The SEC has adopted a new rule (6c-11) that will allow the creation and distribution of exchange-traded funds without having to obtain specific exemptive relief from several provisions of the Investment Company Act. The rule applies to open-end funds that provide daily portfolio transparency and includes conditions common to most ETF exemptive orders concerning holdings, disclosure, and pricing. The SEC will rescind individualized exemptive orders for funds that can rely on the new rule. The SEC has issued more than 300 ETF exemptive orders since 1992, allowing for the launch of approximately 2,000 ETFs with over $3.3 Trillion in assets. The rule becomes effective 60 days after publication.
If this rule were the only legacy of the Clayton/Blass SEC, we would consider it a success. This rule is long overdue and should level the playing field for smaller ETF sponsors burdened with the expense of obtaining exemptive relief.
The SEC staff has granted no-action relief to allow index funds to become non-diversified as a result of market changes to the underlying index components. Without the relief, an index fund that tracks a third-party index would have to obtain shareholder approval to change its status from diversified to non-diversified when certain underlying component securities increased in value such that they would make up more than 5% of the portfolio. The relief would require prospectus disclosure that the fund could become non-diversified during these periods. The fund would still be constrained by the diversification requirements of the tax code and the applicable exchange on which it is traded.
This issue has dogged large index funds and ETFs for the last couple of years as the FAANG securities have increased in market value as compared to other index components. This letter offers welcome relief.
The SEC proposed a new rule that would allow exchange-traded funds to launch without obtaining an individualized exemptive order, a discretionary process that can take several months. Proposed rule 6c-11 would allow ETFs structured as open-end funds to operate so long as they provide daily portfolio transparency on their websites, disclose historical premium, discount and bid-ask spread information, and adopt policies and procedures about the use of custom baskets. Other conditions may be included in the full proposal once it is released. The proposed rule would rescind current exemptive relief granted to ETFs that could rely on the new rule. Since 1992, the SEC has issued more than 300 ETF exemptive orders, creating a $3.4 trillion market that includes over 1,900 ETFs representing nearly 15% of total investment company assets.
OUR TAKE: The SEC already went down this road back in 2008. Let’s hope that the Commission adopts a rule and ends the costs and delay associated with requiring formulaic exemptive orders.
The SEC’s Director of the Division of Investment Management, Dalia Blass, questioned whether ETF index providers should continue to claim a blanket exemption from investment adviser registration. Ms. Blass, acknowledging an exemption for publishers of broad-based indexes, asked whether providers of more narrow indexes should register as investment advisers especially where such providers create indexes for a single fund or take significant input from the fund sponsor. Ms. Blass cautioned “against assuming that the status of a provider can be determined based simply on its characterization as an index provider” and encouraged fund sponsors and index providers to “refresh your analysis if you are looking at a bespoke or narrowly focused index.” Ms. Blass also advised funds to consider disclosure implications of narrow indexes.
OUR TAKE: As a result of Ms. Blass’s speech, index providers should expect some hard questions from fund counsel and independent directors’ counsel as the lines blur between index creation and investment recommendations.
A large ETF adviser agreed to pay a $1.5 Million fine for operating a fund without obtaining the required exemptive relief. According to the SEC, from 2010 to 2015, the adviser relied on exemptive relief for a separate ETF trust even though the SEC staff had opined that the relief did not apply to the fund at issue. The SEC asserts that both internal and outside counsel advised (incorrectly, according to the SEC) that the firm could rely on the pre-existing exemptive relief. The SEC did acknowledge that the fund complied with exemptive order requirements even though it did not obtain its own, specific relief. The offending fund was merged out of existence in 2015. An exemptive order is required to operate an ETF because it would otherwise violate various pricing provisions of the Investment Company Act.
OUR TAKE: Why would the SEC take action against a fund that no longer exists and an adviser that complied with conditions that would have been applicable to a fund where no investor harm was alleged? The answer is that the SEC is very serious about compliance with exemptive orders and ensuring that ETF sponsors strictly follow the conditions. Just because you are driving safely doesn’t mean you can drive without a license.