Release No. IC-28193 File No. S7-07-08 RIN 3235-AJ60 Exchange-Traded FundsAGENCY: Securities and Exchange Commission. ACTION: Proposed rule. SUMMARY: The Securities and Exchange Commission ("Commission" or "SEC") is proposing a new rule under the Investment Company Act of 1940 that would exempt exchange-traded funds ("ETFs") from certain provisions of that Act and our rules. The rule would permit certain ETFs to begin operating without the expense and delay of obtaining an exemptive order from the Commission. The rule is designed to eliminate unnecessary regulatory burdens, and to facilitate greater competition and innovation among ETFs. The Commission also is proposing amendments to our disclosure form for open-end investment companies, Form N-1A, to provide more useful information to investors who purchase and sell ETF shares on national securities exchanges. In addition, the Commission is proposing a new rule to allow mutual funds (and other types of investment companies) to invest in ETFs to a greater extent than currently permitted under the Investment Company Act. DATES: Comments should be received on or before [May 18, 2008]. ADDRESSES: Comments may be submitted by any of the following methods: Electronic Comments:
Paper Comments:
All submissions should refer to File Number S7-07-08. This file number should be included on the subject line if e-mail 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 Commissions Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for public inspection and copying in the Commissions Public Reference Room, 100 F Street, NE, Washington, DC 20549, on official business days between the hours of 10:00 am and 3:00 pm. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. FOR FURTHER INFORMATION CONTACT: With respect to proposed rule 6c-11 and amendments to Form N-1A, Dalia Osman Blass, Senior Counsel, or Penelope Saltzman, Acting Assistant Director, (202) 551-6792, with respect to proposed rule 12d1-4 and proposed amendments to rule 12d1-2, Adam Glazer, Senior Counsel, or Penelope Saltzman, Acting Assistant Director, (202) 551-6792, Office of Regulatory Policy, Division of Investment Management, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-5041. SUPPLEMENTARY INFORMATION: The Commission is proposing for public comment new rules 6c-11 [17 CFR 270.6c-11] and 12d1-4 [17 CFR 270.12d1-4] and amendments to rule 12d1-2 [17 CFR 270.12d1-2] under the Investment Company Act of 1940 ("Investment Company Act" or "Act"),1 and amendments to Form N-1A2 under the Investment Company Act and the Securities Act of 1933 (the "Securities Act").3 I. INTRODUCTIONExchange-traded funds are an increasingly popular investment vehicle.4 Last year, the number of ETFs traded in U.S. markets increased by 67 percent, from 357 to 601, and the assets held by ETFs increased by about 42 percent, to approximately $580 billion.5 Although aggregate ETF assets are less than seven percent of assets held by traditional mutual funds (i.e., open-end investment companies),6 they are growing more rapidly.7 ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on an exchange through a broker-dealer.8 ETFs therefore possess characteristics of traditional mutual funds, which issue redeemable shares, and of closed-end investment companies, which generally issue shares that trade at negotiated market prices on a national securities exchange and are not redeemable.9 Since they were first developed in the early 1990s, ETFs have evolved. The first ETFs held a basket of securities that replicated the component securities of broad-based stock market indexes, such as the S&P 500.10 Many of the newer ETFs are based on more specialized indexes,11 including indexes that are designed specifically for a particular ETF,12 bond indexes,13 and international indexes.14 Originally marketed as opportunities for investors to participate in tradable portfolio or basket products, ETFs are held today in increasing amounts by institutional investors (including mutual funds) and other investors as part of sophisticated trading and hedging strategies.15 Shares of ETFs can be bought and held (sometimes as a core component of a portfolio),16 or they can be traded frequently as part of an active trading strategy.17 Like money market funds first offered in the 1970s, ETFs represent a new type of registered investment company ("fund"). And like money market funds, they have required exemptions from certain provisions of the Act before they can commence operations.18 Since 1992, the Commission has issued 61 orders to ETFs and their sponsors.19 In this release, we propose a new rule that would codify the exemptive orders we have issued to ETFs. Proposed rule 6c-11 would allow new competitors (i.e., those sponsors who do not already have exemptive orders) to enter the market more easily. We also are proposing amendments to our registration form for open-end funds, Form N-1A, to provide more useful information to individual investors who purchase and sell ETF shares on national securities exchanges. Finally, we are proposing a new rule to allow funds to invest in ETFs to a greater extent than currently permitted under the Act and our rules. II. OPERATION OF EXCHANGE-TRADED FUNDSAll ETFs trading today operate in a similar way.20 Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares ("ETF shares") at net asset value ("NAV"). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks called "creation units."21 A financial institution that purchases a creation unit of ETF shares first deposits with the ETF a "purchase basket" of certain securities and other assets identified by the ETF that day, and then receives the creation unit in return for those assets. The basket generally reflects the contents of the ETFs portfolio and is equal in value to the aggregate NAV of the ETF shares in the creation unit. After purchasing a creation unit, the financial institution may hold the ETF shares, or sell some or all in secondary market transactions.22 Like operating companies and closed-end funds, ETFs register offerings and sales of ETF shares under the Securities Act and list their shares for trading under the Securities Exchange Act of 1934 ("Exchange Act").23 As with any listed security, investors may trade ETF shares at market prices. ETF shares purchased in secondary market transactions are not redeemable from the ETF except in creation units. The redemption process is the reverse of the purchase process. The financial institution acquires (through purchases on national securities exchanges, principal transactions, or private transactions) the number of ETF shares that comprise a creation unit, and redeems the creation unit from the ETF in exchange for a "redemption basket" of securities and other assets.24 An investor holding fewer ETF shares than the amount needed to constitute a creation unit (most retail investors) may dispose of those ETF shares by selling them on the secondary market. The investor receives market price for the ETF shares, which may be higher or lower than the NAV of the shares, and pays customary brokerage commissions on the sale. The ability of financial institutions to purchase and redeem creation units at each days NAV creates arbitrage opportunities that may help keep the market price of ETF shares near the NAV per share of the ETF. For example, if ETF shares begin trading on national securities exchanges at a price below the funds NAV per share, financial institutions can purchase ETF shares in secondary market transactions and, after accumulating enough shares to comprise a creation unit, redeem them from the ETF in exchange for the more valuable securities in the ETFs redemption basket. Those purchases create greater market demand for the ETF shares, and thus tend to drive up the market price of the shares to a level closer to NAV.25 Conversely, if the market price for ETF shares exceeds the NAV per share of the ETF itself, a financial institution can deposit a basket of securities in exchange for the more valuable creation unit of ETF shares, and then sell the individual shares in the market to realize its profit. These sales would increase the supply of ETF shares in the secondary market, and thus tend to drive down the price of the ETF shares to a level closer to the NAV of the ETF share.26 ETF sponsors and market participants report that the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indexes is generally less than 2%. See, e.g., Vanguard U.S. Stock ETFs, Prospectus 56-59 (Apr. 27, 2007). ETFs that track foreign indexes may have a more significant deviation. See, e.g., iShares FTSE/Xinhua China 25 Index Fund, Prospectus 19 (Dec. 1, 2006). Arbitrage activity in ETF shares is facilitated by the transparency of the ETFs portfolio. Each day, the ETF publishes the identities of the securities in the purchase and redemption baskets, which are representative of the ETFs portfolio.27 Each exchange on which the ETF shares are listed typically discloses an approximation of the current value of the basket on a per share basis ("Intraday Value")28 at 15 second intervals throughout the day and, for index-based ETFs, disseminates the current value of the relevant index.29 This transparency can contribute to the efficiency of the arbitrage mechanism because it helps arbitrageurs determine whether to purchase or redeem creation units based on the relative values of ETF shares in the secondary market and the securities contained in the ETFs portfolio. Arbitrage activity in ETF shares also appears to be affected by the liquidity of the securities in an ETFs portfolio. Most ETFs represent in their applications for exemptive relief that they invest in highly liquid securities.30 Effective arbitrage depends in part on the ability of financial institutions to readily assemble the basket for purchases of creation units and to sell securities received upon redemption of creation units, and liquidity appears to be a factor in this process. An ETFs investment in less liquid securities may reduce arbitrage efficiency and thereby increase both the likelihood that a deviation between ETF share market price and NAV per share may occur and the amount of any deviation that does occur. III. EXEMPTIONS PERMITTING FUNDS TO FORM AND OPERATE AS ETFSToday we are proposing for public comment a new rule that would codify much of the relief and many of the conditions of orders that we have issued to index-based ETFs in the past, and more recently to certain actively managed ETFs. The proposed rule is designed to enable most ETFs to begin operations without the need to obtain individual exemptive relief from the Commission. A. Scope of Proposed Rule 6c-111. Index-Based ETFsProposed rule 6c-11, like our orders, would provide exemptions for ETFs that have a stated investment objective of maintaining returns that correspond to the returns of a securities index whose provider discloses on its Internet Web site the identities and weightings31 of the component securities and other assets of the index.32 In this respect, the rule would codify our previous exemptive orders. Our experience is that the conditions included in the index-based ETF orders have effectively preserved the statutory purposes of the Act. The proposed rule would not limit the types of indexes that an ETF may track or the types of securities that comprise any index. Thus, the rule would not limit the exemption to ETFs investing in liquid securities or assets, although existing ETFs generally have represented to us that their portfolios are comprised of highly liquid securities,33 and, as open-end funds, are required to comply with the liquidity guidelines applicable to all open-end funds.34 We request comment regarding the effect of portfolio liquidity on the potential for deviation between ETF share market price and NAV and the amount of any deviation. In addition to the liquidity guidelines applicable to all open-end funds, should the Commission include additional liquidity requirements as a condition of the exemptions? If so, what additional requirements and why? Should the chance (or likelihood) that substantial discounts or premiums may occur if an ETF portfolio contains less liquid securities or assets be a regulatory concern for the Commission, or should it be treated as a material risk to be disclosed to prospective investors, permitting them to evaluate whether the risk makes the ETF an appropriate investment in light of the investors investment objectives?35 We note that currently there is substantially more market interest in ETFs that track broad-based indexes that are comprised of highly liquid securities than ETFs that track more specialized indexes.36 How would liquidity or illiquidity of securities or other assets in an ETFs portfolio affect the ability of financial institutions to assemble securities for a purchase basket and thus the arbitrage mechanism and operation of the ETF? Would liquidity requirements preclude the development of specialty ETFs that serve narrow investment purposes but which may satisfy particular investment needs of certain investors? 2. Actively Managed ETFsWe recently issued exemptive orders to several actively managed ETFs and their sponsors.37 Like our orders, proposed rule 6c-11 would provide an exemption for an actively managed ETF that discloses on its Internet Web site each business day the identities and weightings of the component securities and other assets held by the ETF.38 Unlike index-based ETFs, an actively managed ETF does not seek to track the return of a particular index. Instead, an actively managed ETFs investment adviser, like an adviser to any traditional actively managed mutual fund, generally selects securities consistent with the ETFs investment objectives and policies without regard to a corresponding index. In 2001, we sought comment on the concept of an actively managed ETF ("2001 Concept Release").39 We requested comment on a broad number of questions that we felt were important to consider before expanding the scope of the exemptive orders we had issued. We wanted to know how investors would use an actively managed ETF because it seemed that, unlike an investment in an index-based ETF, an investment in an actively managed ETF could not be used, for example, to implement a hedging strategy. We questioned whether an actively managed ETF would provide investors with the same or similar benefits as index-based ETFs, including potential tax efficiencies and low expense ratios. Our 2001 Concept Release also asked more focused questions about the structural and operational differences between the two types of ETFs and how those differences might affect the market value of ETF shares. We inquired whether as a matter of public policy an ETF must be designed to enable efficient arbitrage and thereby minimize the probability that ETF shares would trade at a material premium or discount.40 We asked, for example, whether actively managed ETFs must have the same degree of portfolio transparency as index-based ETFs, a factor that appeared to contribute significantly to arbitrage efficiency.41 It was unclear to us at that time whether an adviser to actively managed ETFs would be willing to provide the same degree of transparency as an adviser to index-based ETFs because, for example, disclosure could allow market participants to access the funds investment strategy.42 We were concerned that reduced transparency could expose arbitrageurs to greater investment risk and result in a less efficient arbitrage mechanism, which in turn could lead to more significant premiums and discounts than experienced by index-based ETFs. We received 20 comments from market participants, many of which supported the introduction of actively managed ETFs.43 Many commenters stated that actively managed ETFs would have the potential to provide investors with uses and benefits similar to index-based ETFs. For example, commenters maintained that, like index-based ETFs, actively managed ETFs could potentially serve as short-term or long-term investment vehicles, allow investors to gain exposure to an asset category such as value, growth or income, and play a significant role in an investors hedging strategies.44 Commenters also asserted that actively managed ETFs have the potential for providing investors benefits similar to index-based ETFs, including low expense ratios and intra-day exchange trading.45 Other commenters, however, questioned whether some of the investor benefits traditionally associated with index-based ETFs would be present with actively managed ETFs.46 Commenters agreed that actively managed ETFs should be designed, like index-based ETFs, with an arbitrage mechanism intended to minimize the potential deviation between market price and NAV of ETF shares.47 Not all commenters agreed, however, on whether we should be concerned with the extent of premiums or discounts and, therefore, whether we should require full portfolio transparency. Some asserted that the amount of any discount or premium that might develop ought not to be a consideration for us in determining whether to grant exemptive relief.48 One commenter argued that ETFs with share prices that significantly deviate from NAV would likely not attract the interest of investors and would ultimately fail if they did not provide information necessary for market participants to make knowledgeable investment decisions.49 Other commenters asserted that it is important to require that ETFs provide all investors with the same information about portfolio holdings50 and to require clear fund disclosures regarding the risks associated with the level of transparency provided.51 These commenters stressed the need, however, for sufficient market information to value the funds portfolio.52 Others argued that portfolio transparency is essential to support effective arbitrage.53 One commenter asserted that any lack of transparency would negatively impact an ETFs arbitrage mechanism and would likely result in ETF shares trading at secondary market prices that do not reflect the value of the ETFs underlying portfolio.54 The commenter noted that to the extent an ETF operates with less than full transparency during periods of market volatility, this would likely result in some individual investors buying or selling ETF shares at secondary market prices moving in the opposite direction of the ETFs NAV. The commenter urged us to consider carefully the consequence of granting an exemption that might yield such a result.55 The Investment Company Institute asserted that to the extent that all or part of an ETFs portfolio is not transparent, it could raise significant investor protection concerns including the potential for disparate treatment of investors and the potential for the ETF to trade at significant premiums and discounts.56 Today we propose exemptions applicable to both index-based and actively managed ETFs that provide portfolio transparency to market participants. The comments we received, together with subsequent developments, address the principal concerns we raised in the 2001 Concept Release with respect to actively managed ETFs. We have received a number of applications from actively managed ETFs whose sponsors are interested in offering fully transparent, actively managed ETFs, and recently we have issued orders approving several of these ETFs.57 As described in these applications, an actively managed ETF would operate in the same manner as an index-based ETF.58 Each would be registered under the Act as an open-end fund and would redeem shares in creation units in exchange for basket assets. Each would be listed on a national securities exchange, and investors would trade the ETF shares throughout the day at market prices in the secondary market.59 The national securities exchange typically would disseminate the Intraday Value of ETF shares at 15-second intervals throughout the trading day,60 thereby providing institutional investors and other arbitrageurs the information necessary to engage in ETF share purchases and sales on the secondary market, and purchases and redemptions with the fund, which should help keep ETF share prices from trading at a significant discount or premium.61 Finally, the actively managed ETFs represent that they would provide ETF investors with uses and benefits similar to index-based ETFs.62 We believe that permitting fully transparent, actively managed ETFs would provide additional investment choices for investors and that exemptions necessary to permit the operation of these ETFs would be in the public interest and consistent with the policies and purposes of the Act. By proposing this rule we are not, however, suggesting that we will not consider applications for exemptive orders for actively managed ETFs that do not satisfy the proposed rules transparency requirements. Rather, we are at this time proposing to permit fully transparent, actively managed ETFs to be offered without first seeking individual exemptive orders from the Commission. We request comment on allowing actively managed ETFs with fully transparent portfolios to rely on the exemptions provided by the proposed rule. We only recently approved orders to allow certain actively managed ETFs and have not had the opportunity to observe how they operate in the markets over a significant period of time. Should we wait until we have gained greater experience with the operation of actively managed ETFs before adopting a final rule applicable to them? Is there any concern that a fully transparent actively managed ETF would not facilitate an efficient arbitrage mechanism? Would actively managed ETFs provide investors with uses and benefits similar to or different than their index-based counterparts? Do these or any other concerns regarding the operation of a fully transparent actively managed ETF warrant limiting the rule to index-based ETFs and considering exemptions for actively managed ETFs on a case by case basis through the exemptive applications process? Should we consider exemptions for other types of actively managed ETFs? If so, how would the arbitrage mechanism work in these ETFs? What kinds of conditions should we consider in order to facilitate an arbitrage mechanism? 3. Organization as an Open-end Investment CompanyOur proposed rule would be available only to ETFs that are organized as open-end funds.63 We have provided similar exemptions to unit investment trusts ("UITs") in the past.64 However, because we have not received an exemptive application for a new ETF to be organized as a UIT since 2002, there does not appear to be a need to include UIT relief in the proposed rule.65 We understand that ETF sponsors prefer the open-end fund structure because it allows more investment flexibility.66 In addition, unlike an ETF that is a UIT, an open-end fund ETF may participate in securities lending programs and has greater flexibility in reinvesting dividends received from portfolio securities. Of the 601 ETFs in existence as of December 2007, 593 were organized as open-end funds.67 We request comment on whether we should include ETFs organized as UITs in the definition of ETF under the proposed rule. If so, should they be subject to the same conditions set forth in the proposed rule? B. ConditionsETF sponsors have sought exemptions from certain provisions of the Act and our rules so that they may register ETFs as open-end funds. The principal distinguishing feature of open-end funds is that they offer for sale redeemable securities.68 The Act defines "redeemable security" as any security that allows the holder to receive his or her proportionate share of the issuers current net assets upon presentation to the issuer.69 Section 22(d) of the Act prohibits any dealer in redeemable securities from selling open-end fund shares at a price other than a current offering price described in the funds prospectus.70 Rule 22c-1 under the Act requires funds, their principal underwriters, and dealers to sell and redeem fund shares at a price based on the current NAV next computed after receipt of an order to buy or redeem.71 Together, these provisions are designed to require that fund shareholders are treated equitably when buying and selling their fund shares.72 ETFs seeking to register as open-end funds under the Act require exemptions from these provisions because certain investors may purchase and sell individual ETF shares on the secondary market at current market prices, i.e., at prices other than those described in the ETFs prospectus or based on NAV. As discussed above, investors (typically financial institutions) can purchase and redeem shares from the ETF at NAV only in creation units.73 Because these financial institutions can take advantage of disparities between the market price of ETF shares and NAV, they may be in a different position than investors who buy and sell individual ETF shares only on the secondary market.74 The disparities in market price and NAV, however, provide those institutional investors with opportunities for arbitrage that would tend to drive the market price in the direction of the ETFs NAV to the benefit of retail investors.75 Today, we propose a rule with certain conditions that may permit the ETF structure to operate within the scope of the Act without sacrificing appropriate investor protection, and is designed to be consistent with the purposes fairly intended by the policy and provisions of the Act.76 Our orders have provided exemptions from the definition of "redeemable security" and section 22(d) and rule 22c-1 for ETFs with an arbitrage mechanism that helps maintain the equilibrium between market price and NAV. Our proposed rule would codify these exemptions subject to three conditions that appear to have facilitated the arbitrage mechanism: transparency of the ETFs portfolio, disclosure of the ETFs Intraday Value, and listing on a national securities exchange. 1. Transparency of Index and Portfolio HoldingsTo take advantage of the proposed exemption, an ETF must either (i) disclose on its Internet Web site each business day the identities and weightings of the component securities and other assets held by the fund, or (ii) have a stated investment objective of obtaining returns that correspond to the returns of a securities index, whose provider discloses on its Internet Web site the identities and weightings of the component securities and other assets of the index.77 The Web page of the ETF or the index provider, as the case may be, must be publicly accessible at no charge.78 Thus, the proposed rule would allow for an actively managed ETF provided that the actively managed ETF discloses its portfolio assets each business day.79 We seek comment on these transparency conditions. In particular, we request comment on the proposed provision requiring that an ETF that tracks an index and does not disclose its portfolio each business day must track an index whose provider discloses on an Internet Web site the component securities and other assets of the index it tracks.80 Is it necessary for the rule to include this option instead of simply requiring daily portfolio disclosure by the ETF? What circumstances, if any, would prevent an index-based ETF from disclosing its portfolio holdings?81 Would Internet Web site disclosure of portfolio holdings be sufficient? If not, what other means of disclosure should the ETF or the index provider use? We also seek comment on whether we should require ETFs to disclose daily on their Internet Web sites liabilities (as well as portfolio holdings) to permit investors, particularly arbitrageurs, to evaluate the impact of leverage from borrowings on the funds portfolio.82 Should we limit such a requirement to certain kinds of ETFs that may have significant liabilities? If so, how should we identify the ETFs that would be subject to the condition? One of the issues we discussed in the 2001 Concept Release was that full portfolio transparency could give market participants an ability to access the funds market strategies (i.e., "free-riding") and, in some cases, the ability to trade ahead of the ETF (i.e., "front-running").83 Those commenters who addressed the issue generally agreed that intra-day or advance portfolio disclosure may be detrimental to an actively managed ETF because it could enable third parties to front-run the fund.84 Therefore, the proposed rule does not require disclosure of intra-day changes in the portfolio of the ETF, because currently, intra-day changes do not affect the composition of the ETFs basket assets until the next trading day.85 The proposed rule also does not require advance disclosure of portfolio trades.86 We request comment on these aspects of the proposal. Should the rule require disclosure of portfolio changes more often than once a day? How would more frequent disclosure affect the arbitrage mechanism? Would more frequent disclosure increase the likelihood of free-riding or front-running? The rule does not limit ETFs to tracking specialized indexes that change their assets at or below a specified frequency. How might this affect the transparency of the portfolios of ETFs that would rely on index rather than portfolio disclosure?87 Should the proposed rule prohibit advance portfolio disclosure? Would advance portfolio disclosure increase the likelihood of free-riding or front-running? If so, should the risk that participants may engage in these activities be treated as a material risk to be disclosed to prospective investors permitting them to evaluate whether the risk makes the ETF an appropriate investment in light of the particular investors investment objectives? How would advance disclosure affect the arbitrage mechanism? If the portfolio disclosed in advance differed from the actual portfolio acquired, would that affect the markets ability to price the ETFs shares? 2. Listing on a National Securities Exchange and Dissemination of Intraday ValueAn ETF that relies on rule 6c-11 would need to satisfy two additional conditions set forth in the paragraph defining "exchange-traded fund."88 First, shares issued by the ETF would have to be approved for listing and trading on a national securities exchange.89 We have premised our previous exemptive orders on the ETF listing its shares for trading on a national securities exchange.90 Listing on an exchange would provide an organized and continuous trading market for the ETF shares at negotiated prices. Applicants for exemptive relief have noted that this intra-day trading, combined with the arbitrage mechanism inherent in the ETF structure, should prevent significant premiums and discounts between the market price of ETF shares and the Intraday Value.91 Second, an ETF could rely on the rule only if a national securities exchange disseminates the Intraday Value at regular intervals during the trading day.92 Applications for exemptive relief have noted that exchanges typically disseminate the Intraday Value every 15 seconds during trading hours.93 They have also asserted that this regular dissemination of the Intraday Value enables market makers to engage in the arbitrage activities that determine the market price for ETF shares.94 We request comment on these two conditions. Should the rule require that ETF shares be listed on a national securities exchange? Should the rule make allowance for shares that are delisted for a short time, or for suspensions in listing? If an ETFs shares were not listed for trading on a national securities exchange (even on a temporary basis), would the ETF structure permit the arbitrage mechanism to function appropriately? Should the rule require an ETF to liquidate or take other steps in the event of delisting? Should the proposed rule condition relief on listing exchanges disseminating the Intraday Value? If not, are there other means for market makers to receive the Intraday Value? Are there alternatives to using the basket as the basis for the Intraday Value calculation? For example, should the rule require the entity calculating the Intraday Value to use the ETFs portfolio (as opposed to the basket)? Should the calculation method be prescribed? The proposed rule does not require the dissemination of an ETFs Intraday Value at specific intervals because the rules of national securities exchanges, as approved by the Commission, establish the frequency of disclosure.95 Should the rule specify a minimal frequency? For example, should the rule prohibit an ETF from relying on the exemption if it is listed on an exchange that permits dissemination at intervals longer than the current 15 or 60second intervals? 3. MarketingOur exemptive orders included a condition requiring each ETF to agree not to market or advertise the ETF as an open-end fund or mutual fund and to explain that ETF shares are not individually redeemable.96 This condition was designed to help prevent retail investors from confusing ETFs with traditional mutual funds. Similarly, the proposed rule would require each ETF relying on the rule to identify itself in any sales literature as an ETF that does not sell or redeem individual shares, and explain that investors may purchase or sell individual ETF shares in secondary market transactions that do not involve the ETF.97 This condition, like the prior condition in our orders, is designed to help prevent retail investors from confusing ETFs with traditional mutual funds. We request comment on whether the proposed condition is likely to provide a benefit for investors with respect to ETF marketing and advertising materials. Are investors confused about the distinction between ETFs and traditional mutual funds? Should any confusion be addressed through rule requirements? Should the rule require ETFs to identify themselves as either index-based or actively managed ETFs? 4. Conflicts of InterestSection 1(b)(2) of the Investment Company Act states that the public interest and the interest of investors are adversely affected when investment companies are organized, operated, managed, or their portfolio securities are selected, in the interest of directors, officers, investment advisers, or other affiliated persons, and underwriters, brokers, or dealers rather than in the interest of shareholders.98 The operation of an ETFspecifically, the process in which a creation unit is purchased by delivering basket assets to the ETF, and redeemed in exchange for basket assetsmay lend itself to certain conflicts for the ETFs investment adviser, which has discretion to specify the securities included in the baskets. For example, the adviser could direct creation unit purchasers to purchase securities from affiliates of the adviser for subsequent presentation to the ETF. As we noted in the 2001 Concept Release, these conflicts would appear to be minimized in the case of an index-based ETF because the universe of securities that may be included in the ETFs portfolio generally is restricted by the composition of its corresponding index.99 We also noted that the same would not appear to be the case for an actively managed ETF. Because the adviser to an actively managed ETF would have greater discretion to designate securities to be included in the basket assets, a greater potential for conflicts appears to exist. Commenters generally stated that actively managed ETFs would not be faced with conflicts that are different from those that currently exist for actively managed mutual funds.100 One commenter, however, recommended that the Commission impose any prohibitions or conditions under the Act that would apply to transactions directly effected by the adviser on any transactions effected at the advisers discretion.101 The commenter noted that, for example, an ETF that is prohibited from acquiring a security in certain underwritings (under section 10(f) of the Act)102 should be prohibited from circumventing this prohibition by including the security in the ETFs basket assets. Similarly, an adviser could attempt to circumvent section 17(a) restrictions on principal transactions between a registered fund and its affiliates by designating a security for the basket assets that a creation unit purchaser would have to purchase from an affiliate of the adviser.103 We have not included a condition in the proposed rule prohibiting an actively managed ETFs adviser, directly or indirectly, from causing a creation unit purchaser to acquire a security for the ETF through a transaction in which the ETF could not engage directly. An adviser to an actively managed ETF already is subject to section 48(a) of the Act, which prohibits a person from doing indirectly, through another person, what that person is prohibited by the Act from doing directly. An adviser, therefore, would be prohibited from causing an institution that transacts directly with the ETF (or any investor on whose behalf the institution may transact with the ETF) to acquire any security for the ETF through a transaction in which the ETF could not engage directly.104 We request comment on whether it would be useful to include a condition in the proposed rule reminding ETFs relying on the rule of the prohibitions contained in section 48(a) of the Act. We also request comment on potential conflicts of interest for an ETFs investment adviser. Does an adviser to a fully transparent, actively managed ETF face different conflicts of interest from the conflicts of an adviser to a traditional mutual fund? If so, what are those conflicts and how could the rule address them? 5. Affiliated Index ProvidersFederal securities laws and the rules of national securities exchanges require funds and their advisers to adopt measures reasonably designed to prevent misuse of non-public information.105 Funds are likely to be in a position to well understand the potential circumstances and relationships that could give rise to the misuse of non-public information, and can develop appropriate measures to address them. We believe these requirements should be sufficient to protect against the abuses addressed by the terms in the exemptive applications of ETF sponsors that represented they would use an affiliated index provider. The proposed rule, therefore, does not include terms from previous applications that are designed to prevent the communication of material non-public information between the ETF and the affiliated index provider.106 We request comment on our proposal to eliminate these terms. Should the rule include any of the terms included in previous exemptive applications for affiliated index providers? If so, which terms and why? C. Exemptive ReliefThe unique structure of ETFs has required ETF sponsors to seek relief from certain provisions of the Act and our rules in order to form and operate. Proposed rule 6c-11 would permit an ETF that meets the conditions of the rule to redeem shares in creation unit aggregations, to trade at current market prices, to engage in in-kind transactions with certain affiliates and, in certain circumstances, to pay the proceeds from the redemption of shares in more than seven days. The proposed exemptions would be subject to certain conditions that are designed to address the concerns underlying the statute and thereby satisfy the requirement that exemptions from statutory provisions are in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy of the Act.107 1. Issuance of "Redeemable Securities"Our exemptive orders have provided ETFs with relief from sections 2(a)(32) and 5(a)(1)108 of the Act so that they may register under the Act as open-end funds while issuing shares that are redeemable in creation units only.109 In support of the relief, ETF sponsors have noted that because the market price of ETF shares is disciplined by arbitrage opportunities, investors in ETF shares generally should be able to sell the shares in secondary market transactions at approximately their NAV.110 Proposed rule 6c-11 would deem an equity security issued by an ETF to be a "redeemable security" for purposes of section 2(a)(32) of the Act.111 This provision would permit an ETF to register with the Commission as an open-end fund, which the Act defines as an investment company that issues redeemable securities,112 even though ETF shares are issued and redeemed in creation unit aggregations.113 This approach would provide ETFs with the same relief contained in our exemptive orders without exempting ETFs from other requirements imposed under the Act and our rules that apply to funds that issue redeemable securities.114 We request comment on this aspect of the proposed rule. Are there differences in ETFs and other funds that would justify not applying any provision of the Act or our rules that applies to funds that issue redeemable securities? As discussed above, ETFs today operate with an arbitrage mechanism designed to minimize the potential deviation between the market price and NAV of ETF shares. The proposed rule would require that an ETF establish creation unit sizes the number of shares of which are reasonably designed to facilitate arbitrage, which is described in the proposed definition of creation unit as the purchase (or redemption) of shares from the ETF with an offsetting sale (or purchase) of shares on a national securities exchange at as nearly the same time as practicable for the purpose of taking advantage of a difference in the Intraday Value and the current market price of the shares.115 The proposed rule also would require an ETF to disclose in its prospectus and any sales literature the number of ETF shares for which it will issue or redeem a creation unit to alert investors that they cannot purchase or redeem individual ETF shares directly from or with the ETF.116 The proposed condition regarding creation unit size is intended to require ETFs that rely on the proposed rule to choose creation unit sizes that promote an arbitrage mechanism and to preclude ETFs from setting very low or high thresholds, such as one ETF share per creation unit or one million ETF shares per creation unit. A low creation unit size could, as a practical matter, make the use of creation unit redemption irrelevant. The ETF would, in effect, be issuing and redeeming ETF shares like a traditional mutual fund, but the shares would trade on an exchange. Conversely, a high creation unit size could reduce the willingness or ability of institutional arbitrageurs to engage in creation unit purchases or redemptions. Impeding the ability of arbitrageurs to purchase and redeem ETF shares could disrupt the arbitrage pricing discipline, which could lead to more frequent occurrences of pricing premiums or discounts. We request comment on the proposed requirement for creation unit size, which is included in the proposed rules definition of "creation unit." Does the requirement that an ETF establish creation unit sizes the number of which is reasonably designed to facilitate arbitrage provide the sponsor or adviser of the ETF with sufficient guidance in setting appropriate thresholds? Should we include other elements in our description of arbitrage, which is included in the definition of creation unit? If so, what elements? Should the proposed rule instead require the board of directors of the ETF to make a finding that the ETF is structured in a manner reasonably intended to facilitate arbitrage? This finding could require the board, for example, to look at the number of shares in each creation unit and the liquidity of the portfolio securities and other assets. What other elements, if any, should the board be required to review in making this finding? The proposed rule does not include numerical thresholds for the number of ETF shares in each creation unit. Should the proposed rule include minimum or maximum numerical thresholds? If so, what would be appropriate thresholds and why? For example, should the rule set a minimum of 100 ETF shares, and/or a maximum of 500,000 ETF shares, per creation unit? Are our concerns with respect to smaller- or larger-sized creation units addressed by requiring ETFs to establish creation unit sizes that facilitate arbitrage? If the rule does not include any thresholds, would any of the exemptions provided by the proposed rule be inappropriate for an ETF with smaller- or larger-sized creation units? If so, which exemptions? ETF applicants represent that ETF share prices are disciplined by arbitrage opportunities created by the ability to purchase and redeem creation units at NAV on a daily basis.117 Would this pricing mechanism function differently for smaller-or larger-sized creation units? Because ETFs charge transaction fees for direct purchases and redemptions from the fund, ETF applicants have asserted that the interests of long-term shareholders should not be diluted by frequent traders, if those transaction fees accurately reflect the costs to the fund.118 Are smaller-sized creation units likely to cause the transaction fees charged by ETFs to be insufficient to protect the long-term shareholders in the event of more frequent purchases and redemptions? If so, should an ETF relying on the proposed exemption be required to take additional measures designed to protect long-term shareholder interests from being diluted by frequent traders? If so, what measures? As discussed above, ETFs issue and redeem shares in creation unit aggregations in exchange for the deposit or delivery of a basket of securities and other assets. The proposed rule defines "basket assets" to mean the securities or other assets specified each business day in name and number by the ETF as the securities or assets in exchange for which it will issue, or in return for which it will redeem, ETF shares.119 The rule does not require that the basket mirror the portfolio of the ETF because in some circumstances it may not be practicable, convenient or operationally possible for the ETF to operate on an in-kind basis.120 The rule, like our orders, allows an ETF to require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket assets.121 We request comment on the proposed definition of basket assets. Are there any reasons why an ETF should not be permitted to substitute cash for some or all of the assets in the basket? Should the proposed rule include any conditions for when an ETF may require or permit cash substitutions? If so, what conditions should be included? Should the rule specify how the ETF would announce the composition of the basket? For example, should the rule mandate that the ETF post the information on its Internet Web site? Should the rule specify the frequency with which the ETF must announce the composition of the basket? If so, how often? 2. Trading of ETF Shares at Negotiated PricesAs noted above, section 22(d), among other things, prohibits a dealer from selling a redeemable security that is being offered currently to the public by or through an underwriter, except at a current public offering price described in the prospectus.122 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.123 Because secondary market trading in ETF shares takes place at current market prices, and not at the current offering price described in the prospectus or based on NAV, ETFs have obtained exemptions from section 22(d) and rule 22c-1. The provisions of section 22(d), as well as rule 22c-1, are designed to prevent dilution caused by certain riskless trading schemes by principal underwriters and dealers, and to prevent unjust discrimination or preferential treatment among investors purchasing and redeeming fund shares.124 The proposed rule would exempt a dealer in ETF shares from section 22(d) of the Act and rule 22c-1(a) with regard to purchases, sales and repurchases of ETF shares in secondary market transactions at current market prices.125 As discussed above, we have provided exemptions from section 22(d) and rule 22c-1 in our orders because the arbitrage function appears to address the potential concerns regarding shareholder dilution and unjust discrimination that these provisions were designed to address.126 In addition, secondary market trading should not cause dilution for ETF shareholders because those transactions do not directly involve ETF portfolio assets (the transactions are with other investors, not the ETF), and thus have no direct impact on the NAV of ETF shares held by other investors. Moreover, to the extent that different prices for ETF shares exist during a given trading day, or from day to day, these variations occur as a result of third-party market forces, such as supply and demand, and not as a result of discrimination or preferential treatment among purchasers. We request comment on this proposed relief. Should the relief also apply to parties other than dealers in ETF shares? If so, which other parties require similar relief, and why? Do dealers (or others) need relief from other provisions to facilitate transactions in ETF shares on the secondary market? 3. In-Kind Transactions between ETFs and Certain AffiliatesSection 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 to or purchasing any security from the company.127 Purchases and redemptions of ETF creation units are typically in-kind rather than cash transactions,128 and section 17(a) prohibits these in-kind purchases and redemptions by persons who are affiliated with the ETF, including those affiliated because they own 5 percent or more, and in some cases more than 25 percent, of the ETFs outstanding securities ("first-tier affiliates"), and by persons who are affiliated with the first-tier affiliates or who own 5 percent or more, and in some cases more than 25 percent, of the outstanding securities of one or more funds advised by the ETFs investment adviser ("second-tier affiliates").129 We have granted exemptions from sections 17(a)(1) and (a)(2)130 of the Act to allow these first- and second-tier affiliates of the ETF to purchase and redeem creation units through in-kind transactions.131 In seeking this relief, applicants have submitted that because the first- and second-tier affiliates are not treated differently from non-affiliates when engaging in purchases and redemptions of creation units, there is no opportunity for these affiliated persons to effect a transaction detrimental to the other ETF shareholders. The securities to be deposited for purchases of creation units and to be delivered for redemptions of creation units are announced at the beginning of each day. All purchases and redemptions of creation units are at an ETF's next-calculated NAV (pursuant to rule 22c-1), and 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. The proposed rule would permit first- and second-tier affiliates of the ETF to purchase and redeem creation units through in-kind transactions.132 The proposed exemption would not, however, apply to a specific category of redemptions that would be addressed in new rule 12d1-4, which we also are proposing today. Section 12(d)(1) of the Act imposes substantial limitations on the ability of investment companies to invest in other investment companies.133 As discussed in Section IV of this release, proposed rule 12d1-4 would permit investment companies to acquire shares of ETFs in excess of the limitations on those investments under section 12(d)(1) of the Act subject to certain conditions intended to address the concerns underlying those limitations. One of the proposed conditions would prohibit investment companies from redeeming certain ETF shares acquired in reliance on proposed rule 12d1-4.134 In order to make proposed rule 6c-11 consistent with the conditions in proposed rule 12d1-4, we propose to exclude investment companies that acquire ETF shares in reliance on proposed rule 12d1-4 from relying on proposed rule 6c-11(d) to redeem those ETF shares in kind.135 We request comment on this proposed exemption. Does the proposed exemption raise any risks with regard to affiliated transactions with the ETF? If so, should the exemption include any conditions to minimize those risks? Should the relief extend to parties that are affiliated persons of an ETF for other reasons? For example, should a broker-dealer that is affiliated with the ETFs adviser be allowed to transact in-kind with the ETF? 4. Additional Time for Delivering Redemption ProceedsSection 22(e) of the Act generally prohibits a registered open-end investment company from suspending the right of redemption, or postponing the date of satisfaction of redemption requests more than seven days after the tender of a security for redemption.136 Some ETFs that track foreign indexes have stated that local market delivery cycles for transferring foreign securities to redeeming investors, together with local market holiday schedules, require a delivery process in excess of seven days. These ETFs have requested, and we have granted, relief from section 22(e) so that they may satisfy redemptions up to a specified maximum number of calendar days depending upon specific circumstances in 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.137 Section 22(e) of the Act is designed to prevent unreasonable delays in the satisfaction of redemptions, and ETF sponsors have asserted that the requested relief will not lead to the problems that section 22(e) was designed to prevent.138 They have represented that the ETFs SAI would disclose those local holidays (over the period of at least one year following the date of the SAI) that are expected to prevent the satisfaction of redemptions in seven days and the maximum number of days needed to satisfy redemption requests with respect to the foreign securities at issue.139 The delay in satisfying redemption requests seems reasonable under the circumstances described by the ETF sponsors because it is for a limited period of time and disclosed to investors. The proposed rule, therefore, would codify the relief from section 22(e) of the Act previously provided to ETFs. If an ETF has a foreign security in its basket assets and a foreign holiday prevents timely delivery of the foreign security, the ETF would be exempt from the prohibition in section 22(e) against postponing the date of satisfaction upon redemption for more than seven days. To rely on this exemption, the ETF would be required to disclose in its SAI the foreign holidays it expects to prevent timely delivery of the foreign securities and the maximum number of days it anticipates it would need to deliver the foreign securities. Finally, the delivery would have to take place no more than 12 calendar days after the tender of ETF shares (in a creation unit).140 We request comment on this relief in the proposed exemption. Is the relief necessary? We specifically request comment from ETFs regarding the frequency with which they have relied on this exemption. Could an ETF pay cash (as part of the basket assets) in lieu of foreign securities in the case of delays in settlement? Should the relief be limited to ETFs that satisfy redemptions entirely through in-kind transactions? Is the number of days in the proposed rule sufficient or is it too long? Should the rule refer to the applicable local markets settlement cycle without specifying a number of days? Should the disclosure be included in the prospectus of the ETF instead of the SAI, which is only delivered upon request? Should the disclosure be included in any sales literature of the ETF? The rule would provide relief if the ETFs basket assets include a foreign security. Should the rule also provide relief if an ETF has foreign securities included in its portfolio and, if so, why? Would actively managed ETFs present any issues with respect to this exemption that do not exist with respect to index-based ETFs? Could the investment adviser to an actively managed ETF manage the ETF so as to comply with section 22(e)? The proposed rule defines "foreign security" to mean any security issued by a government or any political subdivision of a foreign country, a national of any foreign country, or a corporation or other organization incorporated or organized under the laws of any foreign country, and for which there is no established United States public trading market as that term is used in Item 201 of Regulation S-K under the Exchange Act. Use of the phrase "established United States public trading market" is designed to limit this relief to ETFs that invest in securities that do not have an active trading market in the United States. 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.141 We request comment on the definition of "foreign security." Should the definition provide any additional exceptions? D. Disclosure AmendmentsCongress enacted the federal securities laws to promote fair and honest securities markets, and an important purpose of these laws is to promote full and fair disclosure of important information by issuers of securities to the investing public. The Securities Act and the Exchange Act, as implemented by Commission rules and regulations, provide for systems of mandatory disclosure of certain material information in securities offerings and in periodic reports. Accordingly, the Securities Act requires delivery of a prospectus meeting the requirements of section 10(a) to each investor in a registered offering.142 The Securities Act also requires dealers in a security, for a specified period of time after the registration statement for the security becomes effective, to deliver a final prospectus to purchasers, including to most persons purchasing shares in secondary market transactions.143 The Investment Company Act, however, requires dealers to continue prospectus delivery to investors in open-end funds, including ETFs, which continuously offer their securities to the public.144 1. Delivery of Prospectuses to InvestorsOur orders generally have exempted broker-dealers selling ETF shares from the obligation to deliver prospectuses in most secondary market transactions.145 Applicants have represented that broker-dealers would instead deliver a "product description" containing basic information about the ETF and its shares.146 Proposed rule 6c-11 would not include a similar exemption, and thus broker-dealers would be required to deliver a prospectus meeting the requirements of section 10(a) of the Securities Act to investors purchasing ETF shares.147 We understand that many, if not most, broker-dealers selling ETF shares in secondary market transactions do, in fact, transmit a prospectus to purchasers, and thus they have not relied on the exemptions we have provided in our orders. More important, we believe an exemption allowing dealers to deliver product descriptions would be unnecessary given our proposal regarding summary prospectus disclosure. As discussed below,148 we recently proposed amendments to Form N-1A and to rule 498 under the Securities Act,149 in order to enhance the disclosures that are provided to mutual fund investors ("Enhanced Disclosure Proposing Release").150 The proposed amendments, if adopted, would require key information to appear in plain English in a standardized order at the front of the mutual fund prospectus ("summary section").151 A person could satisfy its mutual fund prospectus delivery obligations under section 5(b)(2) of the Securities Act by sending or giving this key information directly to investors in the form of a summary prospectus and providing a prospectus that meets the requirements of section 10(a) of the Securities Act ("statutory prospectus") on an Internet Web site.152 If adopted, broker-dealers selling ETF shares could deliver a summary prospectus in secondary market transactions. We believe the summary prospectus would contain material information that may not be included in a product description, but, like the product description, would be in a form that would be easy to use and readily accessible. We request comment on this approach. Are we correct in our understanding that many, if not most, broker-dealers deliver a prospectus instead of a product description in connection with sales of ETF shares in secondary market transactions? If so, why? If we were to adopt rule 6c-11 before the amendments proposed in the Enhanced Disclosure Proposing Release, we would expect to permit delivery of a product description in lieu of a prospectus, pending final determination of that proposal by the Commission. We request comment on this approach. Should we permit all ETFs, including actively managed ETFs and index-based ETFs that rely on the rule instead of an exemptive order to deliver product descriptions? Should we prescribe the form of the product description? For example, should we propose specific requirements for product descriptions that would provide ETF investors with information similar to that received by traditional mutual fund investors, such as the fee table, name and length of service of the portfolio manager, and return information, as noted above? Alternatively, should the product description conform to the disclosures in the summary section as proposed in Section III.D.2 below?153 If so, are there any additional disclosures to those in the proposed summary section that ETFs should be required to include in a product description? Are there any disclosures in the proposed summary section that ETFs should not be required to include in the product description? If we do not adopt the amendments proposed in the Enhanced Disclosure Proposing Release, we would anticipate that dealers in ETF shares will nevertheless continue their current practice of delivering prospectuses to investors. We request comment on whether the rule should require dealers to deliver prospectuses instead of product descriptions.154 ETFs are becoming more like traditional mutual funds in several respects. As discussed above, when we began issuing exemptive orders to ETFs, they had basic investment objectives (to track a widely-followed index) and simple investment techniques (investment in all, or a representative sample of, the securities of a widely followed index).155 Soon, however, some ETFs will be actively managed and have portfolio managers whose role is important to the success of the fund.156 ETF operations, investment objectives, expenses, and other characteristics may become more varied as well. Because prospectuses contain information in a standardized form prescribed by the Commission, the use of these disclosure forms could promote greater uniformity in the content and level of disclosure among ETFs.157 In addition, as discussed below, we are proposing to amend Form N-1A to include additional information relevant to a retail investor in an ETF, who does not typically buy or redeem individual shares directly from the fund. If we were to retain the prospectus delivery exemption for broker-dealers, should the exemption be limited to index-based ETFs or only to certain index-based ETFs, such as those that replicate the components of a broad-based stock market index? If we were to retain the exemption, should we require broker-dealers to deliver prospectuses instead of product descriptions to purchasers of actively managed ETF shares? 2. Amendments to Form N-1AWe are proposing several amendments to Form N-1A, the registration form used by open-end management investment companies to register under the Act and to offer their securities under the Securities Act, to accommodate the use of this form by ETFs. The proposed amendments for ETF prospectuses are designed to meet the needs of investors (including retail investors) who purchase shares in secondary market transactions rather than financial institutions purchasing creation units directly from the ETF. We request comment on our proposal to amend Form N-1A to meet the needs of secondary market investors. Is this distinction we propose to draw between purchasers of shares in secondary market transactions and purchasers of creation units from the fund appropriate? Should we instead revise Form N-1A to include the additional disclosure (as discussed below) we are proposing today for secondary market investors without eliminating (as discussed below) certain disclosures relevant to creation unit purchasers? Would secondary market investors be confused if Form N-1A included disclosure relevant to both types of investors? Purchasing and Redeeming Shares. We propose to amend Item 6 of Form N-1A to eliminate the requirement that ETF prospectuses disclose information on how to buy and redeem shares of the ETF because it is not relevant to secondary market purchasers of ETF shares.158 Instead ETF prospectuses would simply state the number of shares contained in a creation unit (i.e. the amount of shares necessary to redeem with the ETF) and that individual shares can only be bought and sold on the secondary market through a broker-dealer.159 Similarly, we also would amend Item 3 to exclude from the fee table fees and expenses for purchases or sales of creation units.160 Instead, the proposed amendment would require an ETF to modify the narrative explanation preceding the example in the fee table to state that individual ETF shares are sold on the secondary market rather than redeemed at the end of the periods indicated, and that investors in ETF shares may be required to pay brokerage commissions that are not reflected in the fee table.161 We request comment on our assumption that investors (including most individual investors) purchasing their shares in secondary market transactions do not need to know information on how creation units are purchased and redeemed, or the payment of transaction fees by investors purchasing or redeeming creation units. If they do need this information, why? ETFs would still be required to include disclosure on how creation units are offered to the public in the SAI.162 We are not proposing to amend this disclosure to include information on creation unit redemption, which Item 6 currently requires and which we propose to eliminate. Should we amend the SAI to include the disclosure requirements we are proposing to eliminate from Item 6? Should we require that the information in the SAI regarding the purchase of creation units also specify associated fees and expenses? As an alternative, should we require purchase and redemption information and associated fees and expenses to remain in Item 3 and Item 6 only for prospectuses provided to investors purchasing creation units, such as in the form of a supplementary prospectus? The proposed alternative disclosures in Items 3 and 6 would not be available, however, to ETFs with creation units of less than 25,000 shares because more retail investors would be able to transact directly with an ETF that has smaller-sized creation units. We request comment on whether the exemptions we are providing from Items 3 and 6 of Form N-1A should be based on the size of the creation unit, and whether 25,000 shares per creation unit is an appropriate threshold. Should it be higher or lower? Should we instead adopt a threshold based on the value of shares rather than the number of shares? Total Return. We propose to modify instructions to several items that require the use of the ETFs NAV to determine its return. In addition to returns based on NAV, ETFs also would be required to include returns based on the market price of fund shares.163 As discussed above, returns based on market price may be different than returns based on the funds NAV and better relate to an ETF investors experience in the fund. We request comment on whether use of market prices, in addition to NAV, would provide secondary market purchasers of ETF shares with meaningful information on their investments. Alternatively, should we require returns to be computed solely using market prices? Would investors find it confusing to have fund returns presented using both market price and NAV? Should we limit this amendment to ETFs with creation units of 25,000 shares or more because more retail investors may be able to transact directly with the ETF in the event of smaller creation units? For purposes of determining ETF returns, we would define "market price" as the last price at which ETF shares trade on their principal U.S. trading market during a regular trading session (i.e. closing price).164 Is this an appropriate definition for market price, or should we instead (or in addition) define the market price as the mid-point price between the highest bid and the lowest offer on the principal U.S. market on which the ETF shares are traded, at the time the funds NAV is calculated?165 Premium/Discount Information. We propose to require that each ETF disclose to investors information about the extent and frequency with which market prices of fund shares have tracked the funds NAV.166 This disclosure, which would be required on the funds Internet Web site and included in its prospectus, is a condition to relief in ETF exemptive orders.167 Proposed rule 6c-11 also would require each ETF to disclose on its Internet Web site the prior business days last determined NAV, the market closing price of its shares and the premium/discount of the closing price to NAV.168 This disclosure is designed to alert investors to the current relationship between NAV and the market price of the ETFs shares, and that they may sell or purchase ETF shares at prices that do not correspond to the NAV of the fund. Proposed Item 6(h)(4) of Form N-1A would require disclosure in the ETF prospectus of the number of trading days, during the most recently completed calendar year and quarters since that year, on which the market price of the ETF shares was greater than the funds NAV and the number of days it was less than the funds NAV (premium/discount information).169 In addition to alerting investors that the ETFs NAV and share price may differ, this disclosure also would provide historical information regarding the frequency of these deviations. In light of the historical premium/discount disclosure in the ETF prospectus and in order to avoid duplicative disclosures that may result in additional regulatory burdens, proposed rule 6c-11, unlike the exemptive orders, would not require ETFs to include historical premium/discount information on their Internet Web sites. We request comment on whether daily and historical premium/discount information, which ETFs currently provide, is useful to investors. One commenter to the 2001 Concept Release suggested that investors need not receive premiums/discounts against NAV disclosure because the more useful information is the Intraday Value of the funds basket as disseminated by national securities exchanges at regular intervals.170 This information, according to the commenter, provides investors with contemporaneous pricing of the funds portfolio and enables the investor to see, at the time his order is entered, whether the Intraday Value is close to (or between) the bid-asked price. We request comment on whether investors need premium/discount disclosure in light of the dissemination of the ETFs Intraday Value at regular intervals during trading hours. We request ETF sponsors commenting on this condition of the rule to provide us with data regarding the frequency with which visitors to their Internet Web sites access this information. In addition to current premium/discount information, should we also require ETF Web sites to provide historical premium/discount information as is currently required by exemptive orders? If the Web site includes historical premium/discount information, should the rule also require historical information in Form N-1A? If so, over what periods? Periodic Report Information. We are proposing conforming amendments to ETF return information in ETF annual reports. The proposed amendments would require each ETF to use the market price of fund shares in addition to NAV to determine its return,171 and include a table with premium/discount information for the five recently completed fiscal years.172 We request comment on whether it is necessary to include similar disclosure in both the prospectus and annual report of an ETF. Should ETFs that provide this information on their Internet Web sites be exempt from this annual report requirement? Is it necessary for the ETF to provide premium/discount data for the most recently completed five fiscal years? Should the reporting period conform to that proposed under Item 6 of the form (i.e., one calendar year and most recent quarters since that year)? We also are proposing to amend the prospectus and annual report requirements of Form N-1A to require an index-based ETF to compare its performance to its underlying index rather than a benchmark index.173 This amendment would permit use of a narrow-based or affiliated index and eliminate the opportunity for an index-based ETF to select an index different from its underlying index which should better reflect whether the ETFs performance corresponds to the index the performance of which it seeks to track.174 We request comment on whether it is appropriate to require an index-based ETF to compare its performance to its underlying index. Should an index-based ETF that tracks an index compiled by an affiliated index provider use a benchmark index instead of, or in addition to, its underlying index? Should an index-based ETF that tracks a fundamental or other custom-designed index use a benchmark index instead of, or in addition to, its underlying index? Summary Prospectus. As noted above, we recently issued the Enhanced Disclosure Proposing Release, which would require key information to appear in plain English in a summary section of the prospectus.175 In addition, a person could satisfy its mutual fund delivery obligations under section 5(b)(2) of the Securities Act by delivering the summary prospectus to investors and providing a statutory prospectus on an Internet Web site. Upon request, a fund also would be required to send the statutory prospectus to the investor.176 As proposed, the summary section would include certain key information, which also would comprise the information in the summary prospectus. This key information would include: (i) investment objectives;177 (ii) costs;178 (iii) principal investment strategies, risks, and performance;179 (iv) the funds top ten portfolio holdings as of the end of its most recent calendar quarter;180 (v) identity of investment advisers and portfolio managers;181 (vi) brief purchase and sale and tax information;182 and (vii) financial intermediary compensation.183 This information is drawn largely from the current risk/return summary and rule 498 fund profile.184 In addition, the summary prospectus would be required to include on the cover page or at the beginning: (i) the funds name and the share classes to which the summary prospectus relates; (ii) a statement identifying the document as a "summary prospectus"; (iii) the approximate date of the summary prospectuss first use; and (iv) the following legend: Before you invest, you may want to review the Funds prospectus, which contains more information about the Fund and its risks. You can find the Funds prospectus and other information about the Fund online at [_______]. You can also get this information at no cost by calling [______] or by sending an e-mail request to [________].185 If adopted, the amendments to Form N-1A and rule 498 proposed in the Enhanced Disclosure Proposing Release would require open-end ETFs to include the summary section in their prospectuses and permit persons to satisfy their prospectus delivery obligations by sending or giving the summary prospectus and providing the statutory prospectus on an Internet Web site in the manner set forth in the proposed rules. Today, we also propose that, if the Enhanced Disclosure Proposing Release is adopted, ETFs include in the summary section of their prospectuses, and in their summary prospectuses, the additional proposed disclosures discussed above. Specifically, we would modify the amendments proposed in the Enhanced Disclosure Proposing Release to include our proposed amendments to ETF disclosures as follows: (i) our proposed amendments regarding disclosures about creation units and the purchase and sale of individual ETF shares would be included in proposed summary prospectus Item 7, which would require brief purchase and sale information;186 (ii) the additional information on market price returns would be included in proposed summary prospectus Item 4, which includes the risk/return summary, bar chart and table;187 and (iii) premium/discount information would be included in proposed summary prospectus Item 7 (purchase and sale information).188 We also would permit ETFs to exclude proposed information regarding the purchase and sale of creation units consistent with our proposal today.189 We request comment on whether ETFs should send or give the proposed additional items in the summary prospectus. If so, should any information from the statutory prospectus, in addition to the items that we are proposing today, be included in the summary section of an ETFs prospectus and, therefore, in its summary prospectus? Should ETFs not be required to include certain items in the summary section? For example, in light of the transparency of portfolio holdings of an ETF, should ETFs not have to include the top ten portfolio holdings? Should ETFs be permitted or required to locate any of the specific disclosures proposed in this release or in the Enhanced Disclosure Proposing Release elsewhere in the prospectus outside the summary section? E. Amendment of Previously Issued Exemptive OrdersAs discussed above, our orders have exempted ETFs from compliance with section 24(d) of the Act to relieve dealers from delivering prospectuses to investors in secondary market transactions. We are proposing today not to include such an exemption in rule 6c-11 to ensure that broker-dealers are subject to the same delivery requirements with respect to all ETFs.190 In addition, we are proposing amendments to Form N-1A that would revise the prospectus requirements in that form in order to provide more useful information to investors in ETF shares. Therefore, pursuant to our authority under section 38(a) of the Act, we propose to amend the exemptive orders we have issued to ETFs that are open-end funds to eliminate the section 24(d) exemptions and require ETFs to satisfy their statutory prospectus delivery requirements.191 The consequence of the amendment to these orders, if adopted, would be to put ETFs that have received exemptive orders on the same footing as ETFs that may in the future rely solely on rule 6c-11, and thus eliminate any competitive advantage they might otherwise obtain by having obtained orders before adoption of the rule.192 The amendment would be limited to orders issued to ETFs seeking to operate as open-end management companies. We are not proposing to rescind the orders we have issued because we do not believe rescission would be necessary to eliminate competitive advantages for ETFs that have already received exemptive orders. With the exception of the section 24(d) exemption (and the related prospectus disclosure requirements), the proposed rule contains broader exemptive relief than that provided in our orders and therefore we expect most, if not all, ETFs would rely on the rule if and when it is adopted. We request comment on whether we should rescind our previous orders. Is our assumption correct that most ETFs that have orders would rely on the rule? IV. EXEMPTION FOR INVESTMENT COMPANIES INVESTING IN ETFSA. BackgroundAs we discussed above, institutional investors, including funds, have invested in ETFs to achieve asset allocation, diversification, or other investment objectives.193 Some funds invest primarily in ETFs. A funds ability to invest in ETFs, however, is limited because section 12(d)(1) of the Act prohibits a fund (and companies or funds it controls) ("acquiring fund") from: (i) acquiring more than three percent of any other investment companys outstanding voting securities ("acquired fund"); (ii) investing more than five percent of its total assets in any one acquired fund; or (iii) investing more than ten percent of its total assets in all acquired funds.194 Section 12(d)(1) was enacted to limit so-called "fund of funds" arrangements. Congress was concerned about "pyramiding," a practice under which investors could use a limited investment in an acquiring fund to gain control of another (and potentially much larger) fund and use the assets of the acquired fund to enrich themselves at the expense of acquired fund shareholders.195 Control could be exercised either directly (such as through holding a controlling interest) or indirectly (such as by coercion through the threat of large-scale redemptions).196 Congress also was concerned about the potential for excessive fees when one fund invested in another,197 and the formation of overly complex structures that could be confusing to investors.198 Congress imposed these limits, in part, based on our conclusion in 1966 that fund of funds structures served little or no economic purpose.199 Our views and those of Congress regarding the economic value of fund of funds arrangements have changed over the years as fund of funds arrangements have been created that serve new, legitimate purposes. Recognizing this, in 1996, Congress granted us specific authority to provide exemptions allowing fund of funds arrangements, and directed that we use it "in a progressive way."200 Pursuant to this authority, we have provided exemptions to permit certain fund of funds arrangements that would otherwise be prohibited under section 12(d)(1). For example, in 2006 we adopted rule 12d1-1, which allows funds to invest in money market funds in excess of section 12(d)(1) limits.201 We also have issued exemptive orders that allow many funds to invest in unaffiliated traditional funds ("multigroup fund orders") and that allow the sale of shares issued by several ETFs to unaffiliated funds in excess of the statutory limits.202 The exemptions provided under the rule and these orders facilitate the acquiring funds ability to achieve their investment objectives by expanding their investment options to include investments in unaffiliated funds in a manner consistent with the protection of investors. These exemptions also increase the potential pool of investors and assets available for investment in ETFs and traditional funds. ETF applicants have sought exemptive orders similar to those we have issued to funds investing in unaffiliated traditional funds.203 The conditions included in those orders were designed to prevent the abuses that historically were associated with fund of funds arrangements and that led Congress to enact section 12(d)(1).204 The conditions include: (i) limits on the control and influence an acquiring fund can exert on the acquired fund;205 (ii) limits on certain fees charged to the acquiring fund and its shareholders;206 (iii) limits on the acquired funds ability to invest in other funds;207 (iv) the acquired fund and each acquiring fund must enter into an agreement stating that both funds understand the terms and conditions of the order and agree to fulfill their responsibilities under the order ("participation agreement");208 and (v) the acquiring fund provides a list of certain of its affiliates to the acquired fund.209 More recently, sponsors of some ETFs as well as managers of funds investing in ETFs have expressed concern to our staff that some of the conditions in the exemptive orders are burdensome and unnecessary in the context of a fund investment in an ETF, which is less likely to be subject to at least some of the abuses these conditions were designed to prevent.210 For example, ETF sponsors have communicated to our staff that the participation agreement condition is cumbersome and costly because the ETFs must enter into an agreement with each acquiring fund and each acquiring fund seeks to negotiate different terms in its agreement.211 They have suggested that we develop conditions that address the concerns underlying section 12(d)(1) in a manner that is more suited to fund investments in ETFs.212 B. Proposed Rule 12d1-4 ConditionsToday, we are proposing a new rule 12d1-4, which would provide an exemption to permit acquiring funds to invest in ETFs in excess of the limits of section 12(d)(1), subject to four conditions that are designed to address the historical abuses that result from pyramiding and the threat of large-scale redemptions and may arise in connection with investments in ETFs.213 The relief we propose is subject to fewer conditions than our exemptive orders but, unlike our orders, would limit an acquiring funds ability to redeem ETF shares.214 1. ControlIn order to address the concern that a fund could exert control over another fund, the proposed rule would limit the exemption to an acquiring fund (and any entity in a control relationship with the acquiring fund) that does not "control" an ETF.215 The Act defines "control" to mean "the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company."216 The Act also creates rebuttable presumptions that any person who directly or indirectly beneficially owns more than 25 percent of the voting securities of a company controls the company and that one who does not own that amount does not control it.217 The effect of the proposed rule, if adopted, would be that an acquiring funds beneficial ownership of up to 25 percent of the voting securities of an ETF, by itself, would not constitute control over the ETF. As a result, a fund relying on the rule could make a substantial investment in an ETF (i.e., up to 25 percent of the ETFs shares) without seeking further exemption from us. If, however, an acquiring fund uses its ownership interest in the ETF (even if that interest is 25 percent or less) to exercise a controlling influence over the ETFs management or policies, the fund would not be able to rely on the proposed rule.218 For example, an acquiring fund that used its share position to persuade an ETF manager to enter into a transaction with an affiliate of the acquiring fund or its adviser would almost certainly exercise a controlling influence on the ETFs management and thus lose its exemption under the proposed rule.219 We request comment on the proposed condition. Do ETF sponsors believe that it would sufficiently protect the ETF from the type of coercive behavior on the part of acquiring funds that section 12(d)(1) was intended to prevent? 2. RedemptionsThe proposed rule includes two provisions that would prevent an acquiring fund from redeeming shares it acquired in reliance on the proposed rule. First, the rule would prohibit an acquiring fund that relies on the proposed rule to acquire shares in excess of section 12(d)(1)(A)(i) limits (i.e., to acquire more than three percent of an ETFs shares) from redeeming those shares.220 As a result, acquiring funds would not be able to threaten large-scale redemptions as a means of coercing an ETF. It is our understanding that most acquiring funds purchase and sell ETF shares in secondary market transactions. Accordingly, this condition, while precluding one of the historical abuses associated with fund of funds arrangements, would not prevent acquiring funds from taking passive shareholder positions in ETF shares (in excess of section 12(d)(1) limits) in order to, for example, gain exposure to a particular market segment. We request comment on whether the condition achieves this purpose. If not, are there other conditions that would better address the concern? Second, the proposed rule would prohibit an ETF, its principal underwriter, and a broker or a dealer that relies on the rule to sell ETF shares in excess of section 12(d)(1)(B) limits from redeeming (or submitting an order to redeem) those shares acquired by another fund that exceed the three percent limit in section 12(d)(1)(A)(i).221 We recognize that it may be difficult in all circumstances for an ETF, its principal underwriter, a broker or a dealer to know whether a redemption order is submitted by an acquiring fund that acquired more than three percent of the ETFs shares in reliance on the proposed rule. Accordingly, we are proposing to include a safe harbor for each of those entities if it has: (i) received a representation from the acquiring fund that none of the ETFs shares the acquiring fund is redeeming includes any shares that it acquired in excess of three percent of the ETFs shares in reliance on proposed rule 12d1-4(a); and (ii) no reason to believe that the acquiring fund is redeeming ETF shares that the acquiring fund acquired in excess of three percent of the ETFs shares in reliance on the proposed rule.222 If an acquiring fund attempts to redeem ETF shares in connection with a threat to coerce the ETF, the ETF would know of the attempt. In those circumstances, or if the principal underwriter, broker or dealer knows or has reason to know of the threat, the entity could not redeem (or submit for redemption) the ETF shares held by the acquiring fund. We believe that the proposed condition prohibiting acquiring funds from redeeming ETF shares acquired in reliance on the proposed rule should sufficiently prevent an acquiring fund from threatening redemptions as a means of coercing an ETF adviser. We request comment on these conditions. Do most funds that invest in ETFs redeem their shares or sell them in secondary market transactions? Would the prohibition on redemption impede the ability of acquiring funds to dispose of ETF shares? Do acquiring funds realize significant benefits from the ability to redeem ETF shares? The proposed conditions limiting redemptions of ETF shares are designed to eliminate the threat of redemption that an acquiring fund could otherwise use to coerce an ETF. Accordingly, the proposed rule does not include the conditions in our exemptive orders that require the ETF223 and the acquiring fund to take measures to prevent the acquiring fund from unduly influencing the ETF.224 We request comment on the exclusion of these conditions from the proposed rule. Is there a concern that if the acquiring fund and ETF do not take particular measures to prevent the acquiring fund from unduly influencing the ETF, acquiring funds may be able more easily to coerce the ETF? Notwithstanding the prohibition on control and redemption, should we be concerned about particular transactions between an acquiring fund (or an acquiring fund affiliate) and an ETF, or an ETFs purchase of securities during an underwriting in which a principal underwriter is an affiliate of the acquiring fund or its adviser? If there is reason for concern about ETF purchases of securities in an affiliated underwriting, is that concern limited to purchases from an affiliate of the acquiring fund or its adviser? Should any specific conditions in the exemptive orders be included in the proposed rule in addition to or in place of the proposed conditions to prevent an acquiring fund or an acquiring fund affiliate from unduly influencing an ETF? 3. Complex StructuresTo prevent the formation of overly complex multi-tiered fund structures, the proposed rule would prohibit an acquired ETF from itself being a fund of funds (i.e., the rule would prohibit a fund of funds of funds, or three-tier fund, structure).225 A fund of ETFs has the potential to become a complicated corporate structure of the kind that concerned Congress when section 12(d)(1) was enacted.226 If an acquiring fund invests in an ETF that in turn invests in other funds (including other ETFs), an acquiring fund shareholder could find it difficult to determine the nature and value of the holdings ultimately underlying his or her investment. The proposed rule is designed to allow an ETF the flexibility to invest in other funds in order to meet its investment objectives while preventing shareholder confusion as to the nature of their investment in an acquiring fund by limiting the extent of those ETF investments.227 We request comment on the proposed limits on an ETF itself being a fund of funds. Are the proposed limits on an underlying ETFs investments in other funds sufficient to prevent investor confusion? If not, what limits should the proposed rule include to prevent shareholder confusion? Should the proposed rule include the same limit (and exceptions to the limit) as in our exemptive orders?228 Are there reasons not to restrict the ability of an acquired ETF itself to invest in other funds, including ETFs, beyond the limits of section 12(d)(1)(A)?229 Does the fact that ETF shares trade more like a typical equity security make it less likely that investors would be confused if we were to allow an acquiring fund to invest in an ETF that itself invests more than ten percent of its assets in other ETFs in reliance on proposed rule 12d1-4? 4. Layering of FeesAs discussed above, one of Congress concerns regarding fund of funds arrangements was that acquiring fund shareholders might pay excessive charges due to duplicative fees at the acquiring and acquired fund levels.230 To prevent duplicative fees at the acquiring and acquired fund levels, the proposed rule would limit sales charges and service fees charged by the acquiring fund to those set forth in the Financial Industry Regulatory Authoritys ("FINRA") sales charge rule, which takes into consideration fees charged at both levels of a fund of funds arrangement.231 In addition, like all acquiring funds, funds that invest in ETFs would be subject to our disclosure rules for fund investments in other funds. These rules require all registered funds to disclose in their prospectus fee tables expenses paid by both the acquiring and acquired funds so that shareholders can evaluate the costs of investing in a fund that invests in other funds, including ETFs.232 These rules and the proposed fee limit may fully address congressional concerns with th |
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