Investment Management Alert
March 2008
Authors:
Stacy L. Fuller
+1.202.778.9475
stacy.fuller@klgates.com
Francine J. Rosenberger
+1.202.778.9187
francine.rosenberger@klgates.com
K&L Gates comprises approximately 1,500
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SEC Proposes ETF Rules
At its open meeting on March 4, 2008, the Securities and Exchange Commission (“SEC”) took
an important step forward for ETF development. There, the SEC unanimously approved the
proposal of two new rules (“Proposal”) under the Investment Company Act of 1940 (“Act”)
concerning exchange-traded funds (“ETFs”). The SEC issued the proposed rules on March 11,
2008. In the Proposal, the SEC confronts actively managed ETFs for the first time in almost
seven years and sets forth for the first time ever its vision of an ETF regulatory regime.1
If adopted, the Proposal would:
• adopt new Rule 6c-11 to permit certain index-based and actively managed ETFs that have
fully transparent portfolios to launch without obtaining individualized exemptive orders
from the SEC, as is currently required, essentially codifying the relief in these orders;
• amend the disclosure requirements for ETFs to “provide more useful information to
individual investors;”2
• adopt new Rule 12d1-4 to permit investment companies to make significant investments
in ETFs under simpler conditions than those imposed on traditional mutual funds; and
• expand Rule 12d1-2 to permit registered funds that operate in reliance on it to invest in ETFs
pursuant to new Rule 12d1-4 and to invest in futures and other financial instruments.
The SEC’s stated objective for the Proposal is to “eliminate unnecessary regulatory burdens
and to facilitate greater competition and innovation among ETFs.”3
The deadline for submitting comments on the Proposal is on or about May 12, 2008. The full
text of the proposing release (Release No. IC-28193) is available on the SEC Web site at http://
www.sec.gov/rules/proposed.shtml. Comments received by the SEC regarding the release will
also be available online at http://www.sec.gov/comments/s7-07-08/s70708.shtml.
ETF Regulation and Proposed Rule 6c-11
Although the Act provides a clear regulatory regime for both mutual funds and closed-end
funds, it does not provide a regime for hybrid products, like ETFs. Currently, the SEC fills
this regulatory vacuum by using its exemptive authority to create such a regime. Since ETFs
were first proposed in 1992, the SEC has issued numerous exemptive orders to permit their
operation. Proposed Rule 6c-11 would codify much of this relief for index-based and actively
managed ETFs that satisfy the rule’s definition of “exchange-traded fund,” eliminating their
need to obtain an exemptive order from the SEC and permitting them to register as open-end
funds that utilize the regulatory regime established by the Act for such funds.4
SEC Concept Release: Actively Managed Exchange-Traded Funds, Inv. Co. Act Rel. No. IC-25258 (November
8, 2001). The SEC has generally issued standard exemptive orders without comment in the
intervening period.
2
Proposal at 8.
3
Proposal at 1. See also Open Meeting Transcript (statement of Division Director describing the exemptive
applications process as a “not insignificant barrier” to entering the ETF market).
4
The proposed rule would achieve this end by deeming ETF shares to be redeemable securities within the meaning
of Section 2(a)(32) of the Act, which would result in ETFs being open-end management investment companies
under Section 5(a)(1) of the Act.
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Investment Management Alert
The proposed rule defines “exchange-traded funds”
to mean registered open-end funds that, among other
things, either make daily disclosure of the identities
and weights of their portfolio securities or (1) have
a stated investment objective of obtaining returns
that “correspond” to those of a securities index that
is identified in its registration statement and (2)
the index’s provider makes daily disclosure of the
identities and weights of the index’s securities.5 The
proposed rule would not require disclosure of intraday trades made by an ETF’s adviser(s) because such
trades do not affect the ETF’s NAV on the day of the
trade due to a standard fund accounting mechanism.6
In addition, unlike previous exemptive orders that
required every ETF to provide full portfolio disclosure
(either by identifying creation unit baskets that were
pro rata slices of the ETF portfolio or by posting the
ETF portfolio on its Web site), the Proposal would not
require such disclosure of an ETF that tracks an index,
provided that a weighted composite of the index were
otherwise available; this change in tack by the SEC
may address concerns some have voiced that existing
index-based ETFs could be front-run.
Under Proposed Rule 6c-11, the definition of
“exchange-traded funds” would require ETFs to:
• have their shares listed and traded on a national
securities exchange;7
• market themselves as ETFs whose individual shares
can only be purchased and sold on an exchange;
• when selling and redeeming ETF shares,8 transact
in creation units and have the value of such creation
The proposed rule would not extend to ETFs organized as unit
investment trusts (“UITs”). The Proposal notes that exemptive
relief has not been sought for an ETF organized has a UIT
since 2002 and that, as a result, the SEC concluded that there is
no need for the proposed rules to provide such relief. The release
notes, however, that such relief could still be sought through the
applications process.
6
For further explanation, see Stacy Fuller and Richard M. Phillips,
“SEC Green-Lights First Actively Managed ETFs,” K&L Gates
Client Alert (February 2008), at notes 6 and 7 (and
surrounding text).
7
The proposed rule would provide qualifying ETFs with relief
from Section 22(d) of the Act and Rule 22c-1 under the Act to
permit dealers to sell and repurchase ETF shares at a price other
than NAV.
8
Although the proposed rule does not set a floor or a ceiling on the
number of ETF shares in a creation unit, the definition of
“creation unit” requires the number to be “reasonably designed
to facilitate” arbitrage. Proposed Rule 6c-11(e)(3).
5
units on a per-share basis regularly disseminated
by the exchange; and
• disclose on their Web site every day the previous
day’s NAV and closing market price, as well as
any difference between such NAV and market price
(“premiums/discounts”).
In sum, the Proposal would provide for the industry
at large all of the exemptive relief that is necessary to
launch ETFs comparable to those currently available
and make launching such ETFs easier by eliminating
the need for an exemptive order and reducing certain
disclosure requirements for affiliated and unaffiliated
index-based ETFs.
Disclosure Amendments
Section 24(d) of the Act. The Proposal would not codify
the exemption from Section 24(d) that has been granted
in past exemptive orders to some ETF sponsors.
Pursuant to Section 24(d) exemptions, broker-dealers
have been permitted to deliver a “product description,”
rather than an ETF prospectus, in connection with
secondary market transactions in ETF shares. ETF
sponsors have sought such relief to put secondary
market transactions in ETF shares on par with such
transactions in closed-end fund shares, which do not
necessitate delivery of a prospectus.
According to the Proposal, the SEC determined not
to include Section 24(d) relief in the Proposal for
two reasons. First, despite the SEC’s having granted
the exemption, broker-dealers have continued to
deliver prospectuses in connection with secondary
market transactions in ETF shares.9 Second, and
“[m]ore important,” the SEC recently proposed
the summary prospectus which, if adopted, would
require key information about the ETF to appear in a
summary document that broker-dealers could deliver in
connection with secondary market transactions in ETF
shares to satisfy their prospectus delivery obligation.
To increase the uniformity of ETF disclosures and to
level the playing field among ETFs and between ETFs
and funds, the Proposal would amend outstanding ETF
orders that grant exemptions from Section 24(d) to
rescind such exemptions. As a result, even for ETFs
that had obtained Section 24(d) exemptions, broker9
At the open meeting, the SEC staff indicated that broker-dealers
have opted to deliver a prospectus due to operational and legal
issues posed by the delivery of a product description.
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Investment Management Alert
dealers would be required to use alternative means to
satisfy their prospectus delivery obligation.10
Amendments to Form N-1A. The Proposal would
amend various disclosure requirements in Form N-1A
to tailor ETF prospectuses to “the needs of investors
who purchase shares in the secondary market.” Unlike
existing ETF prospectuses, which primarily address
the concerns of institutional investors that transact
with ETFs in creation units, the Proposal would
revise the ETF prospectus to address an audience of
retail investors. In this regard, the Proposal continues
the theme of unifying the disclosures provided by
mutual funds and ETFs, which the SEC apparently
sees as increasingly competing with and “becoming
more like traditional mutual funds.” Specifically, the
Proposal would:
• replace information currently in the ETF prospectus
on creation unit redemptions with disclosure that
ETF shares can only be bought and sold on the
secondary market through a broker-dealer;11
• replace disclosure in the ETF prospectus regarding
fees incurred in connection with creation unit
transactions with disclosure regarding the possible
payment of brokerage commissions in connection
with secondary market transactions;
• require total return disclosures to show ETF
returns based on market price and NAV, rather than
just NAV;
• require disclosures on the ETF’s Web site, and in its
prospectus and annual report regarding premiums/
discounts; and
• require index-based ETFs to compare their
performance to their underlying indexes.
Under the Proposal, conforming changes would be
required in sales literature and marketing materials for
ETFs. The Proposal would also require conforming
changes to the summary prospectus.
The Proposal would, however, extend previously granted relief
from Section 24(d) throughout any period following adoption
of proposed Rule 6c-11 and preceding adoption of the summary
prospectus proposal.
11
The ETF prospectus would include disclosure on the number of
ETF shares in a creation unit. Proposed Item 6(h)(3) to Form
N-1A. Under the Proposal, the SAI would continue to include
disclosure regarding creation unit purchases.
10
Proposed Rule 12d1-4
In addition to facilitating the launch of ETFs,
the Proposal would facilitate investments in
ETFs by providing a conditional exemption from
Section 12(d)(1) of the Act for such investments.
Section 12(d)(1) limits the ability of investment
companies (including registered and unregistered
funds, open-end and closed-end funds, and business
development companies) (“acquiring funds”) to invest
in registered investment companies (“acquired funds”),
including mutual funds and ETFs.12 Proposed Rule
12d1-4 would permit acquiring funds to invest in ETFs
in excess of Section 12(d)(1)’s statutory limits subject
to the following four conditions:13
• the acquiring fund does not control the ETF, is not
presumed to control the ETF by virtue of owning
25% or more of its shares, and does not seek to
exercise control over the ETF;
• an acquiring fund that owns more than 3% of
the ETF’s shares only sells its holdings in the
secondary market;
• the ETF is not itself a fund of funds;14 and
• the acquiring fund’s sales charges and service fees
comply with limits set by the Financial Industry
Regulatory Authority.15
Proposed Rule 12d1-4 could prove to be the “story” of
this Proposal for the ETF industry. The proposed rule
would make it dramatically easier for a broad swath of
institutional investors to invest in ETFs than in mutual
funds. Under the Proposal, registered funds of all types
(mutual funds, closed-end funds, unit investment
trusts and business development companies), as well
as unregistered funds, including hedge funds, could
make substantial investments in ETFs merely by
Section 12(d)(1) prohibits an acquiring fund from (i) acquiring
more than 3% of an acquired fund’s outstanding voting securities,
(ii) investing more than 5% of its assets in an acquired fund
and (iii) investing more than 10% of its assets in acquired funds
generally.
13
The SEC has previously issued numerous exemptive orders to
permit such investments by acquiring funds.
14
The ETF must have a disclosed policy of not investing more
than 10% of its assets in other funds. Proposal at 74-75 and note
25 (noting exception for master-feeder structures in which the
ETF operates as a feeder fund).
15
See NASD Conduct Rule 2830(d)(3). The proposed rule would
impose additional limits on fees charged by separate accounts
that invest in acquiring funds. Proposal at 77 n.231.
12
March 2008 | 3
Investment Management Alert
complying with the four simple conditions set forth in
the proposed rule. By contrast, in order to make similar
investments in traditional mutual funds, such investors
would be required to obtain an exemptive order from
the SEC and comply with 12 cumbersome and costly
conditions. This difference in treatment may allow
ETFs to challenge the primacy of mutual funds in the
race for investor dollars and, in that regard, further
pressure advisers that have thus far resisted the siren
song of ETFs to reconsider entering the ETF race.
Proposed Revisions to Rule 12d1-2
The Proposal would also revise Rule 12d1-2 under
the Act. Rule 12d1-2 was adopted in 2006 to permit
mutual funds, which invest in other mutual funds
in reliance on Section 12(d)(1)(G), to invest also in
money market funds and other “securities.” Following
adoption of the rule, it became apparent to the SEC
that Rule 12d1-2 was insufficiently broad: funds also
wished to invest in types of financial instruments
other than “securities,” including futures and other
derivatives. Under the Proposal, funds operating in
reliance on Rule 12d1-2 could make such investments
as well as investments in ETFs in reliance on proposed
Rule 12d1-4.
Conclusion
The Proposal marks an important step in the
development of ETFs. In the first time that the
Commission has addressed the issue of actively
managed ETFs since 2001, it has moved to liberalize
the regulatory regime and to unleash forces of
competition that could reshape the fund industry.
Commissioner Casey at the open meeting specifically
asked for comment on the importance of the efficiency
of the arbitrage mechanism, including whether the SEC
should grant exemptive relief to permit ETFs with less
efficient arbitrage mechanisms.16 We expect this to be
an area of intense comment and an area that should
provide significant potential for product innovation
in 2008.
Open Meeting Transcript (statement of Commissioner Casey).
16
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