Investment Management Institute 2017

Transcription

1 CORPORATE LAW AND PRACTICE Course Handbook Series Number B-2310 Investment Management Institute 2017 Volume Two Co-Chairs Barry P. Barbash Paul F. Roye To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI Order Number , Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036

2 87 The Ongoing Evolution of Exchange-Traded Funds: An Overview of the Development of ETFs, Their Regulation, and the Underlying Market (January 11, 2017) Allison M. Fumai Stuart M. Strauss Michelle D. Wong Dechert LLP The authors would like to thank Keunjung Cho for her contributions to this article. If you find this article helpful, you can learn more about the subject by going to to view the on demand program or segment for which it was written

3 2-802 Practising Law Institute

4 Exchange-traded fund ( ETF ) assets have continued to grow globally. ETF asset growth in the United States has increased every year between 2006 and 2015 except This article provides an overview of the development of the ETF as an investment vehicle, outlines the mechanics and operation of ETFs, and examines the evolution of the underlying financial market and network of relevant laws and regulations. I. INTRODUCTION WHAT IS AN ETF? An ETF combines aspects of open-end investment companies, whose shares are continuously redeemable at net asset value ( NAV ) per share, and closed-end investment companies, whose shares trade publicly on a securities exchange throughout the trading day. An ETF is an open-end investment company registered with the Securities and Exchange Commission (the SEC ) under the Investment Company Act of 1940, as amended (the Investment Company Act ). It issues and redeems its shares at NAV only in large aggregations known as creation units (usually 50,000 or 100,000 shares). ETF purchases and redemptions are typically effected on an in-kind basis, wherein a creation unit of ETF shares is exchanged for a basket of securities that generally corresponds pro rata (with variations based on differing exemptive relief) to the positions in the ETF s portfolio. Purchases and redemptions may only be effected by or through Authorized Participants ( APs ). An AP is generally a bank or broker-dealer that is a member of the Depository Trust Company ( DTC ) and that has entered into an agreement with the ETF s distributor to engage in creations and redemptions with the ETF (an AP Agreement ). An ETF may have many APs and APs may have agreements with ETF distributors with respect to many ETFs. Like closed-end funds, ETFs are listed and traded on exchanges. Similar to ordinary stocks, ETF shares can be bought and sold throughout the day. These secondary market transactions occur at market prices rather than at NAV. An ETF is therefore considered to be a hybrid of a closed-end fund and an open-end fund. Because ETFs do not fit squarely within the parameters of the Investment Company Act, ETFs need to obtain exemptive relief from certain provisions of the Investment Company Act. In addition, relief from various provisions of the Securities Exchange Act of 1. See 2016 INVESTMENT COMPANY FACT BOOK (2016), available at icifactbook.org/

5 1934, as amended (the Exchange Act ), is required. These matters are discussed further below in Section III. II. ETF OPERATIONS AND MECHANICS A. Creation and Redemption Process As noted above, ETF shares are created and redeemed only in creation unit sizes by or through APs. The composition of the basket of in-kind portfolio securities to be tendered to the ETF for purchase of a creation unit, or that will be delivered by the ETF upon a redemption, is announced prior to the open of each trading day of the exchange on which the ETF is listed. Cash payments to or from the purchaser make up for any difference between the market value of the basket and the NAV. B. Arbitrage Process and Efficient Trading The ability to purchase and redeem shares of ETFs at NAV throughout the day, coupled with the ability to buy and sell shares on an exchange at market prices, is designed to create an arbitrage pricing mechanism ensuring that market prices of ETF shares remain at or close to NAV. To support the arbitrage process, a variety of information is disseminated to the marketplace. Most ETFs are either required to, or voluntarily provide, full portfolio transparency on a daily basis, meaning that the ETF discloses daily the portfolio securities that serve as the basis for that day s NAV calculation. This portfolio transparency allows for efficient arbitrage in both the primary and secondary markets. In the primary market, participants use the available information about the ETF and its underlying securities to compare throughout the trading day the value of the ETF s underlying portfolio to the market price. In addition, during regular trading hours, an approximate value of the ETF s shares is calculated and disseminated intraday (and is referred to as the intraday NAV or inav ) every 15 seconds by a third party. The ETF is not involved in or responsible for the calculation or dissemination of the inav, and thus makes no warranty as to its accuracy. Subsequently, participants can decide whether to purchase or sell shares of the ETF. When demand for an ETF s shares exceeds supply, the ETF shares tend to trade at a premium. An AP will take advantage of that premium and go into the market to assemble a basket of securities that it transfers to the ETF in connection with a creation order

6 for new shares having an equivalent value, at NAV. The AP then sells those new ETF shares in the open market at the prevailing higher/ premium market price. The AP makes a profit on the spread between the ETF s market price and its NAV, while also providing additional shares to the market to help satisfy demand, narrowing or eliminating the premium. The process works in reverse when supply exceeds demand and the ETF shares trade at a discount. The AP purchases ETF shares in the open market at their discounted price, and then redeems shares from the ETF at their higher NAV, receiving a redemption basket of securities worth more than the purchase price of ETF shares so acquired. In selling the redemption basket on the market, the AP makes a profit. By removing excess shares from the market, the mechanism narrows or closes the supply/demand imbalance and narrows or eliminates the discount. In the secondary market, trading firms are using the same portfolio information to price the ETF portfolio with internal pricing information. These prices and the fact that many trading firms are trading and pricing these ETFs continuously may result in a more efficient market. C. Distribution and Fees The ETF distributor acts as an intermediary between the ETF and APs with respect to creations and redemptions. As noted above, an ETF s distributor generally enters into AP Agreements with APs to allow them to create and redeem with the ETF. Many ETFs use third party distributors with expertise in the mechanics of ETFs, even if the ETF sponsor has its own affiliated distributor. These third party distributors generally do not take a leading role in marketing the ETF to investors. While many ETFs transact primarily in-kind with APs, certain ETFs may transact partially or wholly in cash depending on their underlying portfolios. APs bear transaction fees associated with the creation/ redemption process. Fixed transaction fees may be payable to the ETF s custodian for each transaction regardless of the number of creation units purchased or redeemed. In addition, fixed or variable transaction fees may be borne by APs in order to defray the costs borne by the ETF and ultimately the ETF s shareholders where a portion or all of the transaction is done in cash. Transaction fees for creation or redemption transactions effected partially or wholly in cash are typically higher than those charged for in-kind transactions. Fees may be fixed

7 or variable, but redemption fees may not exceed 2% of the value of the ETF s creation unit (in accordance with the SEC limit on openend funds pursuant to Rule 22c-2 under the Investment Company Act). D. APs and AP Agreements APs enter into an AP Agreement generally with the ETF s distributor. An AP may act as principal or as agent, i.e., acquiring shares of the ETF in creation unit aggregations for itself or for another party. AP Agreements are usually approved by an ETF s board of directors. Procedures for creation and redemption transactions are often included as a handbook or annex to the AP Agreement and are modified in limited instances. ETFs may not be parties to AP Agreements, but are usually third party beneficiaries to such AP Agreements with respect to indemnification and other provisions. Because ETFs sell directly only to APs, ETFs do not have the retail distribution and/or transfer agency operations like that of mutual funds, and this arrangement keeps an ETF s administrative costs relatively low. E. Marketing/Advertising The exemptive relief granted to ETFs requires that ETFs not be labeled as mutual funds. Marketing materials and prospectuses may not refer to ETFs as mutual funds or open-end funds (except to contrast the ETF with such funds). Marketing materials that refer to trading of ETF shares on an exchange must also state that ETF shares are not individually redeemable and may be purchased and redeemed from the ETF only in creation unit aggregations. F. Efficiency of Administration; Tax Aspects Creations and redemptions are made in exchange for a designated basket of securities and other instruments held by the ETF and/or an amount of cash. The in-kind aspect of ETF trading permits ETFs to externalize the cost of acquiring portfolio securities. For ETFs that transact in-kind, the APs that transact directly with the ETF, rather than existing ETF shareholders, generally bear the costs of these creation and redemption transactions. ETFs may also afford certain tax efficiencies. That is because under the Internal Revenue Code of 1986, a redemption in-kind can be effected without an ETF recognizing taxable gains on the transaction. As a result, an ETF can, through the

8 redemption in-kind mechanism, distribute out of the portfolio on a tax-free basis securities with large unrecognized gains. III. REGULATORY PROCEDURES By their nature, ETFs do not clearly fit within the provisions of the Investment Company Act, which did not anticipate their hybrid structure. The Investment Company Act was written at a time when there were only two types of investment companies: 1) open-end investment companies and unit investment trusts ( UITs ) with redeemable securities and 2) closed-end investment companies. Because ETFs possess characteristics of both structures, ETFs must seek exemptive relief from certain provisions of the Investment Company Act. The earliest exemptive orders took years to obtain, as did the first exemptive orders to launch actively-managed ETFs. While the time required to obtain exemptive relief to launch traditional passively-managed and actively-managed ETFs is now relatively quick due to their standardized disclosures, exemptive relief to launch novel types of ETFs or variations on the ETF structure takes time. Over the last few decades, regulatory requirements pertaining to ETFs have evolved commensurate with ETFs own evolution. Developments in the financial industry generally as well as those relating to ETFs have led to the adoption of new rules pertaining to investment companies and, in certain instances, to ETFs specifically. In addition to the adoption of new rules, the last decade has witnessed a modernization of existing rules relating to ETFs. Discussed below is the network of regulations pertaining to exemptive relief, no-action relief and 19b-4 rules, as well as relevant recent developments. A. Investment Company Act Exemptive Relief 1. Section 2(a)(32) Limited Share Redeemability Section 2(a)(32) of the Investment Company Act defines a redeemable security as any security under the terms of which the holder, upon its presentation to the issuer is entitled to receive approximately his proportionate share of the issuer s current net assets, or the cash equivalent thereof. 2 ETF shares are redeemable only in creation unit sizes, and not individual shares, by or through APs. Accordingly, ETF shares do not fit squarely within the 2. Investment Company Act of 1940, 15 U.S.C. 80a-2(a)(32) (2012)

9 definition of redeemable securities in the Investment Company Act. Because of this, ETFs must seek exemptive relief from certain provisions of the Investment Company Act in order to be structured and registered as open-end investment companies and to be traded on an exchange. 2. Section 22(d) and Rule 22c-1 Offering at Prices Other than NAV Section 22(d) of the Investment Company Act restricts the sale of a redeemable security at a price other than a public offering price as described in the prospectus. 3 Rule 22c-1 requires that a dealer sell or redeem a redeemable security only based on NAV. 4 Because an ETF sells and redeems shares at market price rather than at either a prospectus-stated offering price or NAV, ETFs must seek exemptive relief to permit secondary market transactions at market prices. Exemptive relief has been granted on the grounds that secondary market trading at market price does not lead to dilution of shareholder interests or discrimination among purchasers. 3. Section 17(a) Affiliated Party Transactions Section 17(a) of the Investment Company Act makes it unlawful for any affiliated person or promoter of or principal underwriter for a registered investment company knowingly to sell any security [to or to] purchase [any security] from such registered company... 5 An affiliated person includes any person directly or indirectly controlling, controlled by, or under common control with the investment company. 6 Under the Investment Company Act s definition of control in Section 2(a)(9), a controlling person (and thus an affiliate) includes any person [owning] more than 25 per centum of the voting securities of a company. 7 An affiliated person can also be defined as any person owning or holding with power to vote, 5 per centum or more of [an issuer s] outstanding voting securities U.S.C. 80a-22(d) C.F.R c-1 (1993) U.S.C. 80a-17(a) U.S.C. 80a-2(a)(3)(C) U.S.C. 80a-2(a)(3)(A) U.S.C. 80a-2(a)(3)(A)

10 To the extent that a creation or redemption transaction is deemed to involve the sale of securities to an ETF or the purchase of securities from an ETF, 5%-or-more (and 25%-or-more) holders of an ETF s shares would be prohibited by Section 17(a) from effecting creation and redemption transactions in-kind. As a result, ETFs seek exemptive relief from Section 17 to enable 5%-or-more (and 25%-or-more) holders to create and redeem shares of an ETF inkind. To date, the SEC has not been willing to extend Section 17 relief to persons who are affiliated with an ETF for reasons other than 5%-or-more (and 25% or-more) ownership. 4. Section 18 Additional Share Classes Section 18 of the Investment Company Act originally prohibited an open-end investment company from issuing more than one class of shares with respect to the same portfolio. 9 While the adoption of Rule 18f-3 in 1995 permitted certain differences among share classes with regard to shareholder services and distribution, 10 Section 18 does not contemplate ETF and non-etf share classes in one fund. An ETF must thus seek exemptive relief from Section 18 in order to issue different share classes where one or more classes is structured as a mutual fund and another class is structured as an ETF. To date, this relief has only been granted to one fund family. 5. Section 22(e) Extension of Redemption Settlement Period Section 22(e) of the Investment Company Act prohibits a registered investment company (or UIT) from suspend[ing] the right of redemption or postpon[ing] the date of payment or satisfaction upon redemption of any redeemable security for more than seven days after the tender of such security for redemption. 11 Certain ETFs invest in non-u.s. markets with longer trading cycles and, accordingly, request exemptive relief from Section 22(e) to the extent necessary to accommodate local holidays and market practices. The exemptive orders granting this relief require that an ETF s Statement of Additional Information identify instances where, due to local holidays, more than seven calendar days will U.S.C. 80a C.F.R f U.S.C. 80a-22(e)

11 be needed to deliver redemption proceeds in-kind. In this disclosure, the ETF must also list the holidays and disclose the maximum number of days it anticipates it will need in order to deliver the proceeds in-kind. On the grounds that Section 22(e) is designed to prevent unreasonable, undisclosed, or unforeseen delays in the payment of redemption proceeds, the SEC grants exemptive relief to ETFs to allow the in-kind redemption process to operate in the applicable local markets. 6. Section 12(d) Investments in ETFs by other Registered Investment Companies As registered investment companies, ETFs are subject to the Investment Company Act limitations on the ownership of shares of one investment company by another. Under Section 12(d)(1)(A) of the Investment Company Act, a registered investment company cannot acquire ETF shares if, immediately after such purchase, the acquiring investment company (together with any companies controlled by it) would own in the aggregate (i) more than 3% of the ETF s outstanding voting shares; (ii) securities issued by an ETF having an aggregate value in excess of 5% of the value of the total assets of the acquiring company; or (iii) securities issued by investment companies (including ETFs) having an aggregate value in excess of 10% of the value of the total assets of the acquiring company. 12 Under Section 12(d)(1)(B) of the Investment Company Act, an ETF s shares may not be sold by a broker-dealer to any other investment company (including any issuer that relies on Section 3(c)(1) or 3(c)(7) of the Investment Company Act) if, immediately after the sale, (i) more than 3% of the ETF s total outstanding voting shares are owned by the acquiring investment company (and any company or companies controlled by it); or (ii) more than 10% of the ETF s total outstanding voting shares are owned by the acquiring investment company and other investment companies (and any companies controlled by them). 13 Exemptive relief from and permission to invest beyond the limits of Section 12(d)(1) requires an acquiring fund to enter into a participation agreement with the ETF, where the agreement addresses issues regarding the potential for undue influence and fee layering U.S.C. 80a-12(d)(1)(A) U.S.C. 80a-12(d)(1)(B)

12 as a result of transactions between the acquiring fund and the ETF. The agreement should explicitly outline terms to which the acquiring fund must adhere. In particular, these agreements limit the ability of an acquiring fund to exercise control of an ETF 14 and explicitly prohibit the acquiring fund and its affiliates from causing their investments to influence the terms of services or transactions with the ETF. B. No-Action Relief under the Securities Exchange Act of 1934 The simultaneous issuance of new ETF shares to APs while ETF shares are trading in the secondary market leads to a variety of issues under the Exchange Act. Accordingly, ETFs must rely on no-action relief under the Exchange Act in addition to applicable exemptive relief under the Investment Company Act. The SEC has issued class relief to qualifying ETFs from many of the following provisions under the Exchange Act. An ETF may rely on the relief set forth in the no-action letters granting such relief as long as the ETF meets the requirements set forth in those letters. 1. Regulation M Rules 101 and 102 Purchases During an Underwriting Regulation M prohibits a distribution participant from purchasing or attempting to induce any person to purchase a security subject to distribution. 15 Since ETF shares may be purchased and redeemed on a daily basis (e.g., they are continuously in distribution), APs who purchase shares could be deemed distribution participants that would, under Regulation M, be prohibited from purchasing shares. ETFs have generally sought relief from Regulation M. In order to rely on the class relief from Regulation M, both passively-managed and actively-managed ETFs must be listed and trade on a national securities exchange and they must continuously redeem, at NAV, creation unit aggregations of shares, where the 14. Control is defined in the Investment Company Act as 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. 15 U.S.C. 80a-2(a)(9) C.F.R

13 secondary market price of shares does not vary substantially from the NAV of such shares. A passively-managed ETF relying on the class relief under Regulation M is subject to portfolio weighting and diversification requirements with respect to the component securities in its basket, as well as minimum value requirements with regard to its creation units. Passively-managed ETFs must also be managed to track a particular index, all of the components of which have publicly available information regarding the last sale trade. The intra-day proxy value of the ETF s per-share and the value of the benchmark index must be publicly disseminated by a major market data vendor throughout the trading day. 16 For actively-managed ETFs, the class relief requirements pertain mostly to the ETF s transparency. To rely on the class relief under Regulation M, an actively-managed ETF must fulfill the following criteria: On each day the shares trade, prior to commencement of such trading, the ETF must disclose on its website the identities and quantities of the securities and assets held by the ETF which will form the basis of the calculation of the ETF s NAV at the end of such day; The exchange listing the shares or other information provider disseminates the ETF s inav every 15 seconds throughout the trading day through the facilities of the Consolidated Tape Association; Arbitrageurs are expected to take advantage of price variations between shares secondary market price and the ETF s NAV; and The arbitrage mechanism will be facilitated by the transparency of the ETF s portfolio, the availability of the inav, the liquidity of the ETF s portfolio securities, the ability to access such securities, and the arbitrageurs ability to create workable hedges Powershares Exchange-Traded Fund Trust, SEC No-Action Letter (Oct. 24, 2006). 17. SEC DIVISION OF MARKET REGULATION, FREQUENTLY ASKED QUESTIONS ABOUT REGULATION M (2010). See also WisdomTree Trust, SEC No-Action Letter (May 9,

14 2. Rule 14e-5 Purchase Outside of a Tender Offer Rule 14e-5 under the Exchange Act makes it unlawful for covered persons, which include dealer-managers or any persons acting in connection with any purchase of equity securities subject to a tender offer, to purchase such securities except as part of the tender offer. 18 Because an AP may transact in securities held by an ETF and such shares may be subject to a tender offer, Rule 14e-5 could apply to covered persons with respect to ETF shares. The SEC has granted relief to permit covered persons to redeem ETF shares for a redemption basket that may include a security subject to tender offer or exchange offer and to engage in secondary market transactions on the shares during such tender or exchange offer. 3. Section 11(d) Extension of Margin Credit Section 11(d) of the Exchange Act makes it unlawful for a broker-dealer to effect through the use of any facility of a national securities exchange any transaction in connection with which he extends or maintains or arranges for the extension or maintenance of credit to or for a customer on any security (other than an exempted security) which was a part of a new issue in the distribution of which he participated as a member of a selling syndicate or group within thirty days prior to such transaction. 19 ETF shares are continuously offered and traded in the secondary market, so they could be subject to the restrictions under Section 11(d) of the Exchange Act. The SEC has granted no-action relief to permit extension of margin credit by broker-dealers in the case of ETFs on the condition that the broker-dealer does not receive any payment or compensation (or other economic incentive) to promote the shares of the ETF. ETF shares are marginable only 30 days or later after the ETF commences operations. 4. Rule 10b-10 Confirmation Rule Rule 10b-10 under the Exchange Act requires a broker or dealer to send a written notification to any customer with which it transacts. The written notification must include information about the 2008), Powershares Exchange-Traded Fund Trust, SEC No-Action Letter (Oct. 24, 2006), and ishares Trust, SEC No-Action Letter (Apr. 9, 2007) C.F.R e Securities Exchange Act of 1934, 15 U.S.C. 78k(d) (2012)

15 identity, price, and number of shares or principal amount of the security subject to the transaction. 20 The SEC has acknowledged that requirement of such written notification would be both burdensome and impracticable in the case of ETFs because each security in a deposit or redemption basket could to be viewed as the subject of an individual transaction. No-action relief has generally permitted broker-dealers to omit information regarding the identity, price, and number of shares of each individual security tendered or received in an ETF transaction. Broker-dealers are required to provide this information if requested to do so. 5. Rule 15c1-5 and 15c1-6 Notice of Distribution of Securities Rule 15c1-5 under the Exchange Act requires a broker-dealer to disclose to its customers any control relationship with the issuer of a security that the broker-dealer is trying to sell to or buy from a customer. 21 Rule 15c1-6 provides that, if a broker-dealer is trying to sell to or buy from a customer a security in a distribution in which the broker-dealer is participating or has a financial interest, the broker-dealer must provide the customer written notification of its participation or interest at or before the completion of the transaction. 22 The SEC staff has issued no-action relief to ETFs, and to broker-dealers transacting with ETFs, permitting them not to fulfill these disclosure requirements regarding control relationships. Class relief has been granted to ETFs complying with certain portfolio weighting, compensation arrangement, and other requirements Rule 10b-17 Notice of Certain Corporate Actions Rule 10b-17 under the Exchange Act provides that any issuer of a class of publicly traded securities must provide notice in advance of certain actions such as dividends, stock splits, or rights or other subscription offerings. 24 The Rule is not explicitly applicable to redeemable securities issued by registered open-end investment C.F.R b C.F.R c C.F.R c See Securities Industry Association, SEC No-Action Letter (Nov. 21, 2005); Ameristock ETF Trust, SEC No-Action Letter (Jun. 26, 2007); and WisdomTree Trust, SEC No-Action Letter (May 9, 2008) C.F.R b

16 companies. It is unclear whether the Rule applies to ETFs given that shares can be redeemed only in creation unit aggregations. The SEC staff has granted relief from this Rule based primarily upon the exemptive relief under Section 2(a)(32) permitting ETFs to register as open-end investment companies. This relief is also based on the fact that compliance with the Rule s notice requirements would be impractical because an ETF cannot project the amount of a dividend ten days in advance of the record date (which is when the rule requires such notice to be given to the exchange) Sections 13(d) and 16(a) Section 13(d) of the Exchange Act requires beneficial owners of more than 5% of any class of equity security registered pursuant to Section 12 of the Exchange Act to file reports with the SEC. 26 Section 16(a) of the Exchange Act requires each officer, director and beneficial owner of greater than ten percent of any class of equity security ( Insiders ) registered pursuant to Section 12 of the Exchange Act to file a statement with the SEC disclosing the number of shares of all equity securities beneficially owned as well as reports regarding changes in that ownership. 27 The SEC staff has issued no-action relief that provides that, if the shares of an ETF trade at a price that does not deviate materially from NAV, then owners of more than 5% of the ETF shares are not required to file reports under Section 13(d) and Insiders of that ETF are not required to file reports under Section 16(a). 28 To the extent that an ETF s shares trade at a material deviation (whether a premium or discount) from NAV, the no-action relief will no longer be available. C. Listing Standards In addition to the exemptive relief requested under the Investment Company Act and no-action relief from certain provisions of the Exchange Act, ETFs must meet listing rules in order to trade on a listing 25. See, e.g., Order Granting a Limited Exemption from Exchange Act Rule 10b-17 to Certain Actively Managed Exchange-Traded Funds Pursuant to Exchange Act Rule (6)(2), Exchange Act Release No (Jun. 19, 2012) U.S.C. 78m U.S.C. 78p. 28. See Select Sector SPDR Trust, SEC No-Action Letter (pub. avail. May 6, 1999); and PDR Services Corporation, No-Action Letter (pub. avail. Dec. 14, 1998)

17 exchange. Similar to the Investment Company Act and Exchange Act, ETFs were not contemplated when certain listing rules were instituted and, accordingly, requests for rule changes may be necessary to list shares of ETFs on an exchange. 1. Generic Listing Standards ETFs are generally listed on NYSE Arca, Inc. ( NYSE ), Bats BZX Exchange, Inc. ( Bats ), or the National Association of Securities Dealers Automated Quotations ( Nasdaq ). These exchanges have adopted generic listing standards that cover (1) most equity and fixed income passively-managed ETFs and (2) more recently, certain equity and fixed income actively-managed ETFs. Where an ETF does not meet the generic listing standards to list on a particular exchange, the listing exchange must file for a 19b-4 rule change specific to that ETF in order to have that ETF list on the exchange. Depending on the underlying portfolio composition of the ETF, this process can be lengthy b-4 Process For ETFs that do not meet generic listing standards, the relevant exchange must file for a rule change under Rule 19b-4 under the Exchange Act and have the rule change approved by the SEC. The 19b-4 filing is typically prepared by the exchange based on information contained in the ETF s registration statement, in consultation with the ETF sponsor and its counsel. The SEC s goal in evaluating 19b-4 filings is establishing and maintaining standards for fair, orderly, and efficient markets, 29 and it may require an ETF to revise its investment guidelines by placing limitations on certain types of investments. It may also require the exchange to amend the 19b-4 filing multiple times to the SEC staff s satisfaction. In the event that the SEC determines that certain underlying investments in an ETF s portfolio may not have sufficient liquidity or transparency to enable an AP to adequately value the portfolio intraday and, accordingly, lead to what the SEC believes may be inefficient arbitrage (or for other reasons), the SEC may impose limitations on such investments. While time limitations apply to the SEC with respect to making determinations on proposed rule changes filed pursuant to Rule 19b-4 under the Exchange Act, the 29. SECURITIES AND EXCHANGE COMMISSION, WHAT WE DO (2013)

18 19b-4 process can significantly delay or prolong the process of an ETF launch and the SEC may request that such proposed rule change be withdrawn (or may ultimately reject the exchange s 19b-4 filing). IV. DEVELOPMENT OF ETFS AND RELEVANT REGULATORY DEVELOPMENTS A. Development of ETFs In the last decade, ETFs have rapidly proliferated and mutated, extending their reach into non-u.s. markets, specific industries or sectors, alternative asset classes and a wide range of market segments. 1. Actively-Managed ETFs One notable area of ETF innovation has been ETFs approaches to selection and use of their indices. The first ETFs were mainly based on well-established market capitalization weighted securities indices. Over time, ETFs have expanded the use of indices to include more narrow indices focused on non-u.s. markets, including emerging and frontier markets, smart beta indices, fixed income indices, sector indices, and many other narrowly tailored indices in some instances launched solely for use by ETFs. The premise of these passively-managed ETFs remains the same to seek to track (by replication or sampling) an index but the underlying investments, as well as the risk profile for these ETFs, differ. According to the Investment Company Institute, as of December 2015 approximately 95% of ETFs registered under the Investment Company Act are passively-managed. 30 In contrast to passively-managed ETFs, actively-managed ETFs do not seek to track an index but rather (similar to many mutual funds), a manager makes decisions and has discretion as to underlying portfolio allocation. Like passively-managed ETFs, activelymanaged ETFs trade on an exchange and directly with APs. After many years of discussion, in 2008 the SEC finally granted the first exemptive relief to applicants wishing to offer actively-managed ETFs. The key condition of the exemptive relief is that an ETF be fully transparent. Fully transparent for this purpose means that the ETF must disclose on its website, on a daily basis, prior to the INVESTMENT COMPANY FACT BOOK (2016), available at icifactbook.org/

19 opening of trading, the portfolio that will serve as the basis for the NAV calculation that day. Despite the fact that almost nine years have passed since the first actively-managed ETF relief was granted, actively-managed ETFs still account for only 5.6% of the Investment Company Act ETFs offered. 31 This may be a result of many active managers being unwilling to fully disclose their portfolio holdings on a daily basis because of concerns that others may replicate their securities selection strategy or for other reasons. As additional active managers enter the ETF space and, as discussed below, the speed of entry becomes quicker, it is anticipated that the number of actively-managed ETFs will increase. 2. ETMFs On November 6, 2014, the SEC granted exemptive relief to Eaton Vance Management ( Eaton Vance ) from various provisions of the Investment Company Act, permitting Eaton Vance to offer 18 exchange-traded managed funds ( ETMFs ) as well as future funds that would comply with the conditions of the exemptive order. 32 ETMFs are hybrids of ETFs and mutual funds. 33 They are not fully transparent, and they differ from ETFs in that their market price is based on NAV. Like ETFs, ETMFs are exchange-traded (but at prices based on NAV plus or minus a premium or discount determined in the market at the time of the execution of the transaction), directly issued and redeemed only in creation units by and through APs (but in as few as 5,000 share quantities) subject to transaction fees, generally transact on an in-kind basis (but are not required to have baskets that are generally a pro rata slice of their portfolios), and disseminate inavs (but only at 15 minute intervals). Because 31 Id. 32. See In the Matter of Eaton Vance Management, et al., Investment Company Act Release Nos (Nov. 6, 2014) (notice) and (Dec. 2, 2014) (order). 33. Id. An ETMF is defined in Eaton Vance s exemptive application as a new kind of registered investment company that is a hybrid between traditional mutual funds and exchange-traded funds....like exchange-traded funds ( ETFs ), ETMFs would: list and trade on a national securities exchange[; ]directly issue and redeem Shares only in creation units; impose fees on creation units issued and redeemed to Authorized Participants to offset the related costs to the ETMFs; and primarily utilize in-kind transfers of Portfolio Positions in issuing and redeeming creation units. Like mutual funds, ETMFs would be bought and sold at prices linked to NAV and would seek to maintain the confidentiality of their current Portfolio Positions

20 ETMFs trade based on NAV, they are, like mutual funds, not subject to strict transparency requirements. ETMFs are only required to disclose their full portfolio holdings on a quarterly basis with a 60-day lag. Following the SEC s granting of exemptive relief to Eaton Vance, the SEC separately approved a rule proposal submitted by Nasdaq that governs the exchange-listing and trading of ETMFs (the 19b-4 Order ). 34 The 19b-4 Order requires SEC approval of ETMF-specific rule proposals before the listing of each ETMF. In addition, the SEC must declare effective the initial registration statement of each ETMF registrant before the initial ETMF series of a registrant may commence operations. NAV-based trading operates based on methodologies patented by Eaton Vance Stock NextShares (EVSTC). Other fund sponsors looking to launch an ETMF must enter into a license agreement to use such methodologies. Such fund sponsors can incorporate Eaton Vance s exemptive order by reference in order to expedite the exemptive application process. 3. Non-Transparent Actively-Managed ETFs For over a decade, a number of applications with differing approaches have been filed with the SEC requesting exemptive relief that would allow actively-managed ETFs to maintain a degree of non-transparency over their holdings, although no application has yet been approved and several have been denied or withdrawn. These applications generally propose an alternative to full portfolio transparency various patented processes that range from providing portfolio holdings to a calculation agent (which provides indicative pricing and redemption in-kind through a blind trust) to disclosing portfolio contents that represent but do not wholly reveal the full contents of the ETF s portfolio daily. Even though none of these applications has been approved to date, these and various related Rule 19b-4 applications have been and/or are currently being reviewed and discussed with the SEC such that over time, offerings in the ETF industry may continue to expand. 4. Global Distribution of U.S. ETFs Some ETF providers have been seeking to distribute their U.S. ETFs globally. Thus, in addition to the requirements imposed by the 34. The NASDAQ Stock Market LLC, Exchange Act Release No (Nov. 7, 2014)

21 SEC, it has become increasingly important to work through the challenges of complying with multiple sets of country-specific rules and regulations. B. Recent Regulatory Developments Pertaining to ETFs With the birth and proliferation of different ETFs, laws and regulations pertaining to ETFs have had to and will continue to evolve. Not only does this entail a modernization of securities regulations to reflect new ETF and related models, it also speaks to an increasingly tangled network of laws and regulations that will apply to ETFs as they reach the markets. The next section discusses regulatory developments that have recently occurred in the United States. 1. Exemptive and No-Action Relief The SEC granted exemptive relief to leveraged and inverse ETFs, but in 2010, it announced in a press release that it would defer consideration of exemptive requests under the Investment Company Act to permit ETFs that would make significant investments in derivatives. 35 The SEC stated that this decision would affect new and pending exemptive requests from certain actively-managed and leveraged ETFs. 36 While the freeze was lifted from activelymanaged ETFs, 37 no new exemptive relief has been granted to leveraged ETFs. Moreover, the SEC has more recently taken the view that if an ETF invests a certain percentage of its assets in leveraged or inverse ETFs, it may need an exemptive order to do so, which order the SEC is not currently granting. In 2006, the SEC staff granted exemptive relief to WisdomTree Investments, Inc., WisdomTree Asset Management, Inc., and WisdomTree Trust to launch self-indexed ETFs based on indices created and maintained by a WisdomTree affiliate. This relief imposed stringent requirements on the separation between the ETF s portfolio 35. SECURITIES AND EXCHANGE COMMISSION, SEC STAFF EVALUATING THE USE OF DERIVATIVES BY FUNDS (2010). 36. Id. 37. See, SEC OFFICE OF EXEMPTIVE APPLICATIONS/OFFICE OF INVESTMENT COMPANY REGULATION DIVISION OF INVESTMENT MANAGEMENT, MORATORIUM LIFT (2012). For a discussion by the SEC about leveraged and inverse ETFs, see SECURITIES AND EXCHANGE COMMISSION, LEVERAGED AND INVERSE ETFS: SPECIALIZED PRODUCTS WITH EXTRA RISKS FOR BUY-AND-HOLD INVESTORS (2009)

22 management and index provider operations. 38 In 2013, the SEC staff granted similar relief to Guggenheim Funds Investment Advisors ( Guggenheim ). However, this relief eliminated many of the structural requirements in the WisdomTree relief and imposed a new requirement that such ETFs disclose their full portfolio holdings on their websites on a daily basis, similar to actively-managed ETFs. 39 Subsequent applicants for self-indexing ETF exemptive relief have followed the Guggenheim example. In 2010, the SEC staff began granting exemptive relief to launch ETFs as part of a master-feeder structure, which could include both ETF and mutual fund feeders. The master fund in a masterfeeder structure is subject to the requirements imposed on the ETF feeder i.e., if an actively-managed ETF feeder is involved, the master fund must disclose its portfolio holdings daily. Other requirements also apply to the launch of this type of structure. 2. Listing Standards Until recently, generic listing standards were available only to passively-managed ETFs, and exchanges had to obtain approval pursuant to Rule 19b-4 under the Exchange Act in order to list each actively-managed ETF on an exchange. As noted earlier, the 19b-4 process is time-consuming (often requiring several months or more to complete) and also poses the risk of the SEC staff imposing additional restrictions on an ETF s investments as the 19b-4 filing is being considered. Both the restrictions themselves and the timing of their imposition pose burdens on ETF sponsors as they try to plan for new ETFs. On July 22, 2016, NYSE and Bats each received SEC approval to adopt generic listing standards for actively-managed ETFs that meet certain standards. 40 These listing standards include requirements with respect to market capitalization, trading volume, portfolio component weighting (with regard to equity securities, fixed 38. WisdomTree Investments, Inc., et al., Investment Company Act Release Nos (May 18, 2006) (notice) and (Jun. 12, 2006) (order), as amended by WisdomTree Investments, Inc., et al., Investment Company Act Release Nos (Sep. 21, 2007) (notice) and (Oct. 17, 2007) (order). 39. Guggenheim Funds Investment Advisors, LLC, et al., Investment Company Act Release Nos (Jun. 14, 2013) (notice) and (Jul. 10, 2013) (order). 40. Self-Regulatory Organizations; NYSE Arca, Inc., Exchange Act Release No (Jul. 22, 2016) and Self-Regulatory Organizations; BATS Exchange, Inc., Exchange Act Release No (Jul. 22, 2016)

23 income securities, and derivative investments), and principal amount outstanding, as well as issuer diversification. Nasdaq applied for and was subsequently granted approval as well. 41 While 19b-4 processes are cumbersome, obtaining approval under these generic listing standards is perhaps not an automatically easier alternative. Under either process, actively-managed ETFs will be required to satisfy the listing standards not only at the time of listing but also on a continuous basis. This requirement has longterm implications for an actively-managed ETF s investment strategies, wherein an ETF s sponsor should consider its compliance system capabilities with respect to monitoring for compliance with the listing standards on a continuous basis. While the generic listing standards may relieve the burdens of 19b-4 applications for certain ETFs, the listing standards are more stringent than the terms of some 19b-4 rule changes granted to date. It is therefore a case-by-case decision by an actively-managed ETF whether to have its listing exchange pursue an individual 19b-4 approval or to rely on the generic listing standards. This is particularly true in the event that a new actively-managed ETF does not fit the criteria outlined by the standards and either the applicable exchange or the actively-managed ETF sponsor desires more flexibility than is provided by the generic listing standards. Activelymanaged ETFs that are already listed may continue to rely upon their existing Rule 19b-4 orders or, alternatively, have the ability to rely on the generic listing standards going forward. At the insistence of the SEC staff, certain exchanges have filed amendments to the generic listing standards relating to passivelymanaged ETFs to impose additional requirements, including the obligation to test the requirements of the generic listing standards on an ongoing basis instead of just at the time of launch. In addition to mandating that the listing standards be maintained on a continuous basis, the rule change as proposed would require any representations made by the ETF to be continuously maintained, including any representations regarding index composition, the description of portfolio or reference assets, limitations on portfolio holdings or reference assets, dissemination and availability of index values and inavs, 41. See Self-Regulatory Organizations; The NASDAQ Stock Market LLC, Exchange Act Release No (Sep. 23, 2016)

24 and the applicability of exchange rules and surveillance procedures made in any filing to list a series of exchange-traded products Modernization of Reporting Requirements, with Particular Emphasis on Risk Disclosures Recent updates to ETF reporting requirements have reflected the SEC s desire to monitor ETFs more closely and thus protect investors [and] maintain fair, orderly, and efficient markets by heightening reporting and disclosure requirements. 43 On October 13, 2016, the SEC adopted new forms as well as amendments to existing forms in an effort to modernize the reporting of information provided by funds (including ETFs) and to improve the quality and type of information that funds provide to the SEC and investors. The point of the modernization is requiring strong transparency provisions and enhanced investor protections. 44 Effective June 1, 2018, new Form N-PORT is adopted to replace existing Form N-Q, and Form N-SAR will be replaced by new Form N-CEN. With the filing of Form N-PORT, ETFs are required to disclose portfolio-wide and position-level information on a monthly basis with the SEC, no later than 30 days after each month s end. The information required to be reported on Form N- PORT is intended to be helpful for understanding an ETF s investment strategies. Information filed on Form N-PORT for the third month of each fiscal quarter of the ETF will be publicly available 60 days after the end of the ETF s fiscal quarter. As per the new reporting requirements, new Form N-CEN will replace Form N-SAR and will require similar disclosures, including census-type data that facilitates the SEC s categorization of filers by fund type and helps the SEC monitor the fund industry. In the case of a fund designed to match or track an index (such as an passively-managed ETF), Form N-CEN requires disclosure of the fund s tracking difference, tracking error, and information on how the index was constructed. In addition, Form N-CEN requires 42. See Self-Regulatory Organizations; Bats BZX Exchange, Inc., Exchange Act Release No (Dec. 1, 2016); and Self-Regulatory Organizations; The Nasdaq Stock Market LLC, Exchange Act Release No (Oct. 11, 2016). 43. OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS, EXAMINATION PRIORITIES FOR 2016 (2016). 44. Investment Company Reporting Modernization, Investment Company Act Release No (May 20, 2015)

25 information identifying the exchange on which the ETF is listed, identifying information for each AP, information about the dollar values of ETF shares purchased and redeemed during the reporting period, and specific information about creation units and primary market transactions. ETFs are required to report, as to creation units purchased by APs during the reporting period, and as to creation units purchased by APs that were fully or partially composed of cash, the average transaction fee: (i) charged in dollars per creation unit; (ii) charged for one or more creation units on the same business day; and (iii) charged as a percentage of the value of the creation unit. ETFs are required to report parallel information for the redemption of creation units by APs. Information on Form N-CEN is to be made publicly available and is required to be filed electronically in structured extensible markup language (XML) format to promote speed and efficiency of transmission and processing. The modernization rules, as adopted, essentially heighten reporting requirements by calling not only for more detailed information but also for more frequent filings of some of the forms. The availability of new technologies has thus, in addition to revolutionizing the fund industry, also prompted the SEC to impose and amend regulations so as to obtain and process a larger volume of specific information from funds on a more efficient time scale. 4. Liquidity Rule and the In-Kind ETF On the same day that the SEC adopted the modernized reporting and disclosure requirements as outlined above, it adopted Rule 22e-4 under the Investment Company Act (the Liquidity Rule ), requiring funds (including ETFs and ETMFs) to implement liquidity risk management programs intended to promote effective liquidity risk management of funds; limit risks that open-end funds would be unable to meet shareholder redemption requests; and minimize the potential dilutive impact of shareholder transactions. 45 These reforms were proposed in response to the growth of the U.S. asset management industry in general, including the growth of less liquid and alternative strategies, as well as the evolution of settlement periods and redemption practices. 46 The Liquidity Rule 45. Investment Company Liquidity Risk Management Programs, Investment Company Act Release No (Oct. 13, 2016) (Liquidity Program Adopting Release). 46. Id