Although other types of ETFs invest in
commodities, such commodities-based ETFs do not meet the definition of an investment company, and therefore are not subject to
the SEC’s proposed rule.
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