Issues for Broker-Dealers acting as APs or LMMs for ETFs

Transcription

1 Issues for Broker-Dealers acting as APs or LMMs for ETFs ETF Breakfast Roundtable Session I September 20,

2 Agenda Structure t of ETFs Large Ownership Positions in ETFs Issuer and Adviser Directed Orders Issues when an ETF is a Derivatives Counterparty Potential for Recharacterization of Role as an Underwriter & Mitigation Prospectus Delivery Morgan, Lewis & Bockius LLP 2

3 Securities-Related ETFs Funds or UITs Open-ended, collective investment vehicles whose shares are listed and traded on organized securities exchanges ETF shares are traded on exchanges at market prices which may differ from the net asset value ( NAV ) of the fund HOLDRs Grantor Trust Structure - one time exemption granted to Merrill Lynch Exempt from '40 Act registration - based on depositary receipt structure where investors own specified underlying securities Morgan, Lewis & Bockius LLP 3

4 Commodity ETFs ETFs that t are commodity pools Invest in futures, options on futures and swaps Operator (not fund itself) must register with the CFTC Interests in funds are securities (must be Series 7 not series 3 to market) ETFs that hold commodities but are not commodity pools No registration required under '40 Act or CFTC rules Morgan, Lewis & Bockius LLP 4

5 ETFs that are Both Some '40 Act ETFs invest in commodities through h a CFC Currently these are SEC but not CFTC Regulated CFTC R. 4.5 is likely to change and require dual registration (SEC as fund and CFTC as CPO) if Aggregate g initial margin for commodity interests exceeds 5% of fund liquidation value and Fund is marketed as providing exposure to commodities Morgan, Lewis & Bockius LLP 5

6 Section 17 Principal Transactions Section 17(a) : Transactions involving Affiliated Persons (and their affiliated persons) and registered investment companies. Affiliated Person defined in Section 2(a)(3). A Control Person, a subset of affiliated person, is defined in Section 2(a)(9). Section 17(a) by its terms involves purchase/sale of securities or other property. It also includes the lending of money by the investment to affiliated persons. Section 17(b) sets forth the standard for obtaining exemptive relief. SEC takes position that, as a general matter, investment advisers with investment discretion control the fund they advise. Morgan, Lewis & Bockius LLP 6

7 Section 17 Joint Transactions Section 17(d), Rule 17d-11 Covers affiliated persons and principal underwriter, and affiliated persons of such persons, acting as principal. Rule 17d-1 by its terms covers any transaction in connection with, any joint enterprise or other joint arrangement or profit sharing. Requires exemptive application to be filed prospectively. SEC must consider whether the registered investment company s participation is consistent with the 1940 Act and the extent to which such participation p is on a basis different from or less advantageous than that of other participants. Rule 17d-1 contains exemptions for: Certain downstream affiliate transactions. Rule 17d-1(d)(5). Joint liability insurance policies. Rule 17d-1(d)(7). 1(d)(7) Side-by-Side Trading Secondary market transactions. SMC (pub. avail. Sept. 5, 1995). Private Placements. Mass Mutual No Action Letter (pub. Avail. July 28, 2000). Securities Lending Morgan, Lewis & Bockius LLP 7

8 Section 17 Agency Transactions Section 17(e); Rule 17e-11 Covers affiliated persons, and affiliates of such persons Acting as agent or broker Commission, fee or remuneration shall not exceed usual and customary broker s commission ( reasonable and fair ) Quarterly review by fund board Appropriate documentation Morgan, Lewis & Bockius LLP 8

9 5% tests Section 2(a)(3)(A) person directly or indirectly owning, controlling or holding with power to vote 5% + of the voting securities of the other person Section 2(a)(3)(B) any person 5% + of whose outstanding voting securities are directly or indirectly owned, controlled or held with power to vote by the other person Morgan, Lewis & Bockius LLP 9

10 Control Affiliates 2(a)(3)(C) Any person directly or indirectly controlling, controlled by, or under common control with, another person. 25% A IA B C Controls B management D and E = Funds D E Morgan, Lewis & Bockius LLP 10

11 2(a)(3)(D) An officer, director, partner, copartner, or employee of another person Morgan, Lewis & Bockius LLP 11

12 2(a)(3)(E) If the other person is an investment company, any investment adviser thereof or any member of an advisory board thereof Morgan, Lewis & Bockius LLP 12

13 Affiliates and Affiliates of Affiliates A Dir., etc. B Parent Corp. C IA D Dir., etc. Funds = P, Q and R P Q R Morgan, Lewis & Bockius LLP 13

14 Section 2(a)(9) The power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company Rebuttable presumptions Direct or indirect beneficial ownership of 25% of the voting securities People presumed not to be controllable Morgan, Lewis & Bockius LLP 14

15 Affiliation Issues for APs Commodity ETFs Issue Affiliates must aggregate their holdings with funds they are affiliated with for position limit purposes CFTC R limits the number of futures contracts that a person may hold for speculative purposes Under current rules, no issue because only CPO has to aggregate CFTC has proposed to revise exemptions to require aggregation by 10% owners or persons who control trading Does not appear that use of an irrevocable proxy would be effective to mitigate the issue Morgan, Lewis & Bockius LLP 15

16 Affiliation Issues for APs Commodity ETFs (continued) Proposed New Rule If a trader has 10%+ interest in a commodity pool it must aggregate g unless The CPO has information barriers in place regarding the pool s trading and positions, The trader does not have direct, day-to-day y supervisory authority or control over the pool s trading and The CPO has filed an exemption from aggregation on behalf of the trader or class of traders. 25%+ participants in a commodity pool must aggregate all positions in accounts or pools that have identical trading strategies Morgan, Lewis & Bockius LLP 16

17 Issuer and Adviser Directed Orders Rule 102 of Regulation M Concept of Distribution Concept of Affiliated Purchaser Applicability of Global Relief to Issuer and Adviser Repurchases/Sales Stated Purpose of the Relief Scope of the Relief Rule 10b-18 Morgan, Lewis & Bockius LLP 17

18 Issuer and Adviser Directed Orders (continued) Other Manipulation Issues Wash sales, matched orders Marking the close Insider Trading Questions Morgan, Lewis & Bockius LLP 18

19 '40 Act Limits on Leverage Regulations and limitations it ti regarding mutual fund leverage come essentially from three sources: 1. Statutory limits on senior securities and borrowing under the 1940 Act, generally; 2. A fund's investment objective, policies and restrictions (some of which are mandated by statute); and 3. Staff interpretative guidance. Morgan, Lewis & Bockius LLP 19

20 '40 Act Limits on Leverage (continued) Sorting through h the various requirements is complicated, but a good rule of thumb is that regulatory standards may be implicated any time a fund makes an investment that creates an obligation that remains outstanding beyond normal settlement time. Such obligations include, in addition to delayed settlements that expose the fund to significant market risks, transactions such as written options, futures, TBAs, reverse repurchase agreements and swaps. Morgan, Lewis & Bockius LLP 20

21 '40 Act Limits on Leverage (continued) It is not uncommon to refer to investments t that t raise senior security issues as leveraged investments, although from a 1940 Act perspective, p the legal issue is more specifically related to the potential issuance of a senior security. Broadly speaking funds may not issue senior securities but may (1) borrow from banks so long as assets (including the amount borrowed) are at least three times liabilities (Section 18(f)(1)); and (2) borrow up to an amount equal to 5% of total t assets for up to 60 days (Section 18(g)). Morgan, Lewis & Bockius LLP 21

22 '40 Act Limits on Leverage (continued) The Securities and Exchange Commission i ( SEC ) has generally taken the view that obligations incurred in connection with investments will not be viewed as senior securities so long as the obligations are covered. Such obligations may be covered by: owning the underlying security in appropriate cases; earmarking or segregating liquid securities that could be sold to obtain funds to satisfy the obligations; or owning an option or similar right to acquire an offsetting position. Morgan, Lewis & Bockius LLP 22

23 '40 Act Limits on Leverage (continued) The limitations it ti discussed d above generally derive from the following sources: 1. Limits on senior securities or borrowing. Section 18(f)(1) of the 1940 Act says that an open-end fund may not issue senior securities, but may borrow from banks so long as there is 300% coverage. Section (18)(g) of the 1940 Act exempts temporary loans up to 5% of total assets. Morgan, Lewis & Bockius LLP 23

24 '40 Act Limits on Leverage (continued) 2. Adherence to policies i and investment t objectives and investment limits. A fund must declare an investment objective and set forth objectives and policies in its prospectus. It may not deviate from certain policies and may not have disclosure that is materially misleading. Adherence to the names rule imposes certain limits. Funds must adhere to fundamental and non-fundamental policies. Morgan, Lewis & Bockius LLP 24

25 '40 Act Limits on Leverage (continued) 3. Interpretative t ti Guidance. Investment Company Act Release 10666, which initially set for the SEC position on investment techniques that may be viewed as creating a senior security. No Action Letters (including the Dreyfus letter, Merrill Lynch letter, Sanford Bernstein letter and Robertson Stevens letter and Barbash letter on derivatives risk). Morgan, Lewis & Bockius LLP 25

26 '40 Act Limits on Leverage (continued) Once itis determined dthat titi is necessary for a Fund dto cover its obligations, the SEC guidance further provides that the coverage amount needs to be marked to market. Accordingly, the amount of cover necessary for a particular transaction may need to increase as a given transaction moves further into a loss position, but a Fund may be able to reduce the amount of cover as a transaction moves further into a gain position. Multiple positions within a Fund portfolio may be used to cover each other, but only if such positions are truly offsetting positions. Morgan, Lewis & Bockius LLP 26

27 Underwriter Recharacterization Overview (APs and LLMs) Because creation of shares is ongoing, ETFs are deemed to be in continuous distribution under 1933 Act APs, depending on facts and circumstances, could be treated as statutory underwriters 1933 Act: underwriters may be strictly liable for material misstatements/omissions in registration statement ( 11) material misstatements/omissions in prospectus ( 12(a)(2)) 1933 Act provides affirmative due diligence defense reasonable investigation ( 11) and exercise of reasonable care ( 12) What is the right framework within which to perform due diligence on a fund in continuous distribution? Morgan, Lewis & Bockius LLP 27

28 Underwriter Recharacterization Risk Mitigation Not Underwriter Statutory Defenses Indemnification Contribution Morgan, Lewis & Bockius LLP 28

29 Acknowledgement of Underwriter Risk (1940 Act AP Agreement) The AP understands d and acknowledges that t the method by which h Creation Units of Shares will be created and traded may raise certain issues under applicable securities laws. For example, because new Creation Units of Shares may be issued and sold by the Trust on an ongoing g basis, at any point a "distribution", as such term is used in the 1933 Act, may be occurring. The AP understands and acknowledges that some activities on its part, depending on the circumstances, may result in its being deemed a participant in a distribution in a manner which could render it a statutory underwriter and subject it to the prospectus delivery and liability provisions of the 1933 Act. The AP should review the Continuous Offering section of the SAI and consult with its own counsel in connection with entering into this Agreement and placing an Order (defined below). The AP also understands and acknowledges that dealers who are not "underwriters" but are effecting transactions in Shares, whether or not participating in the distribution of Shares, are generally required to deliver a prospectus. Morgan, Lewis & Bockius LLP 29

30 Aggressive Underwriter Risk Disclosure (1933 Act ETF) As of the date of this prospectus, there is no named AP. A list of APs will be available from the Marketing Agent. Because new Shares can be created and issued on an ongoing basis, at any point during the life of the Fund, a distribution, as such term is used in the 1933 Act, will be occurring. APs, other broker-dealers and other persons are cautioned that some of their activities may result in their being deemed participants in a distribution in a manner that would render them statutory underwriters and subject them to the prospectus-delivery and liability provisions of the 1933 Act. For example, the initial AP will be a statutory underwriter with respect to the initial purchase of Creation Baskets. In addition, an AP, other broker-dealer firm or its client will be deemed a statutory underwriter if it purchases a basket from the Fund, breaks the basket down into the constituent Shares and sells the Shares to its customers; or if it chooses to couple the creation of a supply of new Shares with an active selling effort involving solicitation of secondary market demand for the Shares. In this regard, the excess, if any, of the price at which an AP sells a Share over the price paid by such AP in connection with the creation of such Share in a Creation Basket may be deemed to be underwriting compensation. In contrast, APs may engage in secondary market or other transactions in Shares that would not be deemed underwriting. For example, an AP may act in the capacity of a broker or dealer with respect to Shares that were previously distributed by other APs. A determination of whether a particular market participant is an underwriter must take into account all the facts and circumstances pertaining to the activities of the broker-dealer or its client in the particular case, and the examples mentioned above should not be considered a complete description of all the activities that would lead to designation as an underwriter and subject them to the prospectus-delivery and liability provisions of the 1933 Act. Morgan, Lewis & Bockius LLP 30

31 Sample Toned Down Underwriter Risk Disclosure (1940 Act ETF) The method by which h Creation Units are purchased and traded d may raise certain issues under applicable securities laws. Because new Creation Units are issued and sold by the Fund on an ongoing basis, at any point a distribution, as such term is used in the Securities Act, may occur. Broker-dealers and other persons are cautioned that t some activities iti on their part may, depending di on the circumstances, result in their being deemed participants in a distribution in a manner which could render them statutory underwriters and subject them to the prospectus delivery and liability provisions of the Securities Act. For example, a broker-dealer firm or its client may be deemed a statutory tor underwriter riter if it takes Creation Units after placing an order with the Distributor, breaks them down into individual Shares, and sells such Shares directly to customers, or if it chooses to couple the creation of a supply of new Shares with an active selling effort involving solicitation of Secondary Market demand for Shares. A determination of whether one is an underwriter for purposes of the Securities Act must take into account all the facts and circumstances pertaining to the activities of the broker-dealer or its client in the particular case, and the examples mentioned above should not be considered a complete description of all the activities that could lead to categorization as an underwriter. Morgan, Lewis & Bockius LLP 31

32 Underwriter Recharacterization (Defenses to 1933 Act) Section 11(b)(3) defense defendant d had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and did not omit material facts The standard of reasonableness shall be that required of a prudent man in the management of his own property Standard for expert portions of registration statement defendant had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue or that there was an omission of material facts Section 12(a)(2) defense seller did not know, and in the exercise of reasonable care could not have known, of such untruth or omission Morgan, Lewis & Bockius LLP 32

33 Scope of Standard Indemnity '40 Act AP Agreement (i) any breach by the Distributor of any provision of this Agreement that relates to the Distributor and any representation provided by it herein that is false or misleading in any material respect or omits material information necessary to make the statements contained therein complete; (ii) any failure on the part of the Distributor to perform any of its obligations set forth in this Agreement; (iii) any failure by the Distributor to comply with applicable laws in connection with this Agreement and the offer, sale, creation, redemption and marketing of the Shares, including rules and regulations of self-regulatory organizations in relation to its role as Distributor of the Funds, (iv) any untrue statements or omissions made in any promotional material or sales literature furnished to the Participant or otherwise approved in writing by the Distributor, a Trust or a Fund or any disclosure provided by the Distributor to the Participant for inclusion in marketing material or sales literature prepared by the Participant; (v) actions of such Distributor Indemnified Party taken in reliance upon any instructions issued or representations made in accordance with the Procedures (as they may be amended from time to time) reasonably believed by the Distributor Indemnified Party to be genuine and to have been given by or on behalf of the Distributor, in connection with the Participant s acting in its capacity as an authorized participant; i t Morgan, Lewis & Bockius LLP 33

34 Scope of Standard Indemnity '40 Act AP Agreement (continued) (vi) any representation ti by the Distributor, ib t its employees or its agents or other representatives about a Trust, the Shares or any affiliated person of any Fund (as defined in the 1940 Act) or any Distributor Indemnified Party that is not consistent with the Trust s then-current Prospectus made in connection with the offer or sale of or the solicitation it ti of an offer to buy or sell Shares and (vii) any untrue statement or alleged untrue statement of a material fact contained in the Registration Statement, or arising out of or based upon the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, except those statements in the Registration Statement based on information furnished in writing by or on behalf of the Participant expressly for use in the Registration Statement; or (viii) any untrue statement or alleged untrue statement of a material fact contained in the Prospectus or arising out of or based upon the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading, except those statements in the Prospectus based on information furnished in writing by or on behalf of the Participant expressly for use in the Prospectus Morgan, Lewis & Bockius LLP 34

35 Contribution as Indemnity Back-Up If any of the indemnifications provided for above is not permitted pursuant to a final determination by a court of competent jurisdiction, or is insufficient to hold a Distributor Indemnified Party or Participant Indemnified Party harmless in respect of any losses, liabilities, damages, reasonable costs and reasonable expenses referred to therein, then each applicable indemnifying party shall contribute to the amount paid or payable by such Distributor Indemnified Party or Participant Indemnified Party as a result of such losses, liabilities, damages, reasonable costs and reasonable expenses in such proportion as is appropriate to reflect the relative fault of the Distributor and the applicable Trust, on the one hand, and of the Participant, on the other hand, in connection with, to the extent applicable, the statements, omissions or actions that resulted in such losses, liabilities, damages, reasonable costs and reasonable expenses, as well as any other relevant equitable considerations. The relative fault of the Distributor and the applicable Trust on the one hand and of the Participant on the other shall be determined by reference to, among other things, whether the untrue statement or alleged untrue statement of a material fact or omission or alleged omission relates to information supplied by the Distributor or the Trust on the one hand or by the Participant on the other, and the parties relative intent, knowledge, access to information and opportunity to correct or prevent such statement or omission. The amount paid or payable by a party as a result of the losses, liabilities, damages, reasonable costs and reasonable expenses referred to in this Section shall be deemed to include any legal or other fees or expenses reasonably incurred by such party in connection with investigating, preparing to defend or defending any action, suit or proceeding related to such losses, liabilities, damages, reasonable costs and reasonable expenses; provided that, for the avoidance of doubt, none of the Distributor Indemnified Parties or Participant Indemnified Parties shall be entitled to receive an amount from the Participant or the Distributor pursuant to this Section that is greater than the amount that such Distributor Indemnified Party or Participant Indemnified Party would have received under [the indemnities above], as applicable, if an indemnity under such provisions was available. Morgan, Lewis & Bockius LLP 35

36 Prospectus Delivery '40 Act ETFs AP Likely treated as an underwriter for an issuer in continuous offering Rule 15c hour rule for new issuers In connection with an issue of securities, the issuer of which has not previously been required to file reports pursuant to Sections 13(a) or 15(d) such broker or dealer shall deliver a copy of the preliminary prospectus to any person who is expected to receive a confirmation of sale at least 48 hours prior to the sending of such confirmation Section 12(a)(2) - Delivery prior to sale so that investor can make an informed investment decision Section 5(b)(2) - offer or sale must be accompanied/preceded by prospectus Deemed delivery under Rule 172 is not available Exchange listing rules require broker-dealers to deliver the prospectus AP Agreement Undertaking Must deliver prospectus off-shore to foreign investors Narrow Exemptions - Rule 153 & Section 4(4) Morgan, Lewis & Bockius LLP 36

37 Prospectus Delivery '40 Act ETFs (continued) Dealer obligations Section 4(3) typically is available to exempt broker-dealers not acting as underwriters after 25 days for listed securities Funds sought exemptive relief to allow dealers to rely on Section 4(3) Trade off was exemptive relief but dealers had to deliver a product description or prospectus under Exchange Listing Rules Liability profile for non-delivery under exchange rules is different No rescission right since no Section 5 violation Delivery prior to sale so that investor can make an informed investment decision Narrow exemptions Section 4(4) and Rule 153 Morgan, Lewis & Bockius LLP 37

38 Prospectus Delivery - HOLDRS APs Section 5(b)(2) requires delivery Should be able to rely on Rules 172 and 173 Rule 174(f) - selling group members (which APs may be deemed to be) may not rely on exemption Dealers No delivery obligation after 25 days because of Section 4(3) Morgan, Lewis & Bockius LLP 38

39 Commodity ETFs APs Section 5(b)(2) requires delivery but APs may rely on deemed delivery to deliver allocation notices & confirms Rule 173 Disclosure would be required on Confirmations CPO often requires an AP to undertake delivery CFTC Rule 4.12 requires CPOs to provide prospective pool participants with a disclosure document and receive a signed acknowledgment Exemption for ETFs if: Disclosure Document is on ETF web site and CPO or broker-dealer selling units informs purchasers of availability on website Section 12(a)(2) requires delivery of all material information Morgan, Lewis & Bockius LLP 39

40 Commodity ETFs (continued) Dealers No delivery obligation after 25 days because of Section 4(3) CFTC Relief should avoid issues provided the broker-dealer informs purchasers of the availability on the ETF s website Morgan, Lewis & Bockius LLP 40

41 Questions Morgan, Lewis & Bockius LLP 41

42 international presence Beijing Boston Brussels Chicago Dallas Frankfurt Harrisburg Houston Irvine London Los Angeles Miami New York Palo Alto Paris Philadelphia Pittsburgh Morgan, Lewis & Bockius LLP Princeton San Francisco Tokyo Washington 42 Wilmington