The exchange-traded fund (ETF) is arguably

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1 The Investment Lawyer Covering Legal and Regulatory Issues of Asset Management VOL. 23, NO. 8 AUGUST 2016 ETF Industry Adjusts to Increased SEC Regulatory Scrutiny By Bibb L. Strench The exchange-traded fund (ETF) is arguably the most impactful financial product since the hedge fund. Investors have poured over $3 trillion into ETFs, while growth of its sister product the mutual fund has languished in recent years. ETFs have saved investors billions of dollars because of their significantly lower fees than mutual funds, in part because of their lower operating costs. Many industry pundits believe this lower cost structure will make the ETF the ideal product for 401(k) and individual retirement accounts (IRAs) when the new Department of Labor fiduciary rule is implemented. 1 Their signature create-redeem feature has injected tremendous liquidity in the markets where ETF portfolio securities trade. Financial alchemists strongly prefer the ETF structure over traditional open-end and closed-end funds when innovating investment strategies. It therefore may be surprising that ETFs have been under the closest regulatory scrutiny since the first one was launched in The Securities and Exchange Commission (SEC) has begun regulatory initiatives aimed at ETFs that span virtually all of its regulatory powers: disclosure, rulemaking, required reporting, examinations, market regulation, exemptive orders, and enforcement. While it is difficult to gauge its motives for unleashing this acrossthe-board regulatory onslaught, the SEC likely is reacting to the fact that it suddenly is regulating a multitrillion-dollar fund product. This article surveys the wide range of ETF regulatory initiatives that currently are under way at the SEC. As shown below, they impact virtually every ETF participant: ETF issuers, exchanges that trade ETFs, firms that make markets in ETF shares, and administrators and other service providers that support the ETF product. Disclosure Prior to the launch of an ETF, the SEC Staff provides comments on the disclosure in the ETF s prospectus. The SEC Staff also has the opportunity to comment on disclosure when an ETF makes certain material changes to its prospectus that trigger an extra annual update amendment called a 485(a) filing. While an ETF may ignore such comments, most are reluctant to do so. Since the prospectus is both a regulatory document and a marketing piece, SEC Staff comments requesting negative disclosure unfavorably impacts product marketing. For example, the SEC Staff has begun giving a comment that ETF prospectuses should disclose the risk that the market for the ETF shares may become less liquid if the market for the securities in which the ETF invests becomes distressed. In the SEC Staff s view, ETF prospectuses should state that the deteriorating liquidity in the market for the ETF s underlying portfolio holdings may adversely affect the ETF shares liquidity, leading to differences

2 2 THE INVESTMENT LAWYER between the market price of the ETF s shares and the underlying value of those shares. Through the comment process, the SEC Staff has also requested more detailed disclosure about the ETF s intra-day indicative value, including the risks that it will be inaccurate. ETFs can expect more suggested prospectus disclosure from the SEC Staff as the SEC continues to formulate its views of the risks associated with the ETF product. Rulemaking Oddly, no ETF rule exists for the $3 trillion ETF industry. A rule was proposed in 2008 but never adopted. Nevertheless, the vast majority of ETFs are open-end investment companies and SEC rules that apply to open-end investment companies (which include mutual funds) apply to ETFs. Two recently proposed rules addressing derivatives and portfolio liquidity would, if adopted in their current form, significantly impact ETFs. Derivatives On December 11, 2015, the SEC proposed Rule 18f-4 under the Investment Company Act of 1940 (1940 Act) that, if adopted, will, among other things: Limit the amount of notional exposure to derivatives an ETF can have to 150 percent of the ETF s net assets (or, a less likely scenario, to 300 percent if the ETF actually offers lower market risk because of that notional exposure). Require asset segregation for all derivative transactions, necessitating segregating assets through: (1) mark-to-market coverage, where the ETF s assets are equal to the amount that the [ETF] would pay if the [ETF] exited the derivatives transaction; or (2) risk-based coverage, where assets of the ETF would be required to be segregated as additional risk-based coverage representing a reasonable estimate of the potential amount the [ETF] would pay if the [ETF] exited the derivatives transaction under stressed conditions. 2 In the release proposing Rule 18f-4, the SEC acknowledged that certain leveraged ETFs would need to modify their portfolios to reduce their use of derivatives to comply with the 150 percent exposure limitation. Subsequently, SEC Chief Economist Mark Flannery acknowledged that Rule 18f-4 would cause a large number of leveraged ETFs to shut down. Besides leveraged ETFs, Rule 18f-4 in its present form would impede the use of derivatives by more mainstream ETFs, making certain investment strategies not possible or only achievable by using other instruments that are less than optimal. Liquidity On September 22, 2015, the SEC proposed Rule 22e-4 under the 1940 Act, which would require ETFs (as well as other open-end funds that are not money market funds) to establish a liquidity risk management program. 3 Each ETF would have to classify its portfolio assets on a continual basis into six buckets and monitor the assets liquidity. An ETF would also have to establish a minimum amount of its assets that would be held in cash and assets it believes are convertible to cash within three business days at a price that does not materially affect the assets value immediately prior to the sale. In the release proposing Rule 22e-4, the SEC noted that a significant amount of illiquid securities in an ETF s portfolio might negatively impact its create-redeem process by making arbitrage opportunities harder to evaluate because it would be difficult for market makers to price, trade, and hedge their exposure to the ETF. 4 In the SEC s view, the liquidity of the ETF s portfolio securities is a key factor that contributes to the effective functioning of [this] arbitrage mechanism and the ETF shares trading at a price that is at or close to the NAV of the ETF. 5 In comment letters to the SEC, ETF issuers have argued that proposed Rule 22e-4 should not apply to ETFs because, unlike mutual funds, ETF shares trade on a market at market prices and ETFs do not have to sell portfolio securities when a shareholder sells his or her shares. Furthermore, the Investment

3 VOL. 23, NO. 8 AUGUST Company Institute, the trade group for the investment company industry, has taken issue with the three-day liquid asset minimum. It stated that this restriction would preclude the ETF from accepting any security deemed a less liquid asset which may preclude the ETF from accepting an in-kind purchase that does not contain less liquid assets held by the ETF. 6 It remains to be seen if the ETF industry can convince the SEC that the proposed safeguards are not necessary, given the SEC s belief that arbitragers need ETF portfolio securities to be liquid so they can drive an ETF s market price to its net asset value per share through the create-redeem process. If not, ETF expense ratios (and those of mutual funds) will certainly rise because of the costs of implementing a liquidity risk program that, among other things, must track and capture information about the liquidity of thousands of portfolio positions on a daily basis. Reporting Like all registered investment companies, ETFs are subject to a regulatory reporting scheme including reports filed on Form N-SAR that are designed to provide the SEC with information it deems necessary to regulate investment companies. On May 20, 2015, the SEC proposed a number of rules and rule amendments and forms and form amendments that will require significantly more reporting and disclosure of information by registered investment companies, including ETFs, through an electronic system called N-PORT. 7 Proposed Form N-CEN would require that ETFs report the total value of creation units that were (1) purchased by authorized participants (APs) primarily in exchange for portfolio securities on an in-kind basis; (2) purchased by APs primarily in exchange for cash; and (3) redeemed on a cash basis. In addition, an ETF would have to report the name of each of its APs, the dollar value of the ETF shares the AP purchased during the reporting period and the dollar value of the ETF shares the AP redeemed during the reporting period. The SEC, when proposing the Rule 22e-4 liquidity risk program, also added still more granular information that ETFs would be required to report on Form N-CEN, including instances when an AP was required to post collateral to the ETF in connection with the purchase or redemption of ETF shares during the reporting period. The liquidity risk and reporting proposing releases reveal the SEC s desire for more knowledge and a better understanding of the basic workings of an ETF, including the create-redeem process and the central role the AP plays in that process. The SEC even asked if it is asking the right questions: Are there other reporting requirements that the Commission should adopt for ETFs? The new reporting scheme will lead to greater costs associated with gathering the information and formatting it in the required manner. Certain processes, like creates and redeems, will be more transparent to the SEC, which undoubtedly will result in regulatory inquiries for APs including market makers and ETF issuers. Of course, it is understandable why the SEC desires this information as it strives to keep up with an industry that is expected to add $1 trillion to $2 trillion in assets under management each year for the foreseeable future. Examinations For the past several years, the Office of Compliance Inspections and Examinations (OCIE), the SEC s inspection arm, has issued its Examination Priorities letter. Past letters made little or no mention of ETFs, 8 but OCIE s 2016 Examination Priorities letter for the first time devoted an entire section to them. OCIE stated that it will examine ETFs for compliance with applicable exemptive relief granted under the Securities Exchange Act of 1934 and the [1940 Act] and with other regulatory requirements, as well as review the ETFs unit creation and redemption process. 9 OCIE also stated that it will focus on sales strategies, trading practices and disclosures involving ETFs, including excessive portfolio concentration, primary and secondary market trading risks, adequacy

4 4 THE INVESTMENT LAWYER of risk disclosure, and suitability, particularly in niche or leveraged/inverse ETFs. 10 Since the release of its Examination Priorities letter, OCIE has expanded the number of ETF complex inspections it conducts compared to other types of investment company complexes. The length of a given ETF examination and the number of the SEC Staff participating also have increased. This trend is expected to continue, placing greater pressure on ETF complexes to implement robust compliance programs. Financial firms entering the ETF business should do so only after establishing complete and thorough compliance programs since such firms likely will be examined by OCIE within a couple of years of entering into the business. Markets As the ETF has grown into a multitrillion-dollar product, its impact on exchanges has increased exponentially. ETFs affect exchanges on two levels: Their shares trade on exchanges and they transact in securities that trade on exchanges. According to one source, about 25 percent of equity trading volume on exchanges can be attributed to ETFs; this could increase to 40 percent in the near future. 11 Because they comprise such a large percentage of the trading volume, ETF actions and reactions to extraordinarily volatile equity and other markets are intertwined with those of other market participants in a manner not fully understood by the SEC and the exchanges. The SEC, on its website and elsewhere, in part describes its mission as being to maintain fair, orderly, and efficient markets. On August 24, 2015, the equity and equity-related futures markets were far from orderly as they experienced extraordinary volume and significant price volatility, particularly at the start of regular trading hours. Big gaps were seen between the value of underlying indexes and the ETFs that track them. As a class, ETFs experienced greater increases in volume and more severe volatility than corporate stocks. Nearly 20 percent of all ETFs trading on the morning of August 24 exhibited abnormally high volatility. 12 Over 40 percent of the ETFs experienced trading halts. In December 2015, the SEC s Division of Trading and Markets addressed these incidents when it released an 88-page research report titled Equity Market Volatility on August 24, Even after issuing this report, the SEC continues to study this event nearly a year after its occurrence. SEC Chair Mary Jo White has stated that the SEC is focused on analyzing these events and any broader implications they may have for how we regulate ETFs. 14 She further stated that the SEC is analyzing the role that authorized participants and market makers play in the operation and trading of ETFs and how much they impact the liquidity in the markets. 15 While no specific recommendations have yet been made, the SEC and the exchanges are looking at market structure issues including the exchanges limit up/limit down rules that mandate trading halts if ETF shares prices rise or fall precipitously during a trading session. ETF industry participants continue to provide the SEC with their own analysis of the August 24 event, knowing that regulatory policies in reaction or overreaction to that event likely could have profound effects on the ETF product. Exemptive Orders Because the SEC has yet to adopt an ETF rule, financial firms seeking to enter into the ETF business must obtain an exemptive order from the SEC. New and existing ETF sponsors looking to launch a novel ETF need exemptive relief from the SEC s Division of Investment Management and the exchanges that trade a novel ETF may need to file proposed rule changes with the SEC s Division of Trading and Markets that establish listing standards for the novel ETF s shares. This exemptive and rulemaking authority allows the SEC to act as gatekeeper for new ETF products. The SEC recently opened the gate by issuing a pioneering order allowing a hybrid ETF-mutual fund called the exchange-traded mutual fund. 16

5 VOL. 23, NO. 8 AUGUST The gate remains closed for other novel exemptive applications, most notably an actively managed ETF that would not reveal its portfolio holdings on a daily basis. Since 2011, several financial firms have filed for exemptive relief but failed to receive it because the applicants had not provided an adequate substitute for portfolio transparency such that the proposed ETFs would consistently trade at or close to the value of their holdings. 17 Financial firms seeking to launch novel ETFs should continue to expect a long road to SEC approval. Enforcement Actions The most powerful tool in the SEC s regulatory arsenal is its ability to bring civil enforcement actions. To date, ETFs have remained below the SEC s enforcement radar. This may be changing. In August 2015, Pacific Investment Management Co. LLC (PIMCO) issued a press release about receiving a Wells notice from the SEC concerning one of its ETFs. 18 A Wells notice is an indication that the SEC s Enforcement Staff intends to recommend to the SEC Commissioners that the agency bring a civil action against a firm for securities laws violations. In this case, the SEC is examining how PIMCO valued smaller-size positions in non-agency mortgage-backed securities purchased by a PIMCO ETF during a four-month period between the ETF s launch on February 29, 2012 and June 30, The SEC also is reviewing the ETF s performance disclosures for that period, as well as PIMCO s compliance policies and procedures. Referrals after OCIE finds violations at a fund complex are a major source of SEC enforcement actions. As noted, the SEC has been ramping up its inspections of ETFs. The increased number of examinations undoubtedly will lead to more ETFrelated referrals by OCIE to the Enforcement Division. Conclusion Financial firms entering into or expanding ETF businesses should closely follow the unfolding ETF-related regulatory actions described above because they will impact firms product initiatives, compliance programs, and cost of doing business. It remains to be seen whether the heightened regulatory scrutiny will create significant headwinds that slow ETF innovation, deter new entrants into the ETF industry, or result in a less ideal financial product. Industry participants hope that their ongoing interactions with the SEC will instead lead to a better ETF product that thrives in a sounder and rational regulatory environment. The ETF industry and the SEC might consider harkening back to 1993 when State Street Bank, the American Stock Exchange, and the SEC worked out their respective differences and issues to settle on the final form of one of history s most successful financial products the ETF. Bibb L. Strench is a partner in Thompson Hine LLP s Washington, DC office. NOTES 1 See Definition of the Term Fiduciary ; Conflict of Interest Rule Retirement Investment Advice, 81 Federal Register (April 8, 2016). 2 Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Rel. No (Dec. 11, 2015). 3 Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Securities Act Rel. No (Sept. 22, 2015) See comment letter from the Investment Company Institute (Jan. 13, 2016), available at org/pdf/29920.pdf. 7 Investment Company Reporting Modernization, Securities Act Rel. No (May 20, 2015). 8 See (Jan. 11, 2016).

6 6 THE INVESTMENT LAWYER Bloomberg, The ETF Files: How the US Government Inadvertently Launched a $3 Trillion Industry (Mar. 7, 2016). 12 Kara Stein, Remarks at the SEC Speaks Conference: What Lies Ahead?, gov/news/speech/stein-sec-speaks-2016.html (Feb. 19, 2016). 13 See market_volatility.pdf (Dec. 2015). 14 Mary Jo White, keynote address, Investment Company Institute 2016 General Meeting The Future of Investment Company Regulation (May 5, 2016) Eaton Vance Management, Investment Company Act Rel. No (Nov. 6, 2014). 17 BlackRock and Precidian Fail to Secure SEC Nod for Dynamic Active ETFs, New York Times (Oct. 23, 2014). 18 Press release, PIMCO Makes Announcement About ETF BOND (Aug. 3, 2015). Copyright 2016 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer, August 2016, Volume 23, Number 8, pages 1, 4 8, with permission from Wolters Kluwer, New York, NY, ,