Proposed rule for ETFs expected to speed up offerings

The Securities and Exchange Commission (SEC) on June 28, 2018, published Release No. 33-10515, Exchange-Traded Funds, to propose updating its rules for exchange-traded funds (ETFs).

The proposed changes will be open for public comments for 60 days after they appear in the Federal Register, which normally occurs a few weeks after a rule is posted on the SEC’s website.

The SEC is proposing to add Rule 6c-11 to the Investment Company Act of 1940 and allow ETFs that satisfy certain conditions to come to market more quickly. If the rule is finalized, the ETFs will be granted exemptions from the Investment Company Act’s requirements that govern the sale of fund shares.

“This proposal is an important step in moving a substantial portion of the $3.4 trillion ETF market under a rules-based framework that continues to provide the oversight and protections investors expect,” SEC Chairman Jay Clayton said in a prepared statement.

Rule 22c-1 of the Investment Company Act of 1940 requires funds to sell and redeem fund shares at a price based on the fund’s current share price, or net asset value (NAV), and Section 22(d) of the law bans dealers in funds and ETFs from selling shares at a price other than the current offering price described in the fund’s prospectus. Unlike traditional mutual funds, which price their NAVs at the end of each trading day, ETFs let investors buy and sell shares on the secondary market at current market prices, which are not in the prospectus.

ETFs will be exempt from Rule 22c-1 and Section 22(d) as long as they make daily disclosures on their websites with the names and weightings of the investments in their portfolios.

SEC officials want to write a consistent rule for the exemption process because the agency has issued more than 300 exemptive orders for ETFs, and regulatory officials believe the individual exemption process unnecessarily delays new fund offerings. Regulators also believe a final version of Rule 6c-11 will establish more consistency in their supervision of the ETF market. The final rule will replace the individual exemptive orders the agency has issued to date.

Because of the particular nature of ETFs, they are frequently subject to brief and relatively small pricing mismatches among the securities in the portfolio and an ETF’s share price, or net asset value (NAV). The mismatches give professional traders an opportunity to make a profit by engaging in arbitrage in an ETF and its individual holdings. The SEC views the arbitrage in the ETF market as a factor that promotes investor protection.

“The proposed rule would provide exemptions from Section 22(d) and Rule 22c-1 because we believe this arbitrage mechanism—and the conditions in this rule designed to promote a properly functioning arbitrage mechanism—have adequately addressed, over the significant operating history of ETFs, the potential concerns regarding shareholder dilution and unjust discrimination that these provisions were designed to address,” the SEC said in Release No. 33-10515

The SEC issued an earlier version of the proposal in 2008 in Release No. 33-8901, Exchange-Traded Funds. The 2008 proposal was issued in response to the ETF market’s rapid growth from its formation in the early 1990s to ease the process for new funds coming to market. But the SEC never finalized rule, and it issued Release No. 33-10515 in part to catch up the market’s rapid growth in the 10 years since the original proposal was issued.

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