From PLI’s Course Handbook
Nuts and Bolts of Financial Products 2009
#18678
8
EXCHANGE TRADED FUNDS AND
EXCHANGE TRADED NOTES
Paul J. McElroy
Sullivan & Cromwell LLP
Submitted by:
Robert S. Risoleo
Sullivan & Cromwell LLP
Copyright © 2008
All Rights Reserved
1
EXCHANGE TRADED FUNDS
AND EXCHANGE TRADED NOTES
Paul J. McElroy
December 18, 2008
Copyright © 2008
All Rights Reserved
2
Biographical Information
Program Title: Nuts & Bolts of Financial Products 2009
Name: Paul J. McElroy
Position or Title: Special Counsel
Firm or Place of Business: Sullivan & Cromwell LLP
Address: 1701 Pennsylvania Ave., NW, Washington,
DC 20006
Phone: 202-956-7550
Fax: 202-293-6330
E-Mail: mcelroyp@sullcrom.com
Primary Areas of Practice: Investment Management,
Securities
Law School: Columbus School of Law, Catholic University
of America
Work History: Associate, Sullivan & Cromwell LLP, 198896; Special Counsel, Sullivan & Cromwell LLP, 1997Present
3
Exchange Traded Funds
and Exchange Traded Notes
I.
Exchange Traded Funds – “ETFs”
A.
Introduction
1.
ETFs offer investors an exchange-listed and traded security that represents an undivided
interest in a pool of securities and other assets.
2.
ETFs share many characteristics with
traditional mutual funds, in light of their
“open-end” structure, providing certain market
participants an opportunity (albeit limited) to
purchase newly issued shares from the ETF
issuer at net asset value (NAV) and to have
the ETF issuer redeem shares at NAV.
3.
ETFs also share characteristics with closedend funds, in that ETF shares can be
purchased and sold by all investors through a
broker-dealer throughout the trading day at
negotiated prices on an exchange or over the
counter.
4.
Hybrid structure of ETFs, combining features
of mutual funds and closed-end funds, affords
ETFs certain advantages over both kinds of
traditional funds: ETFs possess intra-day
liquidity (which mutual funds lack), and ETF
shares generally trade in the secondary market
at prices that closely correlate to their NAV
(in contrast to most closed-end funds).
Investors may sell ETFs short, and write
options and set market, limit and stop-loss
orders on them.
5.
Many ETFs, due to their essentially passive
investment management and their clearance
and settlement through DTC, have low
expense ratios and transfer agency costs and
4
achieve certain tax efficiencies as compared to
traditional mutual funds.
B.
Basic Structures and Classifications of ETFs
1.
ETFs Registered under the 1940 Act vs.
Commodity ETFs
a.
b.
Predominant form of ETF is an issuer
of securities that meets the definition
of “investment company” under the
Investment Company Act of 1940 by
engaging primarily in the business of
investing in securities.
i.
required to register under the
1940 Act and generally are
subject to regulation by that
Act and the rules thereunder
ii.
by nature of their “hybrid”
characteristics, ETFs that
register under the 1940 Act
require exemptions from
certain provisions of the 1940
Act in order to operate and
offer their shares to the public
iii.
in 2008, SEC proposed for
comment rules that would
codify the 1940 Act exemptive
orders that have been issued to
certain kinds of ETFs, but has
not yet promulgated any final
rule
Certain other issuers, also referred to
as exchange-traded funds or ETFs,
invest primarily in commodities or
commodity-based instruments
(“commodity ETFs”), and therefore do
not constitute investment companies
and do not register under the 1940 Act.
5
c.
2.
i.
while commodity ETFs share
many characteristics with ETFs
that are investment companies,
they are not subject to
regulation under the 1940 Act
ii.
commodity ETFs may be
subject other regulation to
which investment company
ETFs are not (e.g., regulation
under the Commodity
Exchange Act)
Unless otherwise specified, references
in this outline to “ETFs” refer only to
ETFs that are registered investment
companies and not to commodity
ETFs.
Organizational Form
a.
ETFs organized as Unit Investment
Trusts (UITs)
i.
organized under a trust
agreement or similar instrument
ii.
have a trustee but no board of
iii.
are only passive, index-based
vehicles; never actively
managed
iv.
fixed portfolio; invest only on a
“full replication” basis (see
B.3. below)
directors
b.
ETFs organized as Open-End
Management Companies
6
3.
i.
usually organized in the
manner of a typical mutual
fund complex, i.e., as a
corporation (or business trust),
with a board of directors, that
issues several series of shares,
each of which represents a
separate pool of assets and is
offered as a separate ETF
ii.
at least one ETF sponsor has
received SEC exemptive relief
to organize each ETF as a class
of shares of a multi-class
mutual fund
iii.
in contrast to UITs, have
greater flexibility in respect of,
e.g., portfolio management,
investment of dividends,
lending of portfolio securities
and creation of rule 12b-1 plans
(for payment of distribution
expenses out of funds assets)
iv.
may invest using full
replication or portfolio
sampling strategy if indexbased (see B.3. below), or may
be actively managed (see B.4.
below)
Index-Based ETFs
a.
Predominant form of ETFs in the
marketplace – attempts to obtain
returns that correspond to those of a
specified underlying securities index
either by replicating or sampling the
component securities of the index.
b.
Full replication vs. portfolio sampling
7
c.
i.
full replication strategy – ETF
invests in every component
security of its underlying index,
in substantially the same
proportions as in the index.
ETFs organized as UITs are
limited to investing on a full
replication basis
ii.
portfolio sampling strategy – in
light of practical difficulties or
substantial costs involved in
holding every security in an
underlying index, ETF uses a
sampling strategy pursuant to
which it invests in some but not
all of the index’s component
securities – those securities in
which the ETF invests are
intended, in the aggregate, to
reflect the underlying index’s
capitalization, industry and
fundamental investment
characteristics, and to perform
like the index.
iii.
sampling ETFs may acquire a
subset of the component
securities of the underlying
index and, in some cases,
certain securities and other
financial instruments that are
not included in the index but
the inclusion of which in the
ETF’s portfolio is intended to
help track the performance of
the index
Underlying indices used by index-
based ETFs
i.
equity indices
ii.
fixed income indices
8
iii.
iv.
segment or sector-based
d.
4.
broad-based indices
narrow indices, e.g., industry,
v.
international indices
vi.
“enhanced” or customized
indices, in some circumstances
created primarily for use by the
ETF
Use of derivative instruments – in an
attempt to achieve results that are
leveraged or inverse relative to its
underlying index, a small minority of
index-based ETFs utilize various
derivative instruments in lieu of or in
addition to investing in component
securities of the index.
Actively Managed ETFs
a.
For the first time in 2008, SEC issued
exemptive orders permitting several
actively managed ETFs.
b.
Unlike index-based ETFs, an actively
managed ETF does not seek to track
the return of a particular index.
c.
Like a traditional actively managed
mutual fund, an actively managed
ETF’s investment adviser selects
portfolio securities consistent with the
ETF’s investment objectives and
policies without regard to a
corresponding index.
d.
In light of certain operational
differences in comparison with indexbased ETFs, SEC has had to impose
some conditions to the granting of
9
exemptive relief for actively managed
ETFs that are not present in the
exemption granted to index-based
ETFs (see C.3.b.ii. below).
C.
Operation of ETFs
1.
Listing and Trading of Individual ETF shares
a.
ETFs register offerings and sales of
their shares under the Securities Act of
1933 (e.g., ETFs organized as openend management companies file on
form N-1A).
b.
ETFs list their shares for trading under
the Securities Exchange Act of 1934.
i.
index-based ETF is permitted
to list if it meets the exchange’s
“generic listing requirements”
(including, among other things,
having an underlying index that
exceeds specified minimum
numbers of index components
and that does not exceed
specified maximum weightings
of individual index components
and of the top five most heavily
weighted components – those
minimums and maximums vary
depending on whether the
index components are U.S.
securities, non-U.S. securities
or a combination)
ii.
for index-based ETFs and
actively managed ETFs that do
not meet the generic listing
requirements, the exchange
must file with SEC an
application under rule 19b-4 of
the 1934 Act for a rule change
10
necessary to allow the ETF to
be listed by the exchange
c.
As with any listed security, investors
may trade ETF shares on the exchange
or over the counter throughout the
trading day at market prices.
2.
Issuance and Redemption of ETF shares only
in “Creation Units”
a.
In contrast to mutual funds, ETFs do
not sell or redeem their individual
shares at NAV.
b.
Financial institutions (typically, those
broker-dealers that have entered into
an agreement with the ETF to serve as
“authorized participants”) may
purchase or redeem ETF shares
directly from the ETF at a price based
on the NAV next computed after the
receipt of the order to purchase or
redeem.
c.
i.
such purchases and
redemptions are permitted only
for transactions in large blocks
of ETF shares called “creation
units”
ii.
creation units vary from ETF to
ETF but typically consist of
aggregations 25,000 to 100,000
shares per unit
Issuances of creation units
i.
authorized participant that
purchases a creation unit of
ETF shares deposits with the
ETF a “purchase basket” of
specified securities and other
assets identified by the ETF
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that day, and then receives the
creation unit in return for those
assets
d.
ii.
the purchase basket generally
reflects the contents of the
ETF’s portfolio and is equal in
value to the aggregate NAV of
the ETF shares in the creation
unit
iii.
after purchasing a creation unit,
authorized participant may hold
the ETF shares, or sell some or
all in secondary market
transactions
Redemptions of creation units
i.
redemption process is the
reverse of the purchase process
ii.
authorized participant has
acquired the number of ETF
shares that comprise at least
one creation unit in primary
issuances of creation units by
the ETF or in secondary market
transactions on an exchange or
over the counter
iii.
authorized participant tenders
for redemption the creation unit
of ETF shares, and the ETF
redeems the creation unit in
exchange for a “redemption
basket” of securities and other
assets identified by the ETF
that is equal to the aggregate
NAV of the ETF shares in the
creation unit
12
e.
In-kind vs. “cash in lieu”
i.
for most ETFs, purchase and
redemption transactions occur
on an “in-kind” basis – ETF
shares are issued or redeemed
in exchange for a basket of
specified securities and other
assets
ii.
in certain circumstances, ETFs
may allow or may specify that
cash be substituted for certain
specified securities in the
basket of assets exchanged for
creation units of ETF shares
iii.
in addition, a small minority of
ETFs – e.g., those that
primarily hold financial
instruments in their portfolios
with limited transferability, or
that hold foreign securities
subject to local law restrictions
on transferability – do not issue
or redeem creation units on an
in-kind basis, but instead issue
and redeem only on a cash
basis
3.
Effect of Arbitrage Opportunities and
Transparency on ETF Share Prices
a.
The ability of financial institutions to
purchase and redeem creation units at
each day’s NAV creates arbitrage
opportunities that are thought to
contribute to keeping the market price
of ETF shares near the NAV per share
of the ETF.
b.
Portfolio transparency
13
i.
an index-based ETF is required
to publish each day the
identities of the securities in the
purchase and redemption
baskets, which serve as a
general representation of the
index-based ETF’s aggregate
portfolio (index-based ETFs
are not required to publish their
aggregate portfolios)
ii.
the actively managed ETFs
operating under the recent
exemptive orders approved by
SEC are required to publish
each day the securities and
other assets in its aggregate
portfolio
c.
Index transparency – not all indices are
published free of charge or everyday –
terms on which and frequency with
which an index provider publishes
information may further enhance the
perceived transparency of index-based
ETFs.
d.
Intraday value – as a condition to
listing, the exchange on which ETF
shares are listed (or designated
publisher) discloses an approximation
of the current value of the ETF’s
basket on a per share basis, typically at
15 second intervals throughout the
trading day and, for index-based ETFs,
disseminates the current value of the
relevant index.
e.
Closing price / NAV deviation – for
ETFs that track domestic indices, e.g.,
ETF sponsors and market participants
have reported average deviations
between the daily closing price and the
daily NAV of generally less than 2%.
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D.
Exemptions Enabling or Supporting ETF Operation
and Trading
1.
1940 Act Exemptions
a.
Issuance of “redeemable securities” –
permits ETFs to register as open-end
investment companies (or as UITs),
notwithstanding that ETFs redeem
only creation units rather than
individual ETF shares, contrary to the
definition of “redeemable security”
under section 2(a)(32).
b.
Trading of ETF shares at prices other
than NAV
c.
certain affiliates
i.
section 22(d) prohibits a dealer
from selling redeemable
securities of a registered
investment company in a
public offering or through an
underwriter except at a current
offering price described in the
prospectus; rule 22c1 requires a
dealer to sell, redeem or
repurchase redeemable
securities of a registered
investment company only at a
price based on NAV
ii.
SEC exemption permits the
secondary market trading of
ETF shares at current,
negotiated market prices rather
than at NAV, notwithstanding
these provisions
In-kind transactions between ETFs and
i.
section 17(a) generally
prohibits an affiliated person of
15
a registered investment
company, or an affiliated
person of such a person, from
selling any security to or
purchasing any security from
the company
ii.
section 2(a)(3) defines
“affiliated person” to include,
among others, any person
directly or indirectly owning,
controlling or holding with
power to vote 5% or more of
the outstanding voting
securities of the other person,
and any person directly or
indirectly controlling,
controlled by or under common
control with the other person (a
control relationship is
presumed where one person
owns more than 25% of
another person’s voting
securities)
iii.
in-kind purchases and
redemptions of ETF creation
units by affiliated persons of
ETFs would fall within the
prohibitions of section 17(a)
iv.
SEC provides a partial
exemption from section 17(a)
to the extent necessary to
permit in-kind purchases and
redemptions of ETF creation
units by (a) persons who are
affiliated persons of an ETF
solely by virtue of holding with
the power to vote 5% or more,
or more than 25%, of the
outstanding shares of the ETF
(“first-tier affiliates”) and (b)
affiliated persons of first-tier
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affiliates who are not otherwise
affiliated with the ETF, and
persons who are affiliated
persons of an ETF solely by
virtue of holding with the
power to vote 5% or more, or
more than 25%, of the
outstanding voting securities of
other registered investment
companies (or series thereof)
advised by the ETF’s
investment advisor (“secondtier affiliates”)
d.
Extension of time to deliver
redemption proceeds
i.
section 22(e) prohibits, among
other things, a registered
investment company from
postponing the date of
satisfaction of redemption
requests more than seven days
after the tender of a security for
redemption
ii.
local market delivery cycles for
transferring certain foreign
securities, coupled with local
market holiday schedules,
cause some ETFs that track
indices contain foreign
securities to be unable to
deliver redemption proceeds
within seven days
iii.
SEC provides partial
exemption from section 22(e)
for such ETFs, allowing the
delivery of redemption
proceeds beyond seven days,
up to a specified maximum
number of calendar days,
depending upon specific
17
circumstances in the relevant
local markets
e.
ETFs organized as UITs have been
granted an additional exemption
permitting the payment, out of ETF
assets, of certain marketing and other
expenses incurred by the sponsor,
notwithstanding prohibitions of such
payments in section 26(a)(2)(c).
f.
Investments in ETF shares by other
investment companies
i.
because ETF shares are shares
of a registered investment
company, the limitations under
the 1940 Act on the ownership
of shares of one investment
company by another
investment company ordinarily
apply to ETF shares
ii.
under section 12(d)(1)(A) – (a)
an investment company
(registered or unregistered)
may own no more than 3% of
the shares of an ETF; (b) shares
of any one ETF may have an
aggregate value of no more
than 5% of the value of the
total assets of an acquiring
investment company; and (c)
securities issued by investment
companies (including ETFs)
may have an aggregate value of
no more than 10% of the value
of the total assets of an
acquiring investment company
iii.
under section 12(d)(1)(B) – an
ETF or a broker-dealer is
prohibited from selling any
security issued by the ETF to
18
any other investment company
(registered or unregistered) if,
after the sale, the acquiring
investment company would
(a) together with companies
and investment companies it
controls, own more than three
percent of the acquired ETF’s
voting securities, or (b)
together with other investment
companies (and companies
they control) own more than
10% of the acquired ETF’s
voting securities
iv.
g.
SEC has granted to some ETFs
exemptions for the acquisitions
and sales of the shares of those
ETFs in excess of the section
12(d)(1) limitations, subject to
compliance with certain
conditions (including, among
other things, there being no
control of the ETF, no undue
influence over ETF services or
transactions and no layering of
investment company fees as a
result of such acquisitions or
sales)
Future series relief – since 2000, SEC
has provided ETF sponsors relief for
any ETFs created in the future in
connection with their exemptive
orders, in order that new ETFs may be
introduced provided they meet the
terms and conditions contained in the
exemptive orders.
19
h.
2.
Proposed rules
i.
proposed rule 6c-11 (and, with
respect to exemptions from
section 12(d)(1) exemptions,
proposed rule 12d1-4) would
codify substantially all of the
1940 Act exemptions
heretofore granted by SEC
order, with the exception of (a)
relief granted to ETFs
organized as UITs and (b)
prospectus delivery relief (see
D.2.b. below)
ii.
as proposed, rule 6c-11 would
apply to both index-based and
actively managed ETFs
meeting the conditions of the
rule, but would not apply to
ETFs organized as UITs
iii.
compared to the conditions to
relief contained in existing
SEC orders, the conditions to
relief in the proposed rules 6c11 and 12d1-4 contain some
additions, deletions and
modifications – SEC is now
considering public comments
received on the proposals
1934 Act “Trading Rules” Relief
a.
Because ETF shares are continuously
offer and are also traded in the
secondary market, various issues with
regard to ETF trading arise under the
1934 Act. For the benefit of brokerdealers that trade ETF shares, the staff
of SEC Division of Trading and
Markets has granted certain no-action
and interpretive relief under several
20
provisions of the 1934 Act and the
rules and regulations thereunder.
b.
Over the years, this relief has been
published in various letters, some
taking the form of “generic class
relief” made available in respect of all
ETFs sharing stated characteristics and
meeting stated conditions, and others
addressing identified ETFs which, in
light of particular structural or
operational features, fall outside the
scope of the generic letters (e.g.,
actively managed ETFs).
c.
Regulation M
i.
regulation M is intended to
prevent manipulation of the
price of a security during the
course of a distribution of that
security: rule 101 thereof
prohibits a distribution
participant, in connection with
a distribution of securities,
from bidding for or purchasing
from or attempting to purchase
or induce any person to bid for
or purchase such security; rule
102 thereof prohibits issuers,
selling security holders, or any
affiliated purchaser of such
person from bidding for,
purchasing, or attempting to
induce any person to bid for or
purchase a covered security
during the applicable restricted
period in connection with a
distribution of securities
effected by or on behalf of an
issuer or selling security holder
ii.
broker-dealers who engage in
creation and redemption
21
transactions of creation units of
ETF shares could be deemed to
be “distribution participants”
within the meaning of
regulation M
iii.
staff has confirmed that the
exception in rule 101(c)(4),
with respect to purchases and
redemptions of shares of openend investment companies and
UITs, applies to transactions in
ETF shares – thereby
permitting persons who may be
deemed to be participating in a
distribution of ETF shares to
bid for or purchase shares
during their participation in
such distribution
iv.
staff also has confirmed the
interpretation of rule 101 that
the redemption of
creation units of ETF shares
and the receipt of baskets in
exchange therefor by a
participant in a distribution of
ETF shares would not
constitute an “attempt to induce
any person to bid for or
purchase a covered security,
during the applicable restricted
period” within the meaning of
regulation M
v.
staff also has confirmed that
that ETFs are excepted under
rule 102(d)(4), with respect to
shares of open-end investment
companies and UITs, and thus
are permitted to redeem
creation units of shares during
the continuous offering of the
ETF shares
22
d.
c.
Content of confirmations
i.
rule 10b-10 requires a brokerdealer who effects a transaction
on behalf of a customer to
provide the customer a written
confirmation at or before the
completion of the transaction,
containing certain specified
information
ii.
compliance with the rule would
be extremely burdensome if its
requirements were applicable
to all securities comprising the
basket of securities tendered or
redeemed in connection with a
purchase or redemption of a
creation unit of ETF shares
iii.
staff has granted relief
permitting broker-dealers to
omit information in the
creation/redemption transaction
confirm regarding the identity,
price and number of shares of
each individual portfolio
security being tendered or
received, subject to the
conditions that (a) the confirm
states that all information
required by rule 10b-10 with
regard to each individual
portfolio security will be
furnished to the customer upon
request and (ii) all such
requests for information be
filled in a timely manner
Notices of corporate actions
i.
rule 10b-17 requires a public
company to give advance
23
notice of certain specified
corporate actions (e.g.,
dividends, stock splits, rights
offerings)
ii.
d.
staff has confirmed that the
exception to the application of
this rule that is available to
redeemable securities issued by
open-end investment
companies also applies to ETFs
Margin
i.
under section 11(d)(1) and rule
11d1-2, a broker-dealer
generally may not extend credit
in connection with the purchase
of any security that is part of a
new issue if the broker-dealer
was a member of the selling
syndicate within the prior thirty
days
ii.
because ETFs are continuously
offered as well as traded in the
secondary market, the
restrictions on margin in
connection with purchases in a
public offering could by
viewed as applicable to ETFs
iii.
staff has granted no-action
relief permitting margin credit
to be extended, in connection
with the purchase of ETF
shares on an exchange, by
broker-dealers who engage
exclusively in secondary market
transactions in ETF shares
iv.
this relief had not been
available to broker-dealers that
create ETF shares, or that
24
otherwise participate in the
distribution of ETF shares as
members of a selling syndicate
or group (i.e., relief unavailable
to ETF authorized participants)
vi.
in 2005, staff extended noaction relief to permit brokerdealers to extend or maintain or
arrange for the extension or
maintenance of credit to or for
customers on the shares of
certain qualifying ETFs for
which such broker-dealers are
authorized participants, subject
to the conditions that (a)
neither the broker-dealer, nor
any natural person associated
therewith, directly or indirectly
receives from the ETF complex
any payment, compensation or
other economic incentive to
promote or sell the shares of
the ETF to persons outside the
ETF complex (other than noncash compensation permitted
under certain FINRA rules) and
(b) the broker-dealer does not
extend, maintain or arrange for
the extension or maintenance
of credit to or for a customer on
shares of the ETF before thirty
days have passed from the date
that the ETF’s shares initially
commence trading (except as
otherwise permitted pursuant to
rule 11d1-1)
vii.
staff has also confirmed that
broker-dealers may treat ETF
shares as shares issued by an
open-end investment company
and therefore may extend credit
or maintain or arrange for the
25
extension or maintenance of
credit on ETF shares that have
been owned for more than 30
days by the persons to whom
credit is to be provided
e.
Tender and exchange offers
i.
rule 14e-5 prohibits a person
who makes a cash tender offer
or exchange offer for an equity
security from purchasing,
directly or indirectly, such
security other than pursuant to
the offer
ii.
as applied to ETFs, the rule
could be read as restricting the
ability of a dealer manager of a
tender offer or exchange offer
for a particular security
included in the ETF’s portfolio
from purchasing and redeeming
ETF shares during the offer
period
iii.
staff has granted exemptive
relief to permit dealermanagers to purchase and
redeem ETF shares during the
pendency of the tender offer or
exchange offer
iv.
staff also has taken a no-action
position with respect to a
broker-dealer, acting as a
dealer-manager of a tender
offer for a component security
of an ETF, that purchases such
securities in the secondary
market for the purpose of
tendering them to purchase a
creation unit of ETF shares, if
such purchases are effected as
26
adjustments to such a basket in
the ordinary course of business
as a result of a change in the
composition of the relevant
index and are not effected for
the purpose of facilitating such
tender offer
f.
Disclosure of control relationships
i.
under rule 15c1-5, a brokerdealer is required to disclose to
its customers any control
relationship between the
broker-dealer and the issuer of
the security being purchased or
sold, and under rule 15c1-6, a
broker-dealer that effects a
transaction with a customer in
connection with any
distribution in which the
broker-dealer is interested, is
required to disclose the
existence of such interest
ii.
staff has confirmed that these
rules do not require disclosure
of a broker-dealer’s
relationship with any issuer of
a security held by an ETF
27
3.
E.
1934 Act Ownership Reporting Relief
a.
Section 13(d) requires beneficial
owners of more than 5% of an issuer’s
outstanding securities to file reports
with SEC, and section 16(a) requires
each officer, director and beneficial
owner of more than 10% of a public
company’s outstanding shares
(“insiders”) to file reports with SEC
disclosing the number of shares
beneficially owned, and reports
regarding changes in ownership.
b.
Staff has granted relief to the effect
that (i) owners of more than 5% of the
ETF shares are not required to file
reports under Section 13(d) and (ii)
insiders are not required to file reports
under Section 16(a).
c.
Section 13 and 16 relief is conditioned
upon the ETF’s shares generally
trading at prices that do not materially
deviate from NAV
Selected Legal and Compliance Issues
1.
1940 Act – Transactions with Affiliates
a.
Except for the narrow exemption from
section 17(a) for in-kind purchase and
redemption transactions by persons
deemed first-tier or second-tier
affiliates generally by reason of 5%
ETF share ownership, the transaction
prohibitions and limitations contained
in section 17 generally apply to ETFs
and their affiliates.
b.
Principal transactions (section 17(a))
i.
a first- or second-tier affiliate,
acting as principal, generally is
28
prohibited from selling
securities or other property to
an ETF, or purchasing
securities or other property
from an ETF, or from
borrowing money or other
property from an ETF
ii.
c.
an ETF affiliate is thus
prohibited from engaging with
the ETF in securities lending
transactions, portfolio
securities transactions other
than in-kind purchase and
redemption transactions (e.g.,
“rebalancings” of an ETF’s
portfolio securities) and foreign
currency transactions
Joint transactions (section 17(d))
i.
section 17(d) generally
prohibits any affiliate, acting as
principal, from effecting any
transaction in which the
registered investment company
is a joint or a joint and several
participant with the affiliate in
contravention of any SEC rules
ii.
section 17(d) and rule 17d-1
thereunder have been construed
very broadly by SEC as a
“catch-all” for many
transactions not expressly
prohibited by section 17(a) and
not obviously prohibited by
section 17(d) – thus,
transactions “involving” in the
broadest sense registered
investment companies
(including ETFs) and their
affiliates may be caught by
section 17(d)
29
d.
2.
Agency transactions (section 17(e))
i.
an affiliate, when purchasing or
selling any property as agent to
or for a registered investment
company, may not accept from
any source any compensation
(other than regular salary or
wages), except in the course of
the person's business as an
underwriter or broker
ii.
an affiliate, when acting as
broker in connection with the
sale of securities to or by a
registered investment company,
may not receive from any
source a commission, fee, or
other remuneration for
effecting such transaction that
exceeds (A) usual and
customary broker’s
commission if the sale is
effected on a securities
exchange, or (B) 2% of the
sales price if the sale is effected
in connection with a secondary
distribution of such securities,
or (C) 1% of the purchase or
sale price in all other cases,
unless SEC by rule, regulation
or order permits a larger
commission
1933 Act and 1940 Act – Prospectus Delivery
a.
Section 5(b)(2) of the 1933 Act makes
it unlawful to carry, or caused to be
carried, through interstate commerce,
any security for the purpose of sale or
delivery after sale unless accompanied
or preceded by a statutory prospectus.
30
b.
Although section 4(3) of the 1933 Act
excepts certain transactions by dealers
from the provisions of Section 5,
section 24(d) of the 1940 Act
disallows such exemption for
transactions in redeemable securities
issued by a UIT or open-end company,
if any other security of the same class
is currently being offered or sold by
the issuer by or through an underwriter
in a public distribution.
c.
Because ETF shares are issued by
UITs or open-end companies and are
continually in distribution, a statutory
prospectus generally is required to be
delivered prior to or at the time of the
confirmations of each secondary
market sale involving a dealer.
d.
Limited exceptions
i.
purchases of ETF shares by an
investor who has previously
been delivered a prospectus
(until such prospectus is
supplemented or otherwise
updated)
ii.
unsolicited brokers’
transactions in ETF shares
(pursuant to Section 4(4) of the
1933 Act)
iii.
under rule 153 under the 1933
Act, the prospectus delivery
obligation owed to an
exchange member in
connection with a sale on the
exchange is satisfied by the fact
that the ETF prospectus is
available at the exchange upon
request
31
e.
SEC has granted exemptive relief from
section 24(d) to some ETFs pursuant
to which, in lieu of a prospectus, ETF
investors may receive, in connection
with certain secondary market
transactions in ETF shares, a shortform “product description”, intended
to briefly describe the ETF’s important
features.
f.
SEC prospectus delivery relief does
not cover (a) the requirement to deliver
a prospectus to those investors who
purchase creation units of ETF shares
from the ETF or (b) the requirement
that an underwriter or distribution
participant of ETF shares deliver a
prospectus – thus, a broker-dealer may
be deemed a statutory underwriter, and
prospectus delivery would be required,
if the broker-dealer purchases creation
units from an ETF and then sells some
or all of the ETF shares comprising
such creation units directly to its
customers, or if it chooses to couple
the creation of a supply of new ETF
shares with an active selling effort
involving solicitation of secondary
market demand for those ETF shares.
g.
The relief granted is of little or no
utility to broker-dealers who are
authorized participants, because it is
inapplicable to creation unit
transactions and because of the
compliance difficulty in distinguishing
secondary market transactions that do
not involve a distribution of ETF
shares from those that may.
h.
Also, because broker-dealers are still
required to deliver “something”, the
compliance burden is not appreciably
diminished.
32
3.
i.
Consequently, few broker-dealers seek
to avail themselves of the prospectus
delivery relief, and few ETF sponsors
still produce the short-form product
descriptions for this purpose.
j.
In light of industry practice and other
factors, SEC’s ETF rule proposal does
not include a section 24(d) exemption
and, further, SEC has proposed to
amend previously issued exemptive
orders to eliminate the section 24(d)
exemptions and require all ETFs to
satisfy their statutory prospectus
delivery requirements.
U.S. Taxation
a.
ETFs are regulated investment
companies for tax purposes, and so
must comply with the diversification
and distribution requirements of
Subchapter M of the Internal Revenue
Code.
b.
Diversification
i.
at least 50% of the market
value of the ETF’s total assets
must be represented by cash
items, U.S. government
securities, securities of other
regulated investment
companies and other securities,
with such other securities
limited for purposes of this
calculation in respect of any
one issuer to an amount not
greater than 5% of the value of
the ETF’s assets and not
greater than 10% of the
outstanding voting securities of
such issuer
33
ii.
b.
II.
not more than 25% of the value
of its total assets may be
invested in the securities of any
one issuer, or of two or more
issuers that are controlled by
the ETF and that are engaged
in the same or similar trades or
businesses or related trades or
businesses (other than U.S.
government securities or the
securities of other regulated
investment companies)
Distribution
i.
ETF portfolio securities
generate current income that is
actually received by the ETF –
ETFs generally must distribute
at least 90% of their annual
income to its shareholders
ii.
ETF shareholders may choose
either to receive their share of
the income as a current
distribution or to reinvest it – if
they choose to reinvest, they
are deemed to have received a
distribution and reinvested that
distribution in the ETF
Exchange Traded Notes – “ETNs”
A.
Introduction
1.
ETNs offer investors an exchange-listed and traded debt security, the value of which
fluctuates in relation to the performance of an
underlying securities index, commodity index
or currency index (or, in some cases, a
specified basket of or single commodity or
currency).
34
B.
2.
ETNs bear many similarities to ETFs, in that
they may be purchased and sold by investors
at negotiated prices on an exchange or over
the counter, and may be tendered to the issuer
for redemption, albeit only in large
aggregations, at a price that corresponds
generally to their intrinsic value.
3.
In contrast to ETFs, ETNs are senior,
unsecured debt obligations subject to the
credit and solvency of their issuer, and they
provide no ownership right or interest in any
underlying assets notwithstanding their use of
an index or specified basket as a referent.
Core Features and Operation of ETNs
1.
Typical Features
a.
ETNs are debt securities, the valuation
of which is derivative of the value of
the underlying index (or basket) to
which it is linked, subject to any
applicable fees.
b.
ETNs typically are non-interestbearing and non-principal protected
and have long maturities (e.g., thirty
years from original issuance).
c.
If ETNs are held to maturity –
i.
in accordance with the terms of
the ETN, at maturity, ETN
holders would receive a cash
payment equal to the principal
amount of the ETNs, multiplied
by the applicable “index
factor”, less any applicable
investor fee
ii.
an index factor on any given
day is typically the ratio of the
35
closing value of the relevant
index on that day over the
closing value of that index on
the original pricing date of the
ETNs
iii.
d.
the investor fee is typically a
stated percentage per annum,
multiplied by the principal
amount of the ETNs, multiplied
by the index factor, calculated
daily
If ETNs are to be disposed of prior to
maturity –
2.
i.
ETNs may be sold (or
purchased) throughout the
trading day on the exchange or
over the counter at current
negotiated prices
ii.
alternatively, ETNs may be
tendered for redemption,
typically on at least a weekly
basis, in large minimum
amounts of ETNs specified by
the issuer in the terms of the
ETN – upon such redemption,
the redeeming holder would
receive a cash payment equal to
the principal amount of the
ETNs being redeemed,
multiplied by the applicable
index factor, and less any
applicable investor fee and/or
redemption fee
Listing and Trading of ETNs
a.
ETN issuers register offerings and
sales of ETNs under the 1933 Act on a
continuous or delayed basis, typically
36
on a WKSI shelf registration
statement.
b.
c.
ETNs are listed for trading under the
1934 Act, typically pursuant to the
exchange’s generic listing criteria for
ETNs, including –
i.
maturity is from one year to 30
years
ii.
nonconvertible debt of the
issuer
iii.
payment at maturity is not
based on a multiple of the
negative performance of the
underlying index (although
payment at maturity may be
linked to a multiple of the
positive performance of the
underlying index)
iv.
redeemable at least once
weekly (in order to waive the
otherwise applicable minimum
400 holder requirement)
v.
aggregate principal amount
meets specified minimum
vi.
underlying index or other
referent meets certain
additional exchange
requirements, such as
capitalization and pricing
information
Dissemination of trading information –
in order to avoid an exchange halt in
ETN trading, intraday “indicative
values” meant to approximate the
economic value of each ETN are
required to be calculated and published
37
every 15 seconds throughout the
trading day – in addition, ETN issuer
typically undertakes to calculate and
publish the closing indicative value on
its website each trading day.
3.
Issuance and Redemption
a.
ETN issuer typically issues ETNs
initially – and may “re-open” an ETN
issuance from time to time – in
amounts greater than it intends initially
to sell to the public at the time of
issuance, thereby creating “inventory”
for the continuous offering of the
ETNs to the public.
b.
ETN holders may redeem ETNs
generally on at least a weekly basis so
long as at least a large minimum
number of ETNs are redeemed (e.g.,
50,000 ETNs for an ETN with a $50
principal amount) – to satisfy this
minimum redemption amount, brokerdealers and certain other financial
intermediaries are permitted to
“bundle” an investor’s ETNs with
those of other redeeming investors.
4.
Effect of Arbitrage Opportunities and
Transparency on ETN Prices
a.
ETN issuers represent that the value of
the ETN’s underlying index or other
referent on any day generally will
affect the market price of the ETNs
more than any other factor.
b.
ETN issuers state that as a result of the
potential arbitrage opportunities
inherent in the structure of ETNs,
assuming that the redemption feature
functions as intended, ETNs are not
expected to trade at a material discount
38
or premium to the value of the relevant
underlying indices or other referents.
c.
C.
The dissemination of the “indicative
value” of the ETF throughout the
trading day and at the closing of each
trading day, coupled with the
dissemination of current information
about an ETN’s underlying index or
other referent, are claimed to
contribute favorably to the price
transparency of ETNs in the secondary
market.
Exemptions Facilitating ETN Trading
1.
The issuers of ETNs are not investment
companies and are not subject to regulation
under the 1940 Act – therefore, ETN issuers
are not required to obtain the extensive set of
exemptions that ETFs must obtain.
2.
On behalf of themselves and ETN market
participants, ETN issuers obtain a portion of
the same relief obtained for ETFs in respect of
certain of the “trading rules” under the 1934
Act – viz., under regulation M and section
11(d)(1).
a.
Regulation M
i.
as discussed above, rules 101
and 102 of regulation M
generally prohibit a
“distribution participant”, and
the issuer or a selling security
holder, respectively, in
connection with a distribution
of securities, from bidding for
or purchasing or from
attempting to induce any
person to bid for or purchase, a
"covered security" during the
applicable restricted period
39
b.
ii.
broker-dealers who engage in
bids for or purchases of ETNs,
including redemptions of
ETNs, could be deemed to be
“distribution participants”
within the meaning of
regulation M
iii.
on the basis of ETN issuer
representations in no-action
requests, particularly that ETNs
are redeemable on at least a
weekly basis and that the
secondary market price of the
ETNs should not vary
substantially from the value of
the relevant underlying indices,
the staff of SEC Division of
Trading and Markets has
confirmed that it will not
recommend enforcement action
(a) under rule 101, thus
permitting persons who may be
deemed to be participating in a
distribution of ETNs to bid for
or purchase ETNs during their
participation in such
distribution, or (b) under rule
102, thus permitting the ETN
issuer and affiliated purchasers
to redeem ETNs
Margin
i.
as discussed above, under
section 11(d)(1), a brokerdealer generally may not
extend credit in connection
with the purchase of any
security that is part of a new
issue if the broker-dealer was a
member of the selling
40
syndicate within the prior thirty
days
D.
ii.
rule 11d1-2 provides an
exemption for section 11(d)(1)
for a security issued by a
registered open-end investment
company or unit investment
trust with respect to
transactions by a broker-dealer
who extends credit on such
security, provided the person to
whom credit has been extended
has owned the security for
more than 30 days
iii.
although an ETN issuer is not a
registered open-end investment
company or unit investment
trust, in view of the substantial
similarity between ETNs and
ETFs, ETN issuers have
requested the same relief
afforded by rule 11d1-2 to
ETFs and other registered
open-end investment
companies
iv.
staff has confirmed that brokerdealers may treat ETNs as
shares issued by an open-end
investment company and
therefore may extend credit or
maintain or arrange for the
extension or maintenance of
credit on ETNs that have been
owned for more than 30 days
by the persons to whom credit
is to be provided
U.S. Taxation
1.
Holder of an ETN holds only a contract with
the issuer to receive a payment at a future date
41
based on the level of the underlying index or
other referent – in contrast to ETFs, ETN
holder has no ownership interest in the assets
that comprise the underlying referent and does
not actually receive dividends, interest or
other current income on underlying referent
assets, and only receives payment at maturity.
Also, ETN issuer is not required to own the
referent assets underlying the ETN, and
consequently may receive no current income
with respect to those assets.
2.
ETN disclosure documents generally provide
that ETN holders should treat the ETNs for
federal tax purposes as a cash-settled pre-paid
contract with respect to the underlying index
or other referent and that, if the ETNS are so
treated, the holder should recognize capital
gain or loss upon the sale, redemption or
maturity of the ETNs in an amount equal to
the difference between the amount received at
such time and the holder’s tax basis in the
ETNs.
3.
Exception: pursuant to IRS ruling 2008-1,
certain financial instruments linked directly to
the value of a foreign currency – including
single currency ETNs – should be treated like
debt for federal tax purposes.
4.
ETN disclosure documents caution that the
U.S federal income tax consequences of
investments in ETNs are uncertain, and that
the IRS and the U.S. Treasury are actively
considering the tax treatment of instruments
such as ETNs and may in the future assert
alternate tax treatment.
III.
Summary: Principal Similarities and Differences
between ETFs and ETNs
A.
Legal and Operational
42
1.
Organizational form of issuer
ETF: corporation or business trust (UITs are
trusts)
ETN: corporation
2.
Character of security
ETF: equity – an undivided interest in a pool
of assets
ETN: debt – senior, unsecured
3.
Term of security
ETF: if a corporation, perpetual; if a trust,
long term
ETN: typically 30 years
4.
Registration
ETF: ETF shares – 1933 Act, 1934 Act; ETF
issuer – 1940 Act
ETN: 1933 Act, 1934 Act
5.
Disclosure document
ETF: prospectus (part of registration
statement, usually on Form N-1A)
ETN: prospectus supplement (to MTN
prospectus supplement and debt shelf
prospectus, part of shelf registration
statement on Form S-3)
6.
Regulation
ETF: substantial regulation under 1940 Act
ETN: not regulated under 1940 Act
7.
Regulatory relief necessary
ETF: exemptive order under 1940 Act; noaction relief under 1934 Act
ETN: no-action relief under 1934 Act
43
8.
Exchange listing
ETF: pursuant to generic listing criteria (or
one-off 19b-4 order)
ETN: pursuant to generic listing criteria (or
one-off 19b-4 order)
9.
Principal service providers
ETF: sponsor (typically investment advisor),
administrator, distributor, custodian,
independent accountant, legal, index
provider/ calculator, exchange, market
participants (authorized participants,
other broker-dealers)
ETN: indenture trustee, underwriter,
independent accountant, legal, index
provider/ calculator, exchange, market
participants
10.
Portfolio assets
ETF: generally, all or portion of
securities/assets in underlying index
ETN: none (although issuer may hedge with
securities, derivatives, etc.)
11.
Portfolio management
ETF: index-based – limited to achieving
index performance;
actively managed – pursuant to stated
investment objectives
ETN: none
12.
Issuance of securities
ETF: continuous, in creation units, generally
for in-kind deposit at NAV
ETN: from time to time (and sometimes
reopened), at negotiated prices
13.
Redemption of securities
44
ETF: daily, in creation units, generally for
in-kind proceeds at NAV
ETN: at least once weekly, in large
aggregations, for cash, based on
current value of index factor and less
applicable fees
14.
Clearance and settlement
ETF: book-entry through facilities of DTC
ETN: book-entry through facilities of DTC
15.
Voting rights
ETF: if open-end form, yes; if UIT form,
generally none
ETN: none
16.
Taxation
ETF: taxation as a RIC
ETN: with certain exceptions, treatment as a
cash-settled prepaid contract (although
subject to change by IRS and U.S.
Treasury)
B.
Economic
1.
Liquidity
ETF: intraday over exchange or OTC at
market prices; redemption of creation
units at least once daily at NAV
ETN: intraday over exchange or OTC at
market prices; redemption of large
blocks at least once weekly based on
index factor
2.
Recourse
ETF: assets in portfolio
ETN: credit of the issuer
45
3.
Principal risk
ETF: market risk only
ETN: market risk and issuer credit risk
4.
Arbitrage
ETF: NAV purchase/redemption
mechanism, secondary market
ETN: redemption mechanism, purchases out
of inventory, secondary market
5.
Price transparency
ETF: intraday published indicative value;
published index/basket information
ETN: intraday published indicative value;
published index/basket information
6.
Distributions
ETF: yes; received or reinvested
ETN: none
7.
Fees and expenses
ETF: asset-based expense ratio;
issuance/redemption fees; brokerage
ETN: investor fee; redemption fees;
brokerage
46