Exchange-Traded Funds

Federal RegisterJul 31, 2018

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 239, 270, and 274

[Release Nos. 33-10515; IC-33140; File No. S7-15-18]

RIN 3235-AJ60

Exchange-Traded Funds

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (the “Commission”) is proposing a new rule under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”) that would permit exchange-traded funds (“ETFs”) that satisfy certain conditions to operate without the expense and delay of obtaining an exemptive order. In connection with the proposed exemptive rule, the Commission proposes to rescind certain exemptive orders that have been granted to ETFs and their sponsors. The Commission also is proposing certain disclosure amendments to Form N-1A and Form N-8B-2 to provide investors who purchase and sell ETF shares on the secondary market with additional information regarding ETF trading costs, regardless of whether such ETFs are structured as registered open-end management investment companies (“open-end funds”) or unit investment trusts (“UITs”). Finally, the Commission is proposing related amendments to Form N-CEN. The proposed rule and form amendments are designed to create a consistent, transparent, and efficient regulatory framework for ETFs and to facilitate greater competition and innovation among ETFs.

DATES:

Comments should be received on or before October 1, 2018.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (

http://www.sec.gov/rules/proposed.shtml

); or

• Send an email to

rule-comments@sec.gov.

Please include File Number S7-15-18 on the subject line.

Paper Comments

• Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-15-18. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's internet website (

http://www.sec.gov/rules/proposed.shtml

). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly.

Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission's website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at

www.sec.gov

to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Zeena Abdul-Rahman (Senior Counsel), Joel Cavanaugh (Senior Counsel), John Foley (Senior Counsel), Jacob D. Krawitz (Branch Chief), Melissa S. Gainor (Senior Special Counsel), and Brian McLaughlin Johnson (Assistant Director), Investment Company Regulation Office, at (202) 551-6792, Sumeera Younis (Branch Chief) and Christian Sandoe (Assistant Director), Disclosure Review and Accounting Office, at (202) 551-6921, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

The Commission is proposing for public comment 17 CFR 270.6c-11 (new rule 6c-11) under the Investment Company Act [15 U.S.C. 80a-1

et seq.

]; amendments to Form N-1A [referenced in 17 CFR 274.11A] under the Investment Company Act and the Securities Act of 1933 [15 U.S.C. 77a

et seq.

] (“Securities Act”); and amendments to Forms N-8B-2 [referenced in 17 CFR 274.12] and N-CEN [referenced in 17 CFR 274.101] under the Investment Company Act.

Unless otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act are to title 17, part 270 of the Code of Federal Regulations [17 CFR part 270].

Table of Contents

I. Introduction

A. Overview of Exchange-Traded Funds

B. Operation of Exchange-Traded Funds

II. Discussion

A. Scope of Proposed Rule 6c-11

1. Organization as Open-End Funds

2. Index-Based ETFs and Actively Managed ETFs

3. Leveraged ETFs

B. Exemptive Relief Under Proposed Rule 6c-11

1. Treatment of ETF Shares as “Redeemable Securities”

2. Trading of ETF Shares at Market-Determined Prices

3. Affiliated Transactions

4. Additional Time for Delivering Redemption Proceeds

C. Conditions for Reliance on Proposed Rule 6c-11

1. Issuance and Redemption of Shares

2. Listing on a National Securities Exchange

3. Intraday Indicative Value

4. Portfolio Holdings

5. Baskets

6. Website Disclosure

7. Marketing

D. Recordkeeping

E. Share Class ETFs

F. Master-Feeder ETFs

G. Effect of Proposed Rule 6c-11 on Prior Orders

H. Amendments to Form N-1A

1. Definitions

2. Item 3 of Form N-1A

3. Item 6 of Form N-1A

4. Item 11 of Form N-1A

5. Potential Alternatives to Current ETF Registration Forms

I. Amendments to Form N-8B-2

J. Amendments to Form N-CEN

III. Economic Analysis

A. Introduction

B. Economic Baseline

1. ETF Industry Growth and Trends

2. Exemptive Order Process

3. Market Participants

4. Secondary Market Trading, Arbitrage, and ETF Liquidity

C. Benefits and Costs of Proposed Rule 6c-11 and Amendments to Forms N-1A and N-8B-2

1. Proposed Rule 6c-11

2. Disclosure (Amendments to Forms N-1A and N-8B-2)

D. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency

2. Competition

3. Capital Formation

E. Reasonable Alternatives

1. Treatment of Existing Exemptive Relief

2. ETFs Organized as UITs

3. Basket Flexibility

4. Website Disclosure of Every Basket Used by an ETF

5. The Use of a Structured Format for Additional Website Disclosures and the Filing of Additional Website Disclosures in a Structured Format on EDGAR

6. Treatment of Leveraged ETFs

F. Request for Comments

IV. Paperwork Reduction Act

A. Introduction

B. Proposed Rule 6c-11

1. Website Disclosures

2. Recordkeeping

3. Policies and Procedures

4. Estimated Total Burden

C. Rule 0-2

D. Form N-1A

E. Disclosure Amendments to Forms N-8B-2 and S-6

F. Form N-CEN

G. Request for Comments

V. Initial Regulatory Flexibility Analysis

A. Reasons for and Objectives of the Proposed Actions

B. Legal Basis

C. Small Entities Subject to the Rule

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Rule 6c-11

2. Disclosure and Reporting Requirements

E. Duplicative, Overlapping or Conflicting Federal Rules

F. Significant Alternatives

G. General Request for Comment

VI. Consideration of Impact on the Economy

VII. Statutory Authority

I. Introduction

The Commission is proposing rule 6c-11 under the Investment Company Act to permit ETFs that satisfy certain conditions to operate without the expense and delay of obtaining an exemptive order from the Commission under the Act. This rule would modernize the regulatory framework for ETFs to reflect our 26 years of experience with these investment products. It is designed to create a consistent, transparent, and efficient regulatory framework for ETFs and to facilitate greater competition and innovation among ETFs.

The Commission approved the first ETF in 1992. Since then, ETFs registered with us have grown to $3.4 trillion in total net assets.

They now account for approximately 15% of total net assets managed by investment companies,

and are projected to continue to grow.

ETFs currently rely on exemptive orders, which permit them to operate as investment companies under the Act, subject to representations and conditions that have evolved over time.

We have granted over 300 of these orders over the last quarter century, resulting in differences in representations and conditions that have led to some variations in the regulatory structure for existing ETFs.

This figure is based on data obtained from Bloomberg. As of December 2017, there were 1,900 ETFs registered with the Commission.

See id.

ICI, 2018 Investment Company Fact Book (58th ed., 2018) (“2018 ICI Fact Book”),

available at https://www.ici.org/pdf/2018_factbook.pdf,

at 96. When the Commission first proposed a rule for ETFs in 2008, aggregate ETF assets were less than 7% of total net assets held by mutual funds.

See

Exchange-Traded Funds, Investment Company Act Release No. 28193 (Mar. 11, 2008) [73 FR 14618 (Mar. 18, 2008)] (“2008 ETF Proposing Release”).

See

Greg Tusar,

The evolution of the ETF industry,

Pension & Investments (Jan. 31, 2017),

available at http://www.pionline.com/article/20170131/ONLINE/170139973/the-evolution-of-the-etf-industry

(describing projections that ETF assets could double to $6 trillion by 2020).

As the orders are subject to the terms and conditions set forth in the applications requesting exemptive relief, references in this release to “exemptive relief” or “exemptive orders” include the terms and conditions described in the related application.

See, e.g., infra

footnote 6.

Since 2000, our ETF exemptive orders have provided relief for future ETFs.

See, e.g.,

Barclays Global Fund Advisors, Investment Company Act Release Nos. 24394 (Apr. 17, 2000) [65 FR 21215 (Apr. 20, 2000)] (notice) and 24451 (May 12, 2000) (order) and related application (“Barclays Global 2000”). This relief has allowed ETF sponsors to form ETFs without filing new applications to the extent that the new ETFs meet the terms and conditions set forth in the exemptive order. Applications granted before 2000, unless subsequently amended, did not include this relief.

Proposed rule 6c-11 would simplify this regulatory framework by eliminating conditions included within our exemptive orders that we no longer believe are necessary for our exemptive relief and removing historical distinctions between actively managed and index-based ETFs. In connection with the proposed rule, we also propose to rescind certain exemptive orders that have been granted to ETFs and their sponsors. As a result, proposed rule 6c-11 would level the playing field for ETFs that are organized as open-end funds and pursue the same or similar investment strategies.

The proposed rule also would assist the Commission with regulating ETFs, as funds covered by the rule would no longer be subject to the varying provisions of exemptive orders granted over time, and instead would be subject to a consistent regulatory framework. Furthermore, creating an efficient regulatory framework for ETFs would allow Commission staff and industry resources to focus the exemptive order process on products that do not fall within the scope of our proposed rule.

As discussed below, the scope of proposed rule 6c-11 does not include ETFs that: (i) Are organized as UITs; (ii) seek to exceed the performance of a market index by a specified multiple or to provide returns that have an inverse relationship to the performance of a market index, over a fixed period of time (“leveraged ETFs”); or (iii) are structured as a share class of a fund that issues multiple classes of shares representing interests in the same portfolio (“share class ETFs”). These ETFs would continue to operate pursuant to the terms of their exemptive orders.

See infra

sections II.A.1 (UIT ETFs), II.A.3 (leveraged ETFs), and II.E (share class ETFs).

In addition, we are proposing certain disclosure amendments to provide additional information to investors who purchase and sell ETF shares in the secondary markets, and to provide investors who purchase UITs with the same disclosures that we propose to require of ETFs organized as open-end funds. The proposed amendments would include new disclosures regarding certain unique costs associated specifically with ETFs, such as the bid-ask spread and premiums and discounts from the ETF's net asset value (“NAV”).

Our proposal takes into account the comments we received in response to our 2008 ETF proposal, which was designed to codify the exemptive relief that had been issued to ETFs at that time.

Developments in the ETF industry since the 2008 proposal and interim Commission actions also have informed the parameters of proposed rule 6c-11 and the related disclosure amendments that we are proposing.

See

2008 ETF Proposing Release,

supra

footnote 3. Comment letters on the 2008 ETF Proposing Release are available at

http://www.sec.gov/comments/s7-07-08/s70708.shtml.

See, e.g.,

Request for Comment on Exchange-Traded Products, Exchange Act Release No. 75165 (June 12, 2015) [80 FR 34729 (June 17, 2015)] (“2015 ETP Request for Comment”), at section I.A; Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues,

Findings Regarding the Market Events of May 6, 2010

(Sept. 30, 2010) (“Final May 6 Report”),

available at http://www.sec.gov/news/studies/2010/marketevents-report.pdf.

Comment letters on the 2015 ETP Request for Comment are available at

https://www.sec.gov/comments/s7-11-15/s71115.shtml.

A. Overview of Exchange-Traded Funds

ETFs are a type of exchange-traded product (“ETP”).

ETFs possess characteristics of both mutual funds, which issue redeemable securities, and closed-end funds, which generally issue shares that trade at market-determined prices on a national securities exchange and are not redeemable.

Because ETFs

have characteristics that distinguish them from the types of investment companies contemplated by the Act, they require exemptions from certain provisions of the Investment Company Act in order to operate. The Commission (and Commission staff under delegated authority) now routinely grants exemptive orders permitting ETFs to operate as investment companies under the Investment Company Act, generally subject to the provisions of the Act applicable to open-end funds (or UITs).

These exemptive orders reflect our determination that, based on the factual representations offered by the applicants and the conditions to which the applicants have agreed, the requested relief is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Investment Company Act.

The Commission also has approved the standards of national securities exchanges, under which ETF shares are listed and traded.

ETFs are investment companies registered under the Investment Company Act.

See

15 U.S.C. 80a-3(a)(1). Other types of ETPs are pooled investment vehicles with shares that trade on a securities exchange, but they are not “investment companies” under the Act because they do not invest primarily in securities. Such ETPs may invest primarily in assets other than securities, such as futures, currencies, or physical commodities (

e.g.,

precious metals). Still other ETPs are not pooled investment vehicles. For example, exchange-traded notes are senior, unsecured, unsubordinated debt securities that are linked to the performance of a market index and trade on securities exchanges.

The Act defines “redeemable security” as any security that allows the holder to receive his or her proportionate share of the issuer's current net assets upon presentation to the issuer. 15 U.S.C. 80a-2(a)(32). While closed-end fund shares are not redeemable, certain closed-end funds may elect to repurchase their shares at periodic intervals pursuant to 17 CFR 270.23c-3 (rule 23c-3) under the Act (“interval funds”). Based on staff analysis, there were 39 interval funds, representing approximately $21 billion in assets, in 2017. Other closed-end funds may repurchase their shares in tender offers pursuant to 17 CFR 240.13e-4 (rule

13e-4) under the Securities Exchange Act of 1934 (the “Exchange Act”).

Historically, ETFs have been organized as open-end funds or UITs.

See

15 U.S.C. 80a-5(a)(1) (defining the term “open-end company”) and 15 U.S.C. 80a-4(2) (defining the term “unit investment trust”). Some fund groups have multiple orders covering different types of ETFs (

e.g.,

one order covering ETFs organized as UITs and another covering ETFs organized as open-end funds or one order covering index-based ETFs and another covering actively managed ETFs).

See

15 U.S.C. 80a-6(c).

Additionally, ETFs regularly request relief from 17 CFR 242.101 and 242.102 (rules 101 and 102 of Regulation M); section 11(d)(1) of the Exchange Act and 17 CFR 240.11d1-2 (“rule 11d1-2” under the Exchange Act); certain other rules under the Exchange Act (

i.e.,

17 CFR 240.10b-10, 240.10b-17, 240.14e-5, 240.15c1-5, and 240.15c1-6 (rules 10b-10, 10b-17, 14e-5, 15c1-5, and 15c1-6)); and 17 CFR 242.200(g) (rule 200(g) of Regulation SHO).

See

2015 ETP Request for Comment,

supra

footnote 9, at section I.D.2 (discussing the exemptive and no-action relief granted to ETPs under the Exchange Act and the listing process for ETP securities for trading on a national securities exchange).

As discussed above, ETFs have become an increasingly popular investment vehicle over the last 26 years. They also have become a popular trading tool, making up a significant portion of secondary market equities trading. During the first quarter of 2018, for example, trading in U.S.-listed ETFs made up approximately 18.75% of U.S. equity trading by share volume and 28.2% of U.S. equity trading by dollar volume.

These estimates are based on trade and quote data from the New York Stock Exchange and Trade Reporting Facility data from FINRA.

Investors can buy and hold shares of ETFs (sometimes as a core component of a portfolio) or trade them frequently as part of an active trading or hedging strategy.

ETF investors can sell ETF shares short, write options on them, and set market, limit, and stop-loss orders on them. Moreover, because certain costs are either absent in the ETF structure or are otherwise partially externalized, many ETFs have lower operating expenses than mutual funds.

ETFs also may offer certain tax efficiencies compared to other pooled investment vehicles because redemptions from ETFs are often made in kind (that is, by delivering certain assets from the ETF's portfolio, rather than in cash), thereby avoiding the need for the ETF to sell assets and potentially realize capital gains that are distributed to its shareholders.

See, e.g.,

Chris Dieterich,

Are You An ETF `Trader' Or An ETF `Investor'?,

Barrons (Aug. 8, 2017),

available at https://www.barrons.com/articles/are-you-an-etf-trader-or-an-etf-investor-1470673638;

Greenwich Associates,

Institutions Find New, Increasingly Strategic Uses for ETFs

(May 2012) (“More than one-in-five asset managers that use [ETFs] report employing ETFs for active exposures in domestic equities and commodities, and about 17% note using them for active exposures in international equities.”); Joe Renninson,

Institutional Investors Boost Ownership of ETFs,

Financial Times (Apr. 13, 2017),

available at https://www.ft.com/content/c70113ac-ab83-33ac-a624-d2d874533fb0?mhq5j=e7.

For instance, ETFs typically do not bear distribution or shareholder servicing fees. In addition, ETFs that transact on an in-kind basis can execute changes in the ETF's portfolio without incurring brokerage costs, leading to transaction cost savings.

ETFs today provide investors with a diverse set of investment options. While the first ETFs held portfolios of securities that replicated the component securities of broad-based domestic stock market indexes, some ETFs now track more specialized indexes, including international equity indexes, fixed-income indexes, or indexes focused on particular industry sectors such as telecommunications or healthcare.

Some ETFs seek to track highly customized or bespoke indexes, while others seek to provide a level of leveraged or inverse exposure to an index over a fixed period of time.

Investors also have the ability to invest in ETFs that do not track a particular index and are actively managed.

The Commission historically has referred to ETFs that have stated investment objectives of maintaining returns that correspond to the returns of a securities index as “index-based” ETFs.

See, e.g.,

Parker Global Strategies, LLC,

et al.,

Investment Company Act Release Nos. 32528 (Mar. 10, 2017) [82 FR 14043 (Mar. 16, 2017)] (notice) and 32595 (Apr. 5, 2017) (order) and related application (“Parker Global Strategies”).

Inverse ETFs are often marketed as a way for investors to profit from, or at least hedge their exposure to, downward moving markets.

See infra

section II.A.3.

An actively managed ETF's investment adviser, like an adviser to any actively managed mutual fund, generally selects securities consistent with the ETF's investment objectives and policies without trying to track the performance of a corresponding index. Actively managed ETFs represent approximately 1.3% of total ETF assets as of September 2017. Based on data obtained from the Market Information Data Analytics System (“MIDAS”), Bloomberg, and Morningstar Direct.

B. Operation of Exchange-Traded Funds

An ETF issues shares that can be bought or sold throughout the day in the secondary market at a market-determined price. Like other investment companies, an ETF pools the assets of multiple investors and invests those assets according to its investment objective and principal investment strategies. Each share of an ETF represents an undivided interest in the underlying assets of the ETF. Similar to mutual funds, ETFs continuously offer their shares for sale.

Unlike mutual funds, however, ETFs do not sell or redeem individual shares. Instead, “authorized participants” that have contractual arrangements with the ETF (or its distributor) purchase and redeem ETF shares directly from the ETF in blocks called “creation units.”

An authorized participant may act as a principal for its own account when purchasing or redeeming creation units from the ETF. Authorized participants also may act as agent for others, such as market makers, proprietary trading firms, hedge funds or other institutional investors, and receive fees for processing creation units on their behalf.

Market makers, proprietary trading firms, and hedge funds provide additional liquidity to the ETF market through their trading activity. Institutional investors may engage in primary market transactions with an ETF through an authorized participant as a way to efficiently hedge a portion of their portfolio or balance sheet or to

gain exposure to a strategy or asset class.

Our exemptive orders typically contain a representation by the applicant that an authorized participant will be either: (a) A broker or other participant in the continuous net settlement system of the National Securities Clearing Corporation, a clearing agency registered with the Commission and affiliated with the Depository Trust Company (“DTC”), or (b) a DTC participant, which has executed a participant agreement with the ETF's distributor and transfer agent with respect to the creation and redemption of creation units.

See, e.g.,

Emerging Global Advisors, LLC,

et al.,

Investment Company Act Release Nos. 30382 (Feb. 13, 2013) [78 FR 11909 (Feb. 20, 2013)] (notice) and 30423 (Mar. 12, 2013) (order) and related application. Proposed rule 6c-11(a) would define “authorized participant” as a member or participant of a clearing agency registered with the Commission, which has a written agreement with the ETF or one of its service providers that allows the authorized participant to place orders for the purchase and redemption of creation units.

See

David J. Abner,

The ETF Handbook: How to Value and Trade Exchange Traded Funds,

2nd ed. (2016) (“ETF Handbook”).

Id.

An authorized participant that purchases a creation unit of ETF shares directly from the ETF deposits with the ETF a “basket” of securities and other assets identified by the ETF that day, and then receives the creation unit of ETF shares in return for those assets.

The basket is generally representative of the ETF's portfolio

and, together with a cash balancing amount, equal in value to the aggregate NAV of the ETF shares in the creation unit.

After purchasing a creation unit, the authorized participant may hold the individual ETF shares, or sell some or all of them in secondary market transactions.

Investors then purchase individual ETF shares in the secondary market. The redemption process is the reverse of the purchase process: The authorized participant redeems a creation unit of ETF shares for a basket of securities and other assets.

An ETF may impose fees in connection with the purchase or redemption of creation units that are intended to defray operational processing and brokerage costs to prevent possible shareholder dilution (“transaction fees”).

The basket might not reflect a

pro rata

slice of an ETF's portfolio holdings. Subject to the terms of the applicable exemptive relief, an ETF may substitute other securities or cash in the basket for some (or all) of the ETF's portfolio holdings. Restrictions related to flexibility in baskets have varied over time.

See infra

section II.C.5.

An open-end fund is required by law to redeem its securities on demand from shareholders at a price approximating their proportionate share of the fund's NAV at the time of redemption.

See

15 U.S.C. 80a-22(d). Title 17 CFR 270.22c-1 (“rule 22c-1”) generally requires that funds calculate their NAV per share at least once daily Monday through Friday.

See

rule 22c-1(b)(1). Today, most funds calculate NAV per share as of the time the major U.S. stock exchanges close (typically at 4:00 p.m. Eastern Time). Under rule 22c-1, an investor who submits an order before the 4:00 p.m. pricing time receives that day's price, and an investor who submits an order after the pricing time receives the next day's price.

See also

17 CFR 270.2a-4 (“rule 2a-4”) (defining “current net asset value”).

ETFs register offerings of shares under the Securities Act, and list their shares for trading under the Exchange Act. Depending on the facts and circumstances, authorized participants that purchase a creation unit and sell the shares may be deemed to be participants in a distribution, which could render them statutory underwriters and subject them to the prospectus delivery and liability provisions of the Securities Act.

See

15 U.S.C. 77b(a)(11) (defining the term “underwriter”).

The combination of the creation and redemption process with secondary market trading in ETF shares provides arbitrage opportunities that are designed to help keep the market price of ETF shares at or close to the NAV per share of the ETF.

For example, if ETF shares are trading on national securities exchanges at a “discount” (a price below the NAV per share of the ETF), an authorized participant can purchase ETF shares in secondary market transactions and, after accumulating enough shares to compose a creation unit, redeem them from the ETF in exchange for the more valuable securities in the ETF's redemption basket. The authorized participant's purchase of an ETF's shares on the secondary market, combined with the sale of the ETF's basket assets, may create upward pressure on the price of the ETF shares, downward pressure on the price of the basket assets, or both, bringing the market price of ETF shares and the value of the ETF's portfolio holdings closer together.

Alternatively, if ETF shares are trading at a “premium” (a price above the NAV per share of the ETF), the transactions in the arbitrage process are reversed and, when arbitrage is working effectively, keep the market price of the ETF's shares close to its NAV.

To date, the arbitrage mechanism has been dependent on daily portfolio transparency.

As part of this arbitrage process, authorized participants are likely to hedge their intraday risk. For example, when ETF shares are trading at a discount to an estimated intraday NAV per share of the ETF, an authorized participant may short the securities composing the ETF's redemption basket. After the authorized participant returns a creation unit of ETF shares to the ETF in exchange for the ETF's baskets, the authorized participant can then use the basket assets to cover its short positions.

Market participants also can engage in arbitrage activity without using the creation or redemption processes. For example, if a market participant believes that an ETF is overvalued relative to its underlying or reference assets (

i.e.,

trading at a premium), the market participant may sell ETF shares short and buy the underlying or reference assets, wait for the trading prices to move toward parity, and then close out the positions in both the ETF shares and the underlying or reference assets to realize a profit from the relative movement of their trading prices. Similarly, a market participant could buy ETF shares and sell the underlying or reference assets short in an attempt to profit when an ETF's shares are trading at a discount to the ETF's underlying or reference assets. As with the creation and redemption process, the trading of an ETF's shares and the ETF's underlying or reference assets may bring the prices of the ETF's shares and its portfolio assets closer together through market pressure.

Some studies have found the majority of all ETF-related trading activity takes place on the secondary market.

See, e.g.,

Rochelle Antoniewicz & Jane Heinrichs,

Understanding Exchange-Traded Funds: How ETFs Work,

ICI Research Perspective 20, No. 5 (Sept. 2014) (“Antoniewicz”),

available at https://www.ici.org/pdf/per20-05.pdf,

at 2 (“On most trading days, the vast majority of ETFs do not have any primary market activity—that is, they do not create or redeem shares.”).

The arbitrage mechanism is important because it provides a means to maintain a close tie between market price and NAV per share of the ETF, thereby helping to ensure ETF investors are treated equitably when buying and selling fund shares. In granting relief under section 6(c) of the Act for ETFs to operate, the Commission has relied on this close tie between what retail investors pay (or receive) in the secondary market and the ETF's approximate NAV to find that the required exemptions are necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act. Investors also have come to expect that an ETF's market price will maintain a close tie to the ETF's NAV per share, which may lead some investors to view ETFs more favorably than similar closed-end funds.

On the other hand, this expectation may lead investors to view ETFs as a less attractive investment option or cause them to sell ETF shares if market price and NAV per share diverge, particularly during periods of market stress.

Scott W. Barnhart & Stuart Rosenstein,

Exchange-Traded Fund Introductions and Closed-End Fund Discounts and Volume,

45 The Financial Review 4 (Nov. 2010) (within a year of the introduction of a similar ETF, the average discount widens significantly and volume falls significantly in U.S. domestic equity, international equity, and U.S. bond closed-end funds, which may indicate that closed-end funds lose some desirability when a substitute ETF becomes available). As of December 31, 2017, total net assets of ETFs were $3.4 trillion compared to $275 billion for closed-end funds.

See

2018 ICI Fact Book,

supra

footnote 3.

See

Staff of the Office of Analytics and Research, Division of Trading and Markets,

Research Note: Equity Market Volatility on August 24, 2015

(Dec. 2015) (“August 24 Staff Report”),

available at https://www.sec.gov/marketstructure/research/equity_market_volatility.pdf

(discussing spikes in ETF trading volume on August 24, 2015 when U.S. equity markets experienced unusual price volatility).

see also

Item C.3.c. of Form N-CEN (requiring funds to identify if they seek to achieve performance results that are a multiple of an index or other benchmark, the inverse of an index or other benchmark, or a multiple of the inverse of an index or other benchmark).

See

ETF Handbook,

supra

footnote 22, at 266.

The strategy that leveraged ETFs pursue requires them to rebalance their portfolios on a daily basis in order to maintain a constant leverage ratio. This daily reset, and the effects of compounding,

can result in performance that differs significantly from some investors' expectations of how index investing generally works.

This effect can be more pronounced in volatile markets.

As a result, buy-and-hold investors in a leveraged ETF with an intermediate or long-term time horizon—who may not evaluate their portfolios frequently—may experience large and unexpected losses.

For example, as a result of compounding, leveraged ETFs can outperform a simple multiple of its index's returns over several days of consistently positive returns, or underperform a simple multiple of its index's returns over several days of volatile returns.

See

Office of Investor Education and Advocacy, SEC,

Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors

Investor Alert and Bulletins (Aug. 1, 2009),

available at http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm

; FINRA,

Non-Traditional ETFs: FINRA Reminds Firms of Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds,

Regulatory Notice 09-31 (June 2009),

available at http://www.finra.org/sites/default/files/NoticeDocument/p118952.pdf

(“FINRA Regulatory Notice 09-31”) (providing an example of a four-month period where a specified index gained 2%, while an ETF seeking to deliver twice the daily return of that index fell 6%, and the related ETF seeking to deliver twice the inverse of the index's daily return fell 26%).

See

FINRA Regulatory Notice 09-31,

supra

footnote 74 (“Using a two-day example, if the index goes from 100 to close at 101 on the first day and back down to close at 100 on the next day, the two-day return of an inverse ETF will be different than if the index had moved up to close at 110 the first day but then back down to close at 100 on the next day. In the first case with low volatility, the inverse ETF loses 0.02 percent; but in the more volatile scenario the inverse ETF loses 1.82 percent. The effects of mathematical compounding can grow significantly over time, leading to scenarios such as those noted above.”).

See id.

(reminding member firms of their sales practice obligations relating to leveraged ETFs and noting that leveraged ETFs are typically not suitable for retail investors who plan to hold these products for more than one trading session).

See also

ProShares Trust,

et al.,

Investment Company Act Release Nos. 28696 (Apr. 14, 2009) [74 FR 18265 Apr. 21, 2009)] (notice) and 28724 (May 12, 2009) (order) and related application (amending the applicant's prior order) (“ProShares”); Rafferty Asset Management, LLC,

et al.,

Investment Company Act Release Nos. 28889 (Aug. 27, 2009) [74 FR 45495 (Sept. 2, 2009)] (notice) and 28905 (Sept. 22, 2009) (order) and related application (amending the applicant's prior order) (“Rafferty”).

See

Derivatives Proposing Release,

supra

footnote 40. Section 18 of the Act limits a fund's ability to obtain leverage or issue senior securities. 15 U.S.C. 80a-18.

In light of our ongoing consideration, including the potential staff recommendation of a re-proposal on funds' use of derivatives, we do not believe it is appropriate to permit additional leveraged ETF sponsors to form leveraged ETFs and operate under our proposed rule at this time.

Accordingly, we propose to include a condition that would prevent leveraged ETFs from relying on proposed rule 6c-11.

ETFs that seek to provide returns that exceed the performance (or inverse performance) of a market index by a specified multiple over a fixed period could not operate under our proposed rule.

See supra

footnote 77. As discussed in more detail in section II.G below, we are not proposing here to rescind the existing leverage ETF orders. Existing leveraged ETF sponsors would continue to operate under their exemptive orders. Existing leveraged ETFs, however, would be subject to the proposed amendments to Form N-1A discussed below.

Proposed rule 6c-11(c)(4).

The daily or other periodic reset, and more particularly the effects of compounding, are what distinguish a leveraged ETF strategy from other strategies pursued by ETFs. The proposed condition relating to leveraged ETFs thus includes a temporal element (

i.e.,

“over a fixed period of time”) in order to specifically capture ETFs that seek to deliver the leveraged or inverse return of a market index over a fixed period of time, daily or otherwise.

In addition, the proposed rule's use of the term “multiple” includes leverage that is not evenly divisible by 100, such as a fund that seeks to provide a return equal to 150% of the performance of an index.

Finally, we believe it is important to specify that an ETF may not

indirectly

seek to provide returns that exceed the performance of a market index by a specified multiple or to provide returns that have an inverse relationship to the performance of a market index over a fixed period of time in order to prevent a fund from circumventing this condition, such as by embedding inverse leverage in the underlying index.

The current exemptive orders that allow leveraged ETFs contemplate a daily reset, because the orders relate to ETFs that pursue daily investment objectives.

See supra

footnote 77. For example, one application describes its leveraged ETFs as “seek[ing] to provide daily investment results, before fees and expenses, that correspond to 300% of the daily performance, or 300% of the inverse (opposite) daily performance, of its Underlying Index.”

See

Rafferty,

supra

footnote 77. Another describes its leveraged ETFs as “attempt[ing], on a daily basis, to achieve its investment objective by corresponding to a specified multiple of the performance (either 125%, 150% or 200%), or the inverse performance, or the inverse multiple (either 125%, 150% or 200% of the opposite) of the performance of a particular securities index.”

See

ProShares,

supra

footnote 77.

Similarly, an “inverse ETF” includes both inverse strategies (

i.e.,

−100% of an index's performance) and leveraged inverse strategies (

e.g.,

−125% or −200% of an index's performance).

We request comment on excluding leveraged ETFs from the scope of funds that may rely on the proposed rule.

• Do commenters agree that it is appropriate for proposed rule 6c-11 to include a condition that an ETF may not seek, directly or indirectly, to provide returns that exceed the performance of a market index by a specified multiple, or to provide returns that have an inverse relationship to the performance of a market index, over a fixed period of time?

• Alternatively, do commenters believe that the structure and operation of leveraged ETFs do not raise issues that warrant our excluding them from a rule of general applicability related to the structure and operations of ETFs? If so, are there any conditions specific to leveraged ETFs that should be part of the rule? For example, should we permit leveraged ETFs to operate in reliance on the rule but prohibit a leveraged ETF that exceeds a specific multiple of the performance, or inverse performance, of a market index? If so, what multiple should we use? For example, ETFs currently may not seek investment results over 300% of the return (or inverse of the return) of the underlying index. Should we maintain the status quo with respect to the maximum amount of leveraged market exposure that leveraged ETFs may obtain (

i.e.,

300%)? Should we limit ETFs to a higher or lower multiplier? If so, what multiplier and why?

• Does the proposed rule's use of “a fixed period of time” effectively describe the daily reset mechanism in leveraged ETFs? Are there other descriptions we should use? Could an ETF seek to provide returns that are a multiple, or inverse, of an index without this limitation? For example, would such an ETF be able to operate without the daily (or other periodic) reset? Would such an ETF raise the same investor protection issues as the leveraged ETFs that we are proposing to exclude from relying on proposed rule 6c-11? Would they raise other investor protection issues? If so, what issues and why?

• Does the proposed rule prevent an ETF from circumventing this limitation by embedding leverage in an index or through any other means? If not, should we consider other conditions or limitations, and if so, what? For example, should the rule provide that an ETF may not “obtain” or “provide” leveraged exposure, rather than stating that an ETF may not “seek” to provide leveraged exposure as proposed? Alternatively, should we define leveraged ETFs as funds currently do in their applications (

i.e.,

to achieve its investment objective by corresponding to a specified multiple of the performance (either 125%, 150% or 200%), or the inverse performance, or the inverse multiple (either 125%, 150% or 200% of the opposite) of the performance of a particular securities index)?

See supra

footnote 81.

• Proposed rule 6c-11 does not seek to address any concerns raised under section 18 of the Act by leveraged ETFs. Do commenters agree that this is appropriate? Should we consider additional conditions in rule 6c-11 for leveraged ETFs designed to address concerns raised under section 18 or other investor protection concerns raised by their strategies? If so, what conditions? Should we provide any relief to these ETFs under section 18 of the Act?

• What types of investors purchase shares of leveraged ETFs? What is the proportion of volume from retail versus institutional trading? How do these different types of investors utilize leveraged ETFs? What is the typical holding period of leveraged ETFs by each type of investor?

• What types of intermediaries are active with leveraged ETF investments? Are the current suitability requirements for intermediaries effective with respect to leveraged ETFs? What specific methods, if any, are intermediaries using to meet their suitability obligations for these products? Should we propose as part of a future rulemaking that leveraged ETFs be subject to additional requirements, particularly for retail investors?

See, e.g.,

NASD,

Structured Products: NASD Provides Guidance Concerning the Sale of Structured Products,

Notice to Members (September 2005),

available at http://www.complinet.com/file_store/pdf/rulebooks/nasd_0559ntm.pdf

;

see also

FINRA,

Complex Products: Heightened Supervision of Complex Products,

Regulatory Notice 12-03 (January 2012),

available at http://www.finra.org/sites/default/files/NoticeDocument/p125397.pdf

• The Commission understands that leveraged ETFs typically provide enhanced disclosure of the risks of investing in the ETF.

Do investors understand leveraged ETFs better today than they did when Commission staff and FINRA jointly issued an investor alert expressing the concern that individual investors may be confused about the performance objectives of leveraged ETFs?

For example, are investors more likely to be aware that leveraged ETFs are typically designed to achieve their stated performance objectives on a periodic basis (

e.g.,

daily)? Do investors understand that leveraged ETFs may not achieve those performance objectives over the long-term?

This understanding is based on Commission staff review of registration statements filed with the Commission and ETF websites.

See supra

footnote 74.

See e.g.,

Paolo Guasoni and Eberhard Mayerhofer, Leveraged Funds: Robust Replication and Performance Evaluation (2017) (“Leveraged and inverse exchange-traded funds seek daily returns equal to fixed multiples of indexes' returns. Trading costs implied by frequent adjustments of funds' portfolios create a tension between tracking error, reflecting short-term correlation with the index, and excess return, the long-term deviation from the leveraged index's performance.”); Lu Lei, Jun Wang, and Ge Zhang,

Long-term performance of leveraged ETFs,

21 Financial Services Review 1 (2012) (“Overall our results caution against the use of leveraged ETFs as long-term investment substitutes for long or short positions of the benchmark indices.”).

• Leveraged ETFs typically include charts in their disclosures that explain the potential impact of compounding to an investor's returns. Should we amend Form N-1A to require leveraged ETFs to include such a chart to better explain the impact of compounding? Are there other disclosures that we should require leveraged ETFs to provide? If so, what are they?

• Should we propose rules governing leveraged ETF marketing materials to address concerns that leveraged ETFs may be marketed to investors that do not have an appropriate risk tolerance to invest in these products or that lack understanding of leveraged ETFs' strategies and risks? For example, should we require leveraged ETFs to include prescribed cautionary disclosures regarding these strategies and risks?

B. Exemptive Relief Under Proposed Rule 6c-11

Proposed rule 6c-11 would provide ETFs within the scope of the rule with exemptions from certain provisions of the Act that are necessary to allow ETFs to operate. These exemptions are generally consistent with the relief we have given to ETFs under our exemptive orders.

Proposed rule 6c-11 would permit an ETF that meets the conditions of the rule to: (i) Redeem shares only in creation unit aggregations; (ii) permit ETF shares to be purchased and sold at market prices rather than at NAV per share; (iii) engage in in-kind transactions with certain affiliates; and (iv) in certain limited circumstances, pay authorized participants the proceeds from the redemption of shares in more than seven days. As discussed below in section II.C, the exemptions would be subject to certain conditions that are designed to address the concerns underlying the relevant statutory provisions and to support a Commission finding that the exemptions are in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act.

Our exemptive orders also provide relief allowing certain types of funds to invest in ETFs beyond the limits of section 12(d)(1) of the Act. We are not addressing this relief at this time.

See infra

section II.G. However, we are proposing to rescind the master-feeder relief that we previously granted to ETFs that do not rely on the relief as of the date of this proposal (June 28, 2018). We also propose to grandfather existing master-feeder arrangements involving ETF feeder funds, but prevent the formation of new ones, by amending relevant exemptive orders.

See infra

section II.F.

See

15 U.S.C. 80a-6(c).

1. Treatment of ETF Shares as “Redeemable Securities”

Under proposed rule 6c-11, an ETF, as defined in the rule, would be considered to issue a “redeemable security” within the meaning of section 2(a)(32) of the Act.

As discussed above, ETFs have features that distinguish them from both traditional open-end and closed-end funds. A defining feature of open-end funds is that they offer redeemable securities, which allow the holder to receive his or her proportionate share of the fund's NAV per share upon presentation of the security to the issuer. Although individual ETF shares cannot be redeemed, except in limited circumstances,

they can be redeemed in creation unit aggregations.

Therefore, we believe that ETF shares are most appropriately classified under the proposed rule as redeemable securities within the meaning of section 2(a)(32),

and that ETFs should be regulated as open-end funds within the meaning of section 5(a)(1) of the Act.

Proposed rule 6c-11(b)(1).

See infra

section II.C.1 (discussing circumstances where ETF shares can be individually redeemed).

See

proposed rule 6c-11(a) (defining an exchange-traded fund, in part, as a registered open-end management company that issues and redeems its shares in creation units). The proposed rule would define “creation unit” to mean a specified number of ETF shares that the ETF will issue to (or redeem from) an authorized participant in exchange for the deposit (or delivery) of a basket and a cash balancing amount (if any).

See

proposed definition of “creation unit” in rule 6c-11(a).

If ETF shares were not classified as redeemable securities within the meaning of section 2(a)(32) of the Act, an ETF would be subject to the provisions of the Act applicable to closed-end funds.

See

15 U.S.C. 80a-5(a)(2) (defining a “closed-end company” as any management company other than an open-end company).

15 U.S.C. 80a-5(a)(1) (defining “open-end company”); 15 U.S.C. 80a-2(a)(32) (defining “redeemable security”).

The arbitrage mechanism that is central to the operation of an ETF (and the conditions in our relief designed to facilitate an effective arbitrage mechanism) serves to keep the market price of ETF shares at or close to the ETF's NAV per share. As a result, even though only authorized participants may redeem creation units directly from the ETF at NAV per share, investors are able to sell their ETF shares on the secondary market at or close to NAV, similar to investors in an open-end fund that redeem their shares directly from the fund at NAV per share.

The shares of closed-end funds, on the other hand, generally trade on the secondary market at a discount or premium to NAV.

See

Robert Engle & Debojyoti Sarkar,

Premiums-Discounts and Exchange Traded Funds,

13 Journal of Derivatives 4 (Summer 2006) (“Engle Article”) (observing that premiums and discounts for domestic ETFs are generally small and highly transient, and that while premiums and discounts are larger and more persistent in international ETFs, they are smaller and less persistent than the premiums and discounts of international closed-end funds);

but see, e.g.,

Bradley Kay,

Has the ETF Arbitrage Mechanism Failed?,

Morningstar (Mar. 11, 2009),

available at http://news.morningstar.com/articlenet/article.aspx?id=283302

(stating that market prices for ETFs may deviate significantly from NAV during periods of market stress); Chris Dieterich,

Greece ETF Pacing for Record Tumble on Huge Volume: Here's What You Need to Know,

Barron's (June 29, 2015),

available at https://www.barrons.com/articles/greece-etf-pacing-for-record-tumble-on-huge-volume-heres-what-you-need-to-know-1435597369

(noting that ETFs tied to Greek and Egyptian stocks traded at significant discounts to NAV when the exchanges on which the underlying stocks traded were closed).

Our exemptive orders have provided exemptions from sections 2(a)(32) and 5(a)(1) of the Act so that ETFs may register under the Act as open-end funds while issuing shares redeemable in creation units only. Unlike our exemptive orders, however, the proposed rule would not provide an exemption from the definition of “redeemable security” in section 2(a)(32) or from the definition “open-end company” in section 5(a)(1). We believe that it is more appropriate for the proposed rule to address these questions of status by classifying ETF shares as “redeemable securities.” Thus,

any ETF operating in compliance with the rule's conditions and requirements would meet the definition of open-end company.

Section 5(a)(1) defines an “open-end company” as “a management company which is offering for sale or has outstanding any redeemable security of which it is the issuer.” 15 U.S.C. 80a-5(a)(1).

ETFs operating in reliance on the proposed rule would be subject to the requirements imposed under the Act and our rules that apply to all open-end funds.

We note that our approach is substantially similar to the 2008 proposal, which was generally supported by commenters.

In addition, in our view the rules under the Exchange Act that apply to redeemable securities issued by an open-end fund would apply to ETFs relying on the proposed rule.

Thus, proposed rule 6c-11 would result in ETFs relying on proposed rule 6c-11 becoming eligible for the “redeemable securities” exceptions in 12 CFR 242.101(c)(4) and 242.102(d)(4) (“rules 101(c)(4) and 102(d)(4) of Regulation M”) and 12 CFR 240.10b-17(c) (“rule 10b-17(c) under the Exchange Act”) in connection with secondary market transactions in ETF shares and the creation or redemption of creation units. Similarly, we would view ETFs relying on rule 6c-11 as within the “registered open-end investment company” exemption in rule 11d1-2 under the Exchange Act.

100

See, e.g.,

15 U.S.C. 80a-22; 17 CFR 270.22c-1.

See

2008 ETF Proposing Release,

supra

footnote 3.

See also

ICI 2008 Comment Letter; Xshares 2008 Comment Letter.

See, e.g.,

17 CFR 240.15c3-1.

See also

Securities Transaction Settlement Cycle, Exchange Act Release No. 80295 (Mar. 22, 2017) [82 FR 15564 (Mar. 29, 2017)] (“T+2 Adopting Release”) (shortening the standard settlement cycle for most broker-dealer securities transactions to two business days).

100

Cf.

Securities Industry Association, SEC Staff No-Action Letter (Nov. 21, 2005) (treating certain equity index-based ETFs as registered open-end investment companies for purposes of rule 11d1-2).

We request comment on this aspect of the proposed rule.

• Are there differences between ETFs and other open-end funds that would justify not applying certain open-end fund provisions of the Act or our rules to ETFs? For example, we adopted tailored liquidity risk management program requirements for ETFs under 17 CFR 270.22e-4 (“rule 22e-4”).

101

Should we consider tailored requirements for ETFs in connection with other provisions?

101

See

Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 (Oct. 13, 2016) [81 FR 82142 (Nov. 18, 2016)] (“LRM Adopting Release”), at sections II.A. and II.J.

• As we discussed above, ETFs relying on proposed rule 6c-11 would be able to rely on the “redeemable securities” exceptions in rules 101(c)(4) and 102(d)(4) of Regulation M and rule 10b-17(c) under the Exchange Act and the “registered open-end investment company” exemption in rule 11d1-2 under the Exchange Act. Should the Commission exempt ETFs relying on proposed rule 6c-11 from any other rules under the Exchange Act?

102

If so, which rules and why? For example, ETFs typically request relief from Exchange Act section 11(d)(1) and rule 11d1-2 thereunder; and 17 CFR 240.10b-10, 240.15c1-5, and 240.15c1-6 (rules 10b-10, 15c1-5, and 15c1-6 under Exchange Act). Should the Commission provide relief from these provisions under the Exchange Act? If so, what conditions should apply to such relief, if any, and why? For example, ETFs currently rely on relief that is conditioned on: minimum creation unit sizes;

103

dissemination of the Intraday Indicative Value (“IIV”);

104

restrictions on the payment of certain cash compensation or economic incentives;

105

minimum levels of diversification in the ETF's basket;

106

and whether the ETF is managed to track an index.

107

Should we eliminate or modify any or all of these conditions? We requested comment on exchange listing standards for ETFs and other ETPs in 2015.

108

Do commenters have updated views on those requests for comment?

102

See, e.g., supra

footnote 14.

103

See, e.g.,

Letter from James A. Brigagliano, Deputy Director, Division of Trading and Markets, to W. John McGuire, Morgan, Lewis & Bockius LLP re: U.S. One Trust Actively-Managed Exchange Traded Fund of Exchange Traded Funds, dated May 4, 2010 (conditioning relief under Exchange Act Section 11(d)(1) on the ETFs continuously redeeming, at NAV, creation unit aggregations of 50,000 shares valued at a minimum of $1.25 million).

104

Id.

(representing that the ETFs would disseminate the IIV every 15 seconds throughout the trading day).

105

See, e.g.,

Letter from Catherine McGuire, Chief Counsel, Division of Market Regulation to Securities Industry Association, dated Nov. 21, 2005, at n.3 and accompanying text.

106

Id.

(defining, in part, a “qualifying ETF” as consisting of a basket of twenty or more component securities with no one component security constituting more than 25% of the total value of the ETF).

107

Id.

108

2015 ETP Request for Comment,

supra

footnote 9, at n.106 and accompanying and following text.

2. Trading of ETF Shares at Market-Determined Prices

Section 22(d) of the Act, among other things, prohibits investment companies, their principal underwriters, and dealers from selling a redeemable security to the public except at a current public offering price described in the prospectus.

109

Rule 22c-1 generally requires that a dealer selling, redeeming, or repurchasing a redeemable security do so only at a price based on its NAV.

110

Together, section 22(d) and rule 22c-1 are designed to: (i) Prevent dilution caused by certain riskless trading practices of principal underwriters and dealers; (ii) prevent unjust discrimination or preferential treatment among investors purchasing and redeeming fund shares; and (iii) preserve an orderly distribution of investment company shares.

111

ETFs seeking to register under the Act obtain exemptions from these provisions because investors may purchase and sell individual ETF shares from and to dealers on the secondary market at market-determined prices (

i.e.,

at prices other than those described in the prospectus or based on NAV). Consistent with our prior exemptive orders, proposed rule 6c-11 would provide exemptions from these provisions.

112

109

15 U.S.C. 80a-22(d).

110

See

17 CFR 270.22c-1.

111

See generally

Mutual Fund Distribution Fees; Confirmations, Investment Company Act Release No. 29367 (July 21, 2010) [75 FR 47064 (Aug. 4, 2010)] (discussing legislative history of section 22(d)).

112

See

proposed rule 6c-11(b)(2). The reference in the proposed rule to “repurchases . . . at market-determined prices” refers to secondary market transactions with dealers. Thus, the rule would not allow an ETF to repurchase shares from an investor at market-determined prices.

As discussed above, only authorized participants can purchase and redeem shares directly from an ETF at NAV per share and only in creation unit aggregations. Because authorized participants (and other market participants transacting through an authorized participant) can take advantage of disparities between the market price of ETF shares and NAV per share, they may be in a different position than investors who buy and sell individual ETF shares only on the secondary market.

113

However, if the arbitrage mechanism is functioning effectively, entities taking advantage of these disparities in market price and NAV per share move the market price to a level at or close to the NAV per share of the ETF. 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.

113

See, e.g.,

Comment Letter of Barclays Global Investors on 2001 Concept Release (Jan. 11, 2002) (“[D]uring periods of market volatility . . . it is not unreasonable to assume that some retail investors would buy or sell ETF shares at secondary market prices moving in the opposite direction of a fund's NAV.”).

We proposed the same exemptions in 2008 and commenters who addressed this aspect of the 2008 ETF Proposing Release supported the Commission's approach.

114

Commenters on the 2015 ETP Request for Comment also addressed the existing arbitrage mechanism, generally arguing that it is effective and efficient in ensuring that an ETF's market price does not vary substantially from its NAV per share.

115

On the other hand, one commenter questioned the efficacy of the arbitrage mechanism, particularly at the close of trading when bid-ask spreads tend to widen.

116

One commenter asserted that the arbitrage mechanism does not work well for ETFs holding securities that do not trade during U.S. market hours.

117

Another commenter argued that even if the arbitrage mechanism corrects price mismatches between market price and NAV per share, it does so by creating an unfair windfall for authorized participants who can capitalize on information asymmetries and operational advantages to extract value from the market.

118

114

See

ICI 2008 Comment Letter; Xshares 2008 Comment Letter.

115

See, e.g.,

Comment Letter of KCG Holdings, Inc. on 2015 ETP Request for Comment (Aug. 17, 2015); Comment Letter of Vanguard on 2015 ETP Request for Comment (Aug. 17, 2015); Comment Letter of Charles Schwab & Co., Inc. and Charles Schwab Investment Management, Inc. on 2015 ETP Request for Comment (Aug. 17, 2015) (“Schwab ETP Comment Letter”) (noting that it had not identified any significant systemic differences in efficiency across various ETF products, regardless of ETF's investment strategy).

116

See

Comment Letter of ETF Consultants.com, Inc. on 2015 ETP Request for Comment (Aug. 17, 2015);

See also

Milan Borkovec,

et al., Liquidity and Price Discovery in Exchange-Traded Funds: One of Several Possible Lessons from the Flash Crash,

1 The Journal of Index Investing 2 (2010) (“Borkovec”) (reporting that liquidity of ETFs declined dramatically during the “Flash Crash,” causing spreads to widen significantly).

Market makers may have already exhibited this behavior in periods of extraordinary volatility.

126

For example,

on May 6, 2010, the prices of many U.S.-based equity products experienced a significant decline and recovery, and many of the securities that experienced the greatest price changes were equity-based ETFs.

127

Significant price volatility on the morning of August 24, 2015 triggered limit up-limit down pauses in many equity securities, including many ETFs.

128

In both instances, certain ETFs saw larger intraday premiums/discounts and wider bid-ask spreads for portions of the trading day.

129

Deviations between market price and NAV per share were closed after relatively short periods, however, as the arbitrage mechanism resumed its effectiveness.

130

126

See

Ben-David,

supra

footnote 124 (“ETF market makers and [authorized participants] arguably withdrew from the market after a trading pause in the futures market, which they used to hedge their exposure in volatile trading sessions.”) (internal citations omitted). Many ETFs disclose the risk that ETF shares will trade at a premium or discount, particularly during times of market disruptions, in their prospectuses as part of their principal risk disclosure.

See, e.g.,

iShares Trust rule 485(b) Registration Statement (Nov. 1, 2017),

available at https://www.sec.gov/Archives/edgar/data/1100663/000119312517327588/d486424d485bpos.htm

(“Market Trading Risk: The Fund faces numerous market trading risks, including the potential lack of an active market for Fund shares, losses from trading in secondary markets, periods of high volatility and disruptions in the creation/redemption process. ANY OF

THESE FACTORS, AMONG OTHERS, MAY LEAD TO THE FUND'S SHARES TRADING AT A PREMIUM OR DISCOUNT TO NAV.”).

127

See

Final May 6 Report,

supra

footnote 9, at n.36 and accompanying text (noting that ETFs accounted for approximately 70% of all securities with trades broken pursuant to the clearly erroneous execution rules on May 6).

128

See

August 24 Staff Report,

supra

footnote 32 (noting that ETFs as a class accounted for almost all of the 1,279 trading halts on August 24, 2015, but 80% of ETFs did not experience a single trading halt).

129

See

Borkovec,

supra

footnote 125; Ben-David,

supra

footnote 124.

130

See

Borkovec,

supra

footnote 125, at 40;

see also

Ananth Madhavan,

Exchange-Traded Funds, Market Structure, and the Flash Crash,

68 Financial Analysts Journal 20 (2012) (“Madhavan Article”).

Accordingly, we recognize that under certain circumstances, including during periods of market stress, the arbitrage mechanism may work less effectively for a period of time. We also recognize that secondary market investors who trade in ETF shares during these periods may be harmed by trading at a price that is not close to the NAV per share of the ETF (or the contemporaneous value of the ETF's portfolio). On balance, however, we believe these investors are more likely to weigh the potential benefits of ETFs (

e.g.,

low cost and intraday trading) against any potential for market price deviations when deciding whether to utilize ETFs.

131

Further, we believe that the conditions we are proposing as part of rule 6c-11, along with other recent actions that are designed to promote an effective arbitrage mechanism,

132

would continue to result in a sufficiently close alignment between an ETF's market price and NAV per share in most circumstances, and provide an appropriate basis for the exemptive relief we are proposing. We particularly find this to be the case given the benefits ETFs offer investors, as discussed above.

131

The Commission has taken steps to address disruptions in the arbitrage mechanism. For example, the Commission approved changes to the limit up-limit down rules following the market events on August 24, 2015.

See

Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing and Immediate Effectiveness of a Proposed Rule Change to Clarify the Operation of the Regulation NMS Plan to Address Extraordinary Market Volatility, Exchange Release No. 78435 (July 28, 2016) [81 FR 51239 (Aug. 3, 2016)]; Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing and Immediate Effectiveness of a Proposed Rule Change to Extend the Effective Date of SR-FINRA-2016-028, Exchange Release No.78660 (Aug. 24, 2016) [81 FR 59676 (Aug. 30, 2016)].

132

For example, rule 22e-4 under the Act requires ETFs to consider certain additional factors that address the relationship between the liquidity of the ETF's portfolio and the arbitrage mechanism in assessing, managing, and periodically reviewing its liquidity risk.

See

LRM Adopting Release,

supra

footnote 101. We have taken these requirements into consideration in developing the conditions in this proposal.

Furthermore, to the extent that there are instances where bid-ask spreads widen, or premiums and discounts persist, the proposed rule and disclosure amendments would require ETFs to disclose certain information on their website.

133

We believe that it is important for investors to be informed where costs may increase beyond what they would reasonably expect. Our exemptive orders have required ETFs' websites to disclose, among other things, the ETF's NAV per share for the prior business day, the market closing price or the midpoint of the bid-ask spread at the time of the calculation of NAV, and a calculation of the premium or discount of the market closing price or midpoint of the bid-ask spread against NAV per share.

134

However, the proposed rule and disclosure amendments would require ETFs to disclose additional information on their websites that is not currently required under our exemptive orders.

135

133

See infra

section II.C.6.

134

See, e.g.,

Fidelity Commonwealth Trust, Investment Company Act Release Nos. 32166 (June 29, 2016) [81 FR 44063 July 6, 2016)] (notice) and 32191 (July 26, 2016) (order) and related application; Claymore Exchange-Traded Fund Trust, Investment Company Act Release Nos. 27469 (Aug. 28, 2006) [71 FR 51869 (Aug. 31, 2006)] (notice) and 27483 (Sept. 18, 2006) (order) and related application.

135

See infra

footnote 278 and accompanying and following text (noting that, currently, Form N-1A provides an ETF with the option to omit certain historical information regarding premiums and discounts from its prospectus and annual report if the disclosure is provided on its website).

In particular, as discussed in section II.C.6, we are proposing to require ETFs to disclose on their websites the median bid-ask spread for the ETF's most recent fiscal year and certain historical information about the extent and frequency of an ETF's premiums and discounts. This would allow investors to be more aware of this risk when deciding whether to invest in ETFs generally or in a particular ETF. Our proposed amendments to Form N-1A would require additional disclosure regarding ETF trading information and related costs, including information relating to high-end (95th percentile) spread costs.

136

We also request comment below on whether there are other ways to calculate premiums and discounts, or other metrics we should consider, to better inform investors about an ETF's history of deviations between intraday market prices and (i) the next-calculated NAV; or (ii) the contemporaneous value of the ETF's portfolio.

137

136

See infra

section II.H.

137

See infra

section II.C.6.

We request comment on the proposed exemptions from section 22(d) of the Act and rule 22c-1 thereunder.

• Is the proposed relief sufficient to facilitate transactions in ETF shares on the secondary market?

• Will the proposed conditions (discussed below) promote the arbitrage mechanism and support the Commission granting this relief? Are there other conditions we should consider?

• Under what circumstances could a premium or discount for an ETF develop or persist? For example, when would a premium or discount develop due to a break-down in the arbitrage mechanism? Are there instances where a premium or discount may develop or persist because of price discovery, such as when the underlying markets for the ETF's component securities are closed? Are there instances where a premium or discount may develop or persist because of transaction costs relating to the ETF's basket securities? How can these circumstances be distinguished from one another? Should we consider any changes to our proposal to account for these different circumstances?

• Would the arbitrage mechanism contemplated by the proposed rule keep ETF market prices at or close to NAV per share under normal market conditions? How should this be measured? For example, is it appropriate to assess premiums and discounts solely by comparing ETF market prices to the ETF's NAV, which typically is calculated at the end of the day? Should intraday calculations play a larger role when assessing premiums and discounts? Should we, for example, assess the efficiency of the arbitrage mechanism by comparing the mean/median of the market prices on a given trading day against the end of day NAV? Alternatively, should we compare the mean/median of the market price on a given trading day against an intraday

measure of the value of an ETF's portfolio?

3. Affiliated Transactions

Section 17(a) of the Act generally prohibits an affiliated person of a registered investment company, or an affiliated person of such person, from selling any security or other property to or purchasing any security from the company.

138

Purchases and redemptions of ETF creation units are typically effected in kind, and section 17(a) prohibits these in-kind purchases and redemptions by affiliated persons of the ETF. An affiliated person of an ETF includes, among others: (i) Any person directly or indirectly owning, controlling, or holding with power to vote, 5% or more of the outstanding voting securities of the ETF; (ii) any person 5% or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote by the ETF; and (iii) any person directly or indirectly controlling, controlled by, or under common control with the ETF.

139

138

15 U.S.C. 80a-17(a).

139

15 U.S.C. 80a-2(a)(3)(A), (B) and (C). A control relationship is presumed when one person owns more than 25% of another person's outstanding voting securities. 15 U.S.C. 80a-2(a)(9).

ETF applicants have requested, and we have granted, exemptive relief from section 17(a) of the Act for: (i) Persons affiliated with the ETF based on their ownership of 5% or more of the ETF's outstanding securities (“first-tier affiliates”); and (ii) affiliated persons of the first-tier affiliates or persons who own 5% or more of the outstanding securities of one or more funds advised by the ETF's investment adviser (“second-tier affiliates”).

140

In seeking this relief, applicants have stated that first- and second-tier affiliates are not treated differently from non-affiliates when engaging in purchases and redemptions of creation units.

141

All purchases and redemptions of creation units are at an ETF's next-calculated NAV pursuant to rule 22c-1. Additionally, the securities deposited or delivered upon redemption are valued in the same manner, using the same standards, as those securities are valued for purposes of calculating the ETF's NAV per share.

140

See, e.g.,

Barclays Global 2000,

supra

footnote 6 (“Because purchases and redemptions of Creation Units may be `in-kind' rather than cash transactions, section 17(a) may prohibit affiliated persons of an [ETF] from purchasing or redeeming Creation Units.”).

141

See e.g.,

Barclays Global 2008,

supra

footnote 58.

Proposed rule 6c-11 similarly would provide exemptions from sections 17(a)(1) and (a)(2) of the Act with regard to the deposit and receipt of baskets to a person who is an affiliated person of an ETF (or who is an affiliated person of such a person) solely by reason of: (i) Holding with the power to vote 5% or more of an ETF's shares; or (ii) holding with the power to vote 5% or more of any investment company that is an affiliated person of the ETF.

142

We believe that this relief is necessary to facilitate the efficient functioning of the arbitrage mechanism. Without it, an authorized participant or other market participant that becomes an affiliated person of the ETF due to its holdings would be prevented from engaging in arbitrage using an in-kind basket. This, in turn, could have the adverse effect of limiting the pool of market participants that could engage in arbitrage. Ultimately, it could result in the deviation between market price and NAV per share widening in cases where there are very few authorized participants or other market participants actively engaged in transactions with the ETF. The arbitrage mechanism for newly launched ETFs could be particularly challenged without this relief because every purchaser of a creation unit would be considered an affiliated person of the ETF so long as there are fewer than twenty creation units outstanding. We also believe that this relief is appropriate because all purchases and redemptions of creation units are at an ETF's next-calculated NAV, and the securities deposited or delivered upon redemption would be valued in the same manner, using the same standards, as those securities are valued for purposes of calculating the ETF's NAV.

142

See

proposed rule 6c-11(b)(3).

The exemption in proposed rule 6c-11(b)(3) is similar to the section 17(a) exemption we proposed in 2008, although the relief would be subject to certain additional conditions related to custom baskets.

143

Commenters who addressed the proposed relief in 2008 supported it.

144

Several commenters, however, requested that the relief be expanded to cover additional types of affiliated relationships, such as broker-dealers that are affiliated with the ETF's adviser.

145

These commenters noted that any Commission concern of undue influence by the affiliate would be addressed by the federal securities laws and regulations that prohibit manipulative practices and misuse of nonpublic information, and that ETFs would benefit from an increase in entities eligible to transact with the ETF.

146

An increase in the number of authorized participants could also help to reduce the potential for an ETF to be reliant on one or more particular authorized participants.

147

143

See id.

To utilize custom baskets, proposed rule 6c-11(c)(3) would require an ETF to adopt and implement written policies and procedures that: (i) Set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, including the process for any revisions to, or deviations from, those parameters; and (ii) specify the titles or roles of the employees of the ETF's investment adviser who are required to review each custom basket for compliance with those parameters.

144

See, e.g.,

Comment Letter of Barclays Capital Inc. (May 8, 2008); ICI 2008 Comment Letter; SSgA 2008 Comment Letter.

145

See, e.g.,

ICI 2008 Comment Letter; BGFA 2008 Comment Letter.

146

See, e.g.,

ICI 2008 Comment Letter; ABA 2008 Comment Letter.

147

Item E.2.a. of Form N-CEN requires ETFs to provide certain identifying information regarding its authorized participants.

See

Investment Company Reporting Modernization Adopting Release, Investment Company Act Release No. 32314 (Oct. 13, 2016) [81 FR 81870 (Nov. 18, 2016)] (“Reporting Modernization Adopting Release”) (“[C]ollecting information concerning these entities on an annual basis will allow [the Commission] to understand and better assess the size, capacity, and concentration of the authorized participant framework and also inform the public about certain characteristics of the ETF primary markets.”).

While we acknowledge that an increase in entities eligible to transact with an ETF could facilitate the arbitrage mechanism and reduce concentration risk, we preliminarily do not believe that it is appropriate to expand the scope of affiliated persons covered by the exemption at the same time that we are permitting additional flexibility with respect to custom baskets. The proposed rule would allow an ETF to utilize custom baskets if certain conditions are met, increasing the possibility that affiliates and non-affiliates could be treated differently in connection with an ETF's receipt or delivery of baskets.

148

We believe that the conditions related to the issuance or acceptance of custom baskets in proposed rule 6c-11 would provide appropriate protections against overreaching and similar abusive practices when an ETF exchanges a custom basket with an affiliate; however, limiting the types of affiliates that are permitted to rely on this exemption would serve as an additional protection against potential disparate treatment in connection with an ETF's receipt or delivery of baskets.

148

See

proposed rule 6c-11(c)(3).

We request comment on this aspect of the proposed rule.

• Without an exemption from section 17(a) of the Act, would ETFs or authorized participants bear any costs that they do not incur today?

• As discussed above, the exemptive relief from section 17(a) of the Act that we are proposing would apply only to

in-kind purchases and redemptions of creation units, and only to persons affiliated with the ETF (or affiliates of those persons) by reason of holding the power to vote 5% or more of the ETF's shares or holding the power to vote 5% or more of any investment company that is affiliated with the ETF. Should the relief extend to parties that are affiliated persons of an ETF for other reasons, or to non-creation unit transactions, such as portfolio transactions? For example, should a broker-dealer that is affiliated with the ETF's adviser be allowed to transact in kind with the ETF? If so, should the proposed rule include any additional conditions to minimize potential risks of overreaching for this type of affiliated person? How would expanding the scope of the exemption in this manner interact with the proposed conditions regarding basket flexibility?

4. Additional Time for Delivering Redemption Proceeds

Section 22(e) of the Act generally prohibits a registered open-end management investment company from postponing the date of satisfaction of redemption requests for more than seven days after the tender of a security for redemption.

149

This prohibition can cause operational difficulties for ETFs that hold foreign investments and exchange in-kind baskets for creation units. For example, local market delivery cycles for transferring foreign investments to redeeming investors, together with local market holiday schedules, can sometimes require a delivery process in excess of seven days. These ETFs have previously requested, and we have granted, relief from section 22(e) so that they may satisfy redemptions up to a specified maximum number of days (depending upon the local markets), as disclosed in the ETF's prospectus or statement of additional information (“SAI”). Other than in the disclosed situations, these ETFs satisfy redemptions within seven days.

150

149

15 U.S.C. 80a-22(e).

150

See, e.g.,

Parker Global Strategies,

supra

footnote 18.

Section 22(e) was designed to prevent unreasonable delays in the actual payment of redemption proceeds.

151

Proposed rule 6c-11 would provide an exemption from section 22(e) of the Act because we believe that the limited nature of the exemption addresses the concerns underlying this section of the Act. As proposed, rule 6c-11 would grant relief from section 22(e) to permit an ETF to delay satisfaction of a redemption request for more than seven days if a local market holiday, or series of consecutive holidays, the extended delivery cycles for transferring foreign investments to redeeming authorized participants, or the combination thereof prevents timely delivery of the foreign investment included in the ETF's basket.

152

To rely on this exemption, an ETF would be required to deliver foreign investments as soon as practicable, but in no event later than 15 days after the tender to the ETF.

153

This proposed exemption thus would permit a delay in the delivery of foreign investments only if the foreign investment is being transferred in kind as part of the basket.

154

151

See Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and Currency,

76th Cong., 3d Sess. 291-293 (statements of David Schenker).

152

Proposed rule 6c-11(b)(4). This relief from the requirements of section 22(e) would not affect any obligations arising under rule 15c6-1 under the Exchange Act, which requires that most securities transactions be settled within two business days of the trade date. 17 CFR 240.15c6-1.

153

Proposed rule 6c-11(b)(4).

154

While mutual funds also may invest in foreign investments that require a delivery process in excess of seven days, mutual funds typically deliver redemption proceeds in cash, rather than in kind. Mutual funds, ETFs that redeem in cash, and ETFs that substitute cash in lieu of a particular foreign investment in a basket do not require an exemption from section 22(e) of the Act.

The exemption would permit a delay only to the extent that additional time for settlement is actually required, when a local market holiday, or series of consecutive holidays, or the extended delivery cycles for transferring foreign investments to redeeming authorized participants prevents timely delivery of the foreign investment included in the ETF's basket. To the extent that settlement times continue to shorten, the “as soon as practicable” language embedded in the exemption is designed to minimize any unnecessary settlement delays.

155

If a foreign investment settles in less than 15 days, the ETF would be required to deliver it pursuant to the standard settlement time of the local market where the investment trades.

155

Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Italy, Ireland, the Netherlands, Latvia, Lichtenstein, Lithuania, Luxembourg, Malta, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, Spain (certain fixed-income trades only), Sweden, Switzerland, and the United Kingdom moved to a T+2 settlement cycle by the end of 2014, while Australia and New Zealand transitioned to a T+2 settlement cycle in 2016.

See

Amendments to Securities Transaction Settlement Cycle, Exchange Act Release No. 78962 (Sept. 28, 2016) [81 FR 69240 (Oct. 5, 2016)], at n.134. Like the United States, Mexico, Canada, Peru and Argentina moved to a T+2 settlement cycle in September 2017.

See

T+2 Adopting Release,

supra

footnote 99.

See also

Annie Massa,

Your Trades Will Soon Spend Less Time Stuck in Market's Plumbing,

Bloomberg Markets (Aug. 31, 2017),

available at https://www.bloomberg.com/news/articles/2017-08-31/your-trades-will-soon-spend-less-time-stuck-in-market-s-plumbing.

There are many securities that trade over the counter (OTC) in certain foreign markets with agreed-upon settlement timeframes between the parties that could extend beyond the settlement timeframes of central securities depositories.

In addition, given the continued movement toward shorter settlement times in markets around the world, we believe that the relief from section 22(e) in the proposed rule does not need to be permanent. Accordingly, we propose to include a sunset provision in the proposed rule relating to the relief from section 22(e). Absent further action by the Commission, the exemption from section 22(e) for postponement of delivering redemption proceeds would expire ten years from the rule's effective date. We believe that technological innovation and changes in market infrastructures and operations will lead to further shortening of settlement cycles, although these developments may be gradual. Therefore, we believe it is appropriate for the relief from section 22(e) to be limited in duration to ten years.

156

ETFs that invest in foreign investments from jurisdictions that continue to require more than seven days to deliver redemption proceeds would have the option of redeeming in cash rather than in-kind once the exemptive relief sunsets. Such ETFs also could request targeted exemptive relief from section 22(e) from the Commission.

In 2008, we proposed a similar exemption for postponement of delivering redemption proceeds. However, that exemption would have allowed up to 12 days to deliver redemption proceeds without an offsetting requirement to deliver as soon as practicable and without a sunset provision.

157

Commenters on the 2008 proposal agreed that the specified delay in satisfying redemption requests seemed reasonable because it was for a limited period of time and disclosed to investors.

158

However, one commenter suggested increasing the period of time for settlement beyond 12 days consistent with the terms of exemptive orders that had been issued to some ETFs.

159

Since 2012, numerous applicants for exemptive relief have indicated that payment or satisfaction of redemption requests may take as long as 15 days after a redemption request is received, and we have issued orders permitting delayed delivery of settlement proceeds for up to 15 days.

160

We believe an extended

settlement period in these circumstances of 15 days, with the requirement that delivery nevertheless be made as soon as practicable, is reasonable in light of the limited nature and duration of the exemption.

157

See

2008 ETF Proposing Release,

supra

footnote 3.

158

See, e.g.,

Katten 2008 Comment Letter; Xshares 2008 Comment Letter.

159

Katten 2008 Comment Letter (recommending up to 14 days).

160

See, e.g.,

Legg Mason ETF Trust, Investment Company Act Release Nos. 30237 (Oct. 22, 2012)

[77 FR 65425 (Oct. 26, 2012)] (notice) and 30265 (Nov. 16, 2012) (order) and related application (“Legg Mason”).

The exemption we proposed in 2008 would have required an ETF to disclose in its registration statement the foreign holidays that it expects may prevent timely delivery of foreign securities, and the maximum number of days that it anticipates it will need to deliver the foreign securities.

161

We are not proposing a similar requirement for several reasons. First, we do not believe this disclosure is relevant to investors who purchase ETF shares on the secondary market, because the settlement of these investors' ETF trades would be unaffected by the potential delay. Only authorized participants engaged in redemption transactions with the ETF (and market participants that use the authorized participants as their agents for transacting with the ETF) would be affected. We believe that information regarding these potential delays is typically covered in the agreement governing the relationship between the ETF and the authorized participant (an “authorized participant agreement”) and would likely be shared by the authorized participant with other market participants, as necessary.

162

Therefore, authorized participants already have information regarding potential delays. Second, given that these delays are typically covered by the authorized participant agreement, we do not believe it is necessary to require ETFs to provide registration statement disclosures.

161

See

2008 ETF Proposing Release,

supra

footnote 3.

162

For example, an authorized participant acting as an agent typically would share this information with its customer if it is a necessary part of the creation or redemption process.

The proposed rule would define “foreign investment” as any security, asset or other position of the ETF issued by a foreign issuer (as defined by rule 3b-4 under the Exchange Act) for which there is no established U.S. public trading market (as that term is used in Regulation S-K under the Securities Act).

163

This definition differs from the one we proposed in 2008 in that it references rule 3b-4 rather than enumerating the types of foreign entities that are considered issuers of foreign investments.

164

We believe this approach is appropriate because it creates consistency with a long-accepted definition under Exchange Act rules.

165

The reference to whether the investment has an “established U.S. public trading market” is designed to make the relief unavailable to an ETF that could trade the investment in its basket on a U.S. market, thereby avoiding the settlement delay that is the basis for the relief.

166

In addition, this definition is not limited to “foreign securities,” but also would include other investments that may not be considered securities. Although these other investments may not be securities, they may present the same challenges for timely settlement as foreign securities if they are transferred in kind. This approach is consistent with the terms of some recent exemptive orders that provide relief from section 22(e) for the delivery of foreign investments that may not be securities.

167

163

See

proposed rule 6c-11(a);

see also

rule 201(a) of Regulation S-K [17 CFR 229.201(a)] (describing how a registrant should identify its principal United States market or markets); rule 3b-4 of the Exchange Act [17 CFR 240.3b-4].

164

The 2008 proposal defined “foreign security” as any security issued by a government or political subdivision of a foreign country, or corporation or other organization incorporated or organized under the laws of any foreign country and for which there is no established U.S. public trading market.

See

2008 ETF Proposing Release,

supra

footnote 3.

165

Rule 3b-4 under the Exchange Act was adopted in 1967.

See

Adoption of Rules Relating to Foreign Securities, Exchange Act Release No. 8066 (Apr. 28, 1967) [32 FR 7848 (May 30, 1967)].

166

The rule does not rely on registration status because an unregistered large foreign private issuer may have an active U.S. market for its securities, in which case the ETF should be able to meet redemption requests in a timely manner.

See

Termination of a Foreign Private Issuer's Registration of a Class of Securities Under Section 12(g) and Duty to File Reports Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, Exchange Act Release No. 55540 (Mar. 27, 2007) [72 FR 16934 (Apr. 5, 2007)].

167

See, e.g.,

Redwood Investment Management, LLC,

et al.,

Investment Company Act Release Nos. 33076A (Apr. 26, 2018) [83 FR 19367 (May 2, 2018)] (notice) and 33100 (May 21, 2018) (order) and related application.

We request comment on this aspect of the proposed rule.

• Is this relief necessary, particularly given that many non-U.S. jurisdictions have shorter settlement periods today than when we began granting this relief to ETFs? We specifically request comment regarding how frequently ETFs rely on this exemption. Should we permit the delayed delivery of settlement proceeds for up to 15 days? Is this period too long or too short? Should the rule refer to the applicable local market's settlement cycle without specifying a number of days? Should we require that the ETF deliver foreign investments as soon as practicable, as proposed, in order to minimize unnecessary settlement delays?

• Should we include a sunset provision for this relief as proposed? Is the duration of the proposed sunset provision appropriate? Should it be longer or shorter?

• Is the proposed definition of “foreign investment” appropriate for identifying investments that may routinely settle more than seven days after a redemption request? For example, are there circumstances where a U.S. entity could be subject to delays due to local market restrictions? Should we utilize a definition found elsewhere in rules and regulations set forth under the Exchange Act, the Investment Company Act, or other securities laws (

e.g.,

the definition of “foreign security” set forth in rule 15a-6 under the Exchange Act, or the definition of “foreign assets” set forth in rule 17f-5 under the Investment Company Act)? Alternatively, should we utilize the definition of “foreign security” set forth in the 2008 ETF Proposing Release, or utilize an entirely new definition? If recommending an alternate definition, please explain the specific types of investments that would be better captured or that would be excluded by that definition.

• Should the rule also provide relief if an ETF has foreign investments in its portfolio (and not in a particular basket)? If so, why? Should the rule permit the delayed delivery of the entire basket (instead of the specific foreign investments in a basket) if the basket is composed substantially of foreign investments subject to potential delays in the delivery of settlement proceeds?

• Are we correct that information regarding potential delays in the delivery of settlement proceeds for foreign investments typically is covered in the authorized participant agreement? If so, are we also correct that authorized participants acting as agents typically would share this information with their customers if it is a part of the redemption process?

• Should the rule require disclosure in an ETF's Statement of Additional Information of the foreign holidays an ETF expects may prevent timely delivery of the foreign investments and the maximum number of days it anticipates it would need to deliver the foreign investments as required by current exemptive orders? For example, should we require ETFs relying on this exemption to include a more general statement in their prospectus or SAI that the ETF may take up to 15 days to deliver settlement proceeds for certain foreign investments affected by foreign holidays, rather than the more specific statement of each holiday an ETF expects may prevent timely delivery of the investments that is currently required? Should these disclosures be included in an ETF's sales literature or

on its website? Alternatively, should we require ETFs to provide a written notice of the foreign holidays an ETF expects may prevent timely delivery of the foreign investments to authorized participants as a condition to rule 6c-11? If so, how often should this information be updated?

• Do secondary market investors or others use information regarding delays in the delivery of foreign investments?

C. Conditions for Reliance on Proposed Rule 6c-11

Proposed rule 6c-11 would require ETFs to comply with certain conditions that would allow them to operate within the scope of the Act, and that are designed to protect investors and to be consistent with the purposes fairly intended by the policy and provisions of the Act. These conditions are generally consistent with the conditions we have imposed under our exemptive orders, which we believe have effectively accommodated the unique structural and operational features of ETFs while maintaining appropriate protections for ETF investors. The conditions also reflect certain changes to the conditions imposed under our exemptive orders that, based on 26 years of experience regulating ETFs, we believe will improve the overall regulatory framework for these products.

1. Issuance and Redemption of Shares

Proposed rule 6c-11 would include several requirements in the paragraph defining “exchange-traded fund,” including a requirement that the ETF issue (and redeem) creation units to (and from) authorized participants in exchange for baskets and a cash balancing amount (if any).

168

As such, the proposed rule would seek to preserve the existing structure, reflected in our ETF exemptive orders, whereby only an authorized participant of an ETF may purchase creation units from (or sell creation units to) the ETF. This requirement is designed to preserve an orderly creation unit issuance and redemption process between ETFs and authorized participants. An orderly creation unit issuance and redemption process is of central importance to the arbitrage mechanism, which forms the basis for several of the proposed rule's exemptive provisions.

168

See

proposed rule 6c-11(a).

See also

Reporting Modernization Adopting Release,

supra

footnote 147.

171

See, e.g.,

Legg Mason,

supra

footnote 160. The 2008 proposal would not have defined the term “authorized participant” because this term was not used in the definition of an ETF.

See

2008 ETF Proposing Release,

supra

footnote 3 (defining ETF to mean, in relevant part, a registered open-end management company that issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets).

172

See infra

section II.J.

The proposed rule would define the term “creation unit” to mean a specified number of ETF shares that the ETF will issue to (or redeem from) an authorized participant in exchange for the deposit (or delivery) of a basket and a cash balancing amount (if any).

173

In their exemptive applications, ETFs have stated that they would establish a specific creation unit size (

i.e.,

a minimum number of shares).

174

Creation unit aggregations may differ among ETFs based on an ETF's investment strategy, the type and availability of the assets in the basket, and the types of authorized participants (and other market participants) that are expected to engage in creation and redemption transactions with the ETF. For example, an ETF tracking a narrowly focused niche strategy may establish a smaller creation unit size than an ETF tracking a broad-based index, such as the S&P 500, in order to facilitate arbitrage. Accordingly, we do not believe it is necessary to mandate a particular maximum or minimum creation unit size for all types of ETFs. This approach is consistent with our 2008 proposal, and commenters who addressed this aspect of the 2008 proposal generally supported it.

175

173

Proposed rule 6c-11(a).

174

See, e.g.,

Legg Mason,

supra

footnote 160.

175

See

2008 ETF Proposing Release,

supra

footnote 3;