SEC modernizes rules on exchange-traded funds

Although ETFs were first developed almost three decades ago, these hybrid investment products were not originally allowed under securities laws, the SEC explained in a press release announcing its action. To get around that barrier, the Commission over the years issued upward of 300 exemptive orders that allowed ETFs to operate pursuant to the Investment Company Act of 1940. Now, roughly 2,000 ETFs exist with more than $3.3 trillion in total net assets.

They are a product popular with investors, SEC Commissioner Hester Peirce said earlier this year at a workshop on ETFs and market liquidity. “As of mid-2017, ETFs were in the portfolios of 7.8 million U.S. households,” she said. Peirce described the funds as “a low-cost investment option with tremendous diversity.”

A standardized approach

Although the exercise of getting 1940 Act exemptive relief to operate ETFs had become pretty standardized in recent years, with some 300 different orders out there, “the relief had evolved over time and had provided more or less flexibility depending on who got the relief when,” explains Brian McCabe, a partner at the law firm Ropes & Gray. This piecemeal approach was not necessarily a fair one. “Previously, different ETF groups had different regulatory requirements depending upon when they obtained exemptive relief from the SEC over the last 25 years,” notes Michael Mundt, a partner at the law firm Stradley Ronon Stevens & Young.

The SEC’s new rule “levels the playing field,” McCabe says. Known as Rule 6c-11, it allows the majority of ETFs to operate under the Investment Company Act of 1940, provided that certain conditions, including daily portfolio transparency and Website disclosures, are met. Overall, the new rule “reduces regulatory barriers to entry for new ETF sponsors, who now should be able to bring products to market more quickly and with lower costs,” Mundt says.

The rule also allows ETFs to develop so-called “custom baskets” of securities and other assets that do not reflect a pro-rata representation of the fund’s portfolio or that differ from the initial basket used in transactions on the same business day.

“The rule helps smaller issuers looking to enter the ETF market by removing the additional effort and expense of obtaining exemptive relief.” 

Tanya Cody, Of Counsel, Greenberg Traurig

“The flexibility to do custom baskets is something the ETF industry” had sought for years, observes Adam Teufel, a partner at the law firm Dechert. The new rule does, however, require that an ETF adopt policies and procedures on the construction of custom baskets.

A win for industry?

The SEC’s action was generally met with approval. “The rule helps smaller issuers looking to enter the ETF market by removing the additional effort and expense of obtaining exemptive relief,” says Tanya Cody, of counsel at the law firm Greenberg Traurig. The new requirements also help “issuers already in the ETF space whose exemptive relief does not allow for custom baskets,” she adds.

Also, “costly and unnecessary consumer right type requirements in the proposed rule, such as a bid-ask spread calculator, did not make it into the final rule,” says Bibb Strench, a partner at the law firm Thompson Hine.

That being said, “many ETF participants may still view the disclosure requirements as burdensome and not necessarily helpful given the market’s familiarity with ETFs,” says Laura Flores, a partner at the law firm Morgan Lewis.

It could have been worse, though. “The disclosure requirements imposed by the rule are an improvement when compared to those that were proposed,” she says.

Next steps for compliance

High on the to-do list for compliance teams at organizations relying on the new rule should be the development and implementation of “policies and procedures governing the construction of baskets and the process that the ETF will use for the acceptance of baskets,” Cody suggests. If the ETF will use custom baskets, policies and procedures must also include “detailed parameters for the construction and acceptance of custom baskets that are in the best interest of the ETF and its shareholders,” she notes. In addition, “the titles or roles of the employees of the ETF’s investment adviser who are required to review each custom basket for compliance with those parameters” must also be specified, Cody says.

Entities currently operating under an exemptive order should be aware that “most existing ETF exemptive orders will be rescinded one year after the effective date of the ETF rule,” Mundt says. “Chief compliance officers for existing ETFs therefore will need to consider how previous procedures to ensure compliance with ETF exemptive orders may need to be adjusted to comply with the ETF rule.”

The rule will become effective 60 days after its publication in the Federal Register. “ETFs will have a one-year transition period following the publication of the rule in the Federal Register to prepare to comply with the rule,” Flores says.

Lori Tripoli is a writer based in the greater New York City area who focuses on legal and regulatory issues.