SEC Proposes New Exchange-Traded Fund and Fund of Funds Rules

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1 April 2008 SEC Proposes New Exchange-Traded Fund and Fund of Funds Rules From the Investment Management Practice Group The Securities and Exchange Commission (the SEC or Commission ) recently proposed two new rules under the Investment Company Act of 1940, as amended (the Act ), designed to facilitate the creation of, and investment into, exchange traded funds ( ETFs ). The first proposed rule, rule 6c 11, would permit an ETF to commence operations without first obtaining exemptive relief from the Commission. The second proposed rule, rule 12d1 4, would facilitate investments by other investment companies into ETFs in excess of the limits prescribed by Section 12(d) of the Act, again without first obtaining exemptive relief from the Commission. 1 At the same time, the SEC also proposed amendments to Form N 1A, which is used by open end investment companies, including ETFs, to register under the Act. These amendments are designed to better tailor ETF prospectuses to provide information important to ETF investors. The proposed rules and proposed amendments to Form N 1A are described more fully below. Comments on these proposals are due by May 19, FORMATION AND CREATION OF ETFs PROPOSED RULE 6c-11 Currently, before an ETF can be brought to market, the ETF must obtain an order from the Commission granting exemptions from various provisions of the Act. For example, ETF shares may only be redeemed by certain persons, typically brokers or other financial intermediaries, called authorized participants, and then only in large aggregations of shares called creation units. As a result, retail purchasers typically cannot redeem their ETF shares; instead, they sell these shares over an exchange in secondary market transactions. This limited redeemability violates the provisions of Section 2(a)(32) and 5(a)(1) of the Act. The pricing mechanism for ETFs violates Section 22(d) of the Act, since retail ETF shares are purchased and sold at negotiated market prices, rather than at net asset value ( NAV ). Other aspects of the way that ETFs operate violate Sections 17(a)(1) and (2), and rule 22c 1 of the Act. 2 If adopted, proposed rule 6c 11 would eliminate the need for most ETFs to obtain this exemptive relief. As proposed, the rule would apply equally to traditional index based ETFs as well as to actively managed ETFs, which have recently been approved by the Commission. 3 While proposed rule 6c 11 would codify much of the relief contained in existing exemptive orders, it also liberalizes certain conditions contained in these orders, particularly those applicable to ETFs which seek to replicate an index developed by its adviser or by an affiliated entity. At the same time, the proposed rule would eliminate one element of relief that had been granted in all ETF exemptive orders, which had exempted secondary market purchases of ETF shares from the prospectus delivery requirements of the Act. Conditions of the Rule Proposed rule 6c 11 would permit ETFs to (i) be registered under the Act as open end investment companies; (ii) trade its shares on a national securities exchange at negotiated market prices rather than at NAV; (iii) issue and redeem shares in large aggregations only ( Creation Units ) in exchange for the deposit or delivery of a basket of securities and other assets ( Basket Assets ); and (iv) when satisfying redemption requests (which is typically done by the delivery in kind of a basket of securities), permit the delivery of foreign securities to take place up to 12 calendar days after the tender of a Creation Unit Offices Worldwide Paul, Hastings, Janofsky & Walker LLP

2 The proposed rule would only apply to ETFs that are organized as open end investment companies. It thereby would exclude ETFs that are organized as unit investment trusts ( UITs ). 5 In order to rely on proposed rule 6c 11, ETFs will be required to satisfy the following conditions: Transparency of Index and Portfolio Holdings In order to rely on the rule, an ETF must either (i) disclose on its website each business day the identity and weighting of each component security and other assets held by the fund, or (ii) have a stated investment objective of obtaining returns that correspond to the returns of a securities index, whose provider discloses on its website the identity and weighting of each component security and other assets of the index. As such, the Proposing Release explains that an actively managed ETF would be able to rely on the proposed rule provided, of course, that the actively managed ETF is fully transparent (i.e., it must disclose portfolio holdings at least daily). In the Proposing Release, the Commission noted that it will continue to consider exemptive applications for actively managed ETFs that disclose portfolio holdings less frequently than daily. Listing on a National Securities Exchange In order to rely on the proposed rule, an ETF s shares must be approved for listing and trading on a national securities exchange. By listing on an exchange, the Commission explains that an organized and continuous market would be provided for the ETF shares to trade at negotiated prices. In addition, the national securities exchange on which the ETF s shares trade must provide an intraday value of the Basket Assets of the ETF on a per share basis at regular intervals throughout the trading day ( Intraday Value ). The proposed rule does not, however, require the dissemination of an ETF s Intraday Value at specific intervals because the rules of national securities exchanges, as approved by the Commission, establish the frequency of disclosure. Marketing The proposed rule would require each ETF relying on the rule to be identified in sales literature as an ETF that does not sell or redeem individual shares, and explain that investors may purchase or sell individual ETF shares in secondary market transactions that do not involve the ETF. This condition, the SEC explains, is designed to prevent secondary market investors from confusing ETFs with traditional mutual funds. Conflicts of Interest The proposed rule does not contain the myriad of conditions that exist in current exemptive orders for ETFs which seek to replicate an index developed or maintained by an affiliated entity. These conditions had included so called firewalls between persons involved in the creation and maintenance of the index and portfolio personnel. These firewalls were designed to protect against potential conflicts that may result from this relationship, such as manipulation of the index or the potential misuse of non public information by ETF sponsors who use affiliated index providers. In doing so, the Proposing Release notes that current provisions under the Act, the federal securities laws and the rules of national securities exchanges, already require funds and advisers to establish policies and procedures to manage conflicts of interest and to prevent misuse of non public information. The Commission, therefore, determined that additional requirements in the proposed rule in this area were not necessary. Thus, the Release does not contemplate that policies and procedures reasonably designed to address such conflicts are not required, only that funds and advisers may have more latitude to develop policies appropriately structured to address their particular facts and circumstances. Delivery of Prospectuses to Investors Proposed rule 6c 11 does not contain the exemption, contained in all current ETF orders, from Section 24(d) of the Act exempting broker dealers who sell ETF shares from the obligation to deliver prospectuses in most secondary market purchases. 6 The Section 24(d) exemption had permitted broker dealers to deliver a product description in lieu of a prospectus in secondary market purchases of ETF shares. Product descriptions, however, have no formalized content requirements and generally contain only basic information about the ETF and its shares. By removing this exemption, the proposed rule would require broker dealers to deliver a prospectus meeting the requirements of Section 10(a) of the Securities Act of 1933, as amended (the Securities Act ), to investors purchasing shares of ETFs in secondary market 2

3 transactions. The Commission further proposed to amend all existing exemptive orders issued to ETFs that are organized as open end funds to remove this relief, so that all ETFs, whether they rely on rule 6c 11 or an SEC exemptive order, will be required to satisfy the prospectus delivery requirements of Section 24(d) of the Act for secondary market purchases. 7 In determining that Section 24(d) relief was no longer appropriate for ETFs, the Commission noted that broker dealers selling ETF shares in secondary market transactions do not generally use the product description today, and, therefore, relief from Section 24(d) was not required. The Proposing Release further explains that the Commission s recent summary prospectus proposal 8 also played a role in its determination to discontinue granting Section 24(d) relief to ETFs. The Proposing Release notes that, if adopted, the summary prospectus could be used by broker dealers selling ETF shares in secondary market transactions, in lieu of delivering a full prospectus. In the event that proposed rule 6c 11 is adopted prior to the adoption of the summary prospectus proposal, the Commission would allow dealers to deliver a product description in lieu of a prospectus, pending the outcome of the summary prospectus proposal. Prospectus Disclosure Amendments Amendments to Form N-1A The Proposing Release also proposes amendments to Form N 1A to accommodate the use of the form by ETFs. This proposal is designed to revise the prospectus disclosure requirements in Form N 1A to provide more useful information to secondary market investors in shares of ETFs. In particular, the Commission has proposed, among other things, to: amend Item 6 of Form N 1A to eliminate the requirement that ETF prospectuses disclose information regarding the purchase and sale of ETF shares because this information is not relevant to secondary market investors, and amend Item 3 to exclude the fees and expenses associated with purchases or sales of Creation Units from the fee table; 9 modify instructions to several items that require the use of an ETF s NAV to determine its return so that, in addition to returns based on NAV, ETFs would also be required to include returns based on the market price of shares likely providing retail investors with a better sense of an ETF investor s experience in a given ETF; require disclosure about the extent and frequency that market prices of fund shares have tracked the fund s NAV, which would be provided on the fund s website in addition to being included in the prospectus; amend the prospectus and annual reporting requirements of Form N 1A to require an indexbased ETF to compare its performance to its underlying index rather than a broad based securities markets index currently required by Form N 1A. This change will allow for the use of a narrow based or affiliated index that would more accurately reflect whether the ETF s performance corresponds to the performance of the index which it seeks to track; and require key information to appear in plain English in a summary section of the prospectus, which also would comprise the information in the summary prospectus. Corresponding changes are recommended for the proposed summary prospectus. PROPOSED RULE 12d1-4 As background, Section 12(d)(1) of the Act limits the ability of one investment company (the Acquiring Fund ) to invest in another investment company (the Acquired Fund ). In particular, under Section 12(d)(1)(A), an Acquiring Fund is subject to the following limits when investing in an Acquired Fund (i) the Acquiring Fund may not own more than 3% of the voting stock of the Acquired Fund; (ii) the Acquiring Fund may not invest more than 5% of its total assets in the Acquired Fund; and (iii) the Acquiring Fund may not invest more than 10% of its total assets in the Acquired Fund and in all other investment companies. Section 12(d)(1)(B) effectively imposes similar obligations on the Acquired Fund not to sell its securities to an Acquiring Fund in such a way as to cause the Acquiring Fund to breach these limitations. For many years now, the Commission has issued exemptions from these limitations to both Acquired Funds and Acquiring Funds if the funds agree to certain conditions. The Proposing Release notes that ETF 3

4 sponsors have recently suggested to the Commission that certain conditions in these exemptive orders are burdensome and unnecessary and encouraged the Commission to develop a rule that addresses these concerns with regard to fund investments in ETFs. Scope of Proposed Rule 12d1-4 In response, the Commission has proposed rule 12d1 4 that would permit Acquiring Funds to invest in ETFs in excess of the limits of Section 12(d)(1), subject to the four conditions described below. The proposed rule would apply to investments in ETFs by open end and closedend investment companies, including business development companies, and UITs. In addition to the exemption from Section 12(d)(1) of the Act, the proposed rule would provide exemptions from Sections 17(a)(1), 17(a)(2), 57(a)(1) and 57(a)(2) of the Act, which restrict a fund s ability to enter into transactions with affiliated persons. 10 Proposed rule 12d1 4 would also eliminate or liberalize certain conditions contained in the exemptive orders that have allowed funds to invest in ETFs beyond the limits of Section 12(d)(1). These conditions had included (i) the establishment of specified policies and procedures to limit the control and influence an Acquiring Fund can exert on the ETF; (ii) policies and procedures and Board review of certain fees charged to the Acquiring Fund and its shareholders, fee offsets by an Acquiring Fund adviser which receives compensation, either directly or through an affiliate, such as 12b 1 fees, from an ETF in which the Acquiring Fund invests, as well as required annual determinations by the Acquiring Fund s Board relating to the nonduplicative nature of the Acquiring Fund s advisory fee; (iii) limits on the Acquired Fund s ability to invest in other funds and on an Acquiring Fund s ability to redeem its shares in an ETF; and (iv) the requirement that the ETF and each Acquiring Fund must enter into an agreement ( Participation Agreement ) containing certain specified terms. Importantly, the proposed rule eliminates many of these conditions and in particular eliminates the need for funds to enter into Participation Agreements with ETFs. The proposed rule contains only four conditions: Control Proposed rule 12d1 4 would limit the exemption to an Acquiring Fund that does not control an ETF. As such, an Acquiring Fund could beneficially own up to 25% of the voting securities of the ETF without the need to obtain exemptive relief. Although, if an Acquiring Fund uses its ownership interest to exercise control over an ETF s management or policies, the Acquiring Fund would not be able to rely on the proposed rule, even if the Acquiring Fund had less than a 25% interest in the ETF. Redemptions Proposed rule 12d1 4 includes two mirror provisions that would prevent an Acquiring Fund from redeeming shares that it had acquired in reliance on the proposed rule. First, an Acquiring Fund that acquires more than 3% of an ETF s shares, in reliance on the proposed rule, is prohibited from redeeming those shares directly from the Fund. Instead, an Acquiring Fund seeking to dispose of the ETF s shares would be required to sell those shares in secondary market transactions. Second, the proposed rule would prohibit an ETF, its principal underwriter, and a broker or a dealer that relies on proposed rule 12d1 4 to sell shares in excess of the Section 12(d)(1)(B) limits from redeeming the Acquiring Fund s ETF shares that exceed the 3% limit in Section 12(d)(1)(A). These provisions were designed to limit the potential for an Acquiring Fund to threaten large scale redemptions as a means of coercing an ETF. 11 Complex Structures The proposed rule would prohibit an acquired ETF from itself being a fund of funds. In the Proposing Release, the Commission explains that a fund of ETFs has the potential to become the sort of complicated structure that Section 12(d)(1) was designed to prevent. Layering of Fees The proposed rule would also limit sales charges and service fees charged by the Acquiring Fund to those set forth in the Financial Industry Regulatory Authority s ( FINRA ) sales charge rule. FINRA s sales charge rule takes into account fees charged at both levels of a fund of funds arrangement. 4

5 PROPOSED AMENDMENTS TO RULE 12d1-2 One exception to the investment limits in Section 12(d)(1), Section 12(d)(1)(G), permits a registered open end investment company or UIT to invest in other registered open end investment companies or UITs within the same group of investment companies. A fund, however, that invests in unaffiliated ETFs is, in many circumstances, still subject to the Section 12(d)(1) limits. As such, the Commission proposed to amend rule 12d1 2 to allow Acquiring Funds that invest in affiliated funds in reliance on Section 12(d)(1)(G) to invest in unaffiliated ETFs beyond the Section 12(d)(1) limits, provided that the Acquiring Funds comply with the conditions of proposed rule 12d1 4, as discussed above. If you have any questions concerning these developing issues, please do not hesitate to contact any member of our Investment Management Practice Group. Our Senior Management Team: Chair Investment Management Practice Group Michael R. Rosella mikerosella@paulhastings.com Vice Chair Investment Management Practice Group David A. Hearth davidhearth@paulhastings.com Robert E. Carlson robertcarlson@paulhastings.com Wendell M. Faria wendellfaria@paulhastings.com Michael Glazer michaelglazer@paulhastings.com Rey Pascual reypascual@paulhastings.com Domenick Pugliese domenickpugliese@paulhastings.com Gary D. Rawitz garyrawitz@paulhastings.com Julie Allecta julieallecta@paulhastings.com Jacqueline A. May jacquelinemay@paulhastings.com Arthur L. Zwickel arthurzwickel@paulhastings.com Mitchell E. Nichter mitchellnichter@paulhastings.com 18 Offices Worldwide Paul, Hastings, Janofsky & Walker LLP StayCurrent is published solely for the interests of friends and clients of Paul, Hastings, Janofsky & Walker LLP and should in no way be relied upon or construed as legal advice. For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought. These materials may be considered ATTORNEY ADVERTISING in some jurisdictions. Paul Hastings is a limited liability partnership. Copyright 2008 Paul, Hastings, Janofsky & Walker LLP. IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations governing tax practice, you are hereby advised that any written tax advice contained herein or attached was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code. 5

6 1 See Exchange-Traded Funds, Investment Company Act Release No (March 11, 2008) (the Proposing Release ). 2 In addition, the manner in which ETFs operate in the secondary market also violates a number of provisions of the Securities and Exchange Act of 1934 (the 1934 Act ) and, therefore, exemptions from these 1934 Act provisions are also required. Proposed rule 6c-11 does not address these provisions and, therefore, even if adopted, will not relieve sponsors of the need to obtain these exemptions under the 1934 Act. 3 See our February 2008 client alert, SEC Approves Actively Managed Exchange-Traded Funds, regarding these active management orders. The active management orders are: In the Matter of PowerShares Capital Management LLC, et al., Investment Company Act Release Nos (February 1, 2008) (notice) and (February 27, 2008) (order); In the Matter of Bear Stearns Asset Management, Inc., et al., Investment Company Act Release Nos (February 5, 2008) (notice) and (February 27, 2008) (order); In the Matter of Barclays Global Fund Advisors, et al., Investment Company Act Release Nos (February 6, 2008) (notice) and (February 27, 2008) (order); and In the Matter of WisdomTree Trust, et al., Investment Company Act Release Nos (February 6, 2008) (notice) and (February 27, 2008) (order). 4 Section 22(e) of the Act generally prohibits a registered open-end investment company from suspending the right of redemption, or postponing the date of satisfaction of redemption requests more than seven days after the tender of a security for redemption. Several exemptive orders have been issued to ETFs that track foreign indexes that permit extended redemption settlement because of local market delivery cycles and foreign holidays. Although proposed rule 6c-11 would also permit extended settlement in such circumstances, the delivery would be required to take place no more than 12 calendar days after the tender of ETF shares and would require that all foreign holidays that are expected to prevent the timely delivery of the foreign securities and the maximum number of days that an ETF would anticipate it would need to deliver the foreign securities be disclosed in its statement of additional information ( SAI ). 5 The Commission noted, in the Proposing Release, that there did not appear to be a need to address ETFs structured as UITs since no new ETF has used that structure since The Commission s most recent orders permitting certain actively managed ETFs do not, however, provide this exemption. 7 The Commission did not propose to amend the orders of UITs that have sought and obtained an exemption from Section 24(d) of the Act because the prospectuses for those ETFs are not prepared in accordance with Form N-1A. 8 See Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Investment Company Act Release No (November 21, 2007). 9 In order to take advantage of these Item 3 and 6 disclosure changes, the ETF must have a Creation Unit size of at least 25,000 shares. Otherwise, the proposed rule has no limitation on the size of ETF Creation Units. 10 This relief is necessary so that (i) Acquiring Funds with 5% or more of the securities of an ETF may purchase additional ETF shares at NAV on the same basis as any other purchaser of a Creation Unit; and (ii) to allow an affiliated Acquiring Fund to deposit Basket Assets with the ETF. The proposed rule would also provide limited relief from Section 17(e) (2) of the Act to allow an Acquiring Fund to pay commissions, fees, or other compensation to a (second-tier) affiliated broker-dealer without complying with the quarterly board review and record-keeping requirements set forth in rules 17e-1(b) (3) and 17e-1(d) (2) of the Act. 11 The Commission recognized, however, that it may be difficult in all circumstances for an ETF, its principal underwriter, a broker or a dealer to know whether an Acquiring Fund that has submitted a redemption order was relying on the rule when it became a 3% owner. As such, the Commission proposed to include a safe harbor for each such entity if it has (i) received a representation from an Acquiring Fund that none of the shares to be redeemed were acquired in excess of the limits of Section 12(d) (1) (A) (i) of the Act in reliance on proposed rule 12d1-4; and (ii) no reason to believe that the shares to be redeemed were acquired in excess of the limits of Section 12(d) (1) (A) (i) in reliance on the proposed rule. See proposed rule 12d1-4(b) (2). 6