(Article from Registered Funds Alert, May 2015)
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Recent regulatory activity in the ETF space could signal the SEC’s growing comfort-level with innovative ETFs. Notably, the SEC recently approved the adoption of new listing standards for “Paired Class Shares,” a novel and complex actively-managed ETF product. Furthermore, the NYSE recently proposed a rule change that would allow certain qualified actively-managed ETFs to list and trade their shares on the NYSE Arca, Inc. (NYSE Arca) exchange without first seeking approval from the SEC’s Division of Trading and Markets. Taken together with developments regarding non-transparent, actively managed ETFs discussed in a prior Alert, these developments are welcome respites (or potential respites, in the case of the rule proposal) from the cumbersome regulatory process associated with the development of ETFs.
SEC Approves “Paired Class Shares” Rule
On February 18, 2015, the SEC approved NASDAQ Rule 5713 allowing for the listing and trading of “Paired Class Shares” issued by seven new AccuShares ETFs on NASDAQ. The Paired Class Shares function via a novel and somewhat complex mechanism whereby the funds issue and redeem pairs of shares of opposing classes, described as “Up Shares” and “Down Shares.” The values of the opposing classes move in opposite directions as the value of an “Underlying Benchmark,” such as the CBOE Volatility Index. Up Shares are positively linked to the fund’s Underlying Benchmark while Down Shares are negatively linked.
The SEC found that the proposed Rule was consistent with the requirements of the Securities Exchange Act of 1934, in particular that it was consistent with Section 6(b)(5) of the Act which requires, among other things, that NASDAQ’s rules be designed to promote equitable principles of trade and in general protect investors and the public interest.
Notably, Commissioner Kara M. Stein dissented from the Commission’s decision by voicing concern as to whether the rule as adopted would “in general, protect investors and the public interest” as required by Section 6(b)(5) of the Act. Commissioner Stein points out that similarly structured products have “imploded” in the recent past and casts doubt as to whether AccuShares has solved for these past problems. Furthermore, Commissioner Stein believes the complex distribution mechanism which the Paired Class Shares follow make it so that it is “difficult to envision a scenario where even the most sophisticated investors are not exposed to extreme risks.”
NYSE Arca Proposed Rule Change
On March 4, 2015, the SEC published a notice soliciting public comments in connection with a proposed NYSE Arca rule change. NYSE Arca proposes to amend NYSE Arca Equities Rule 8.600 to adopt generic listing standards for securities issued by actively-managed ETFs (Managed Fund Shares). Under current NYSE Arca regulations, each new series of Managed Fund Shares must first seek approval from the SEC’s Division of Trading and Markets before being listed and traded, a process that can often takes several months or longer. If approved, NYSE Arca would be able to list Managed Fund Shares without the additional burden of seeking a separate SEC approval, thereby significantly reducing the cost and time required to launch actively-managed ETFs. Comments on the proposed rule were due March 31, 2015.
The proposed rule would establish generic listing standard criteria for qualifying Managed Fund Shares, including certain requirements for derivative instruments. While there would be no limitation to the percentage of the portfolio that could invest in derivatives, at least 90% of an ETF’s investments in futures and exchange-traded options must consist of futures and options for which the principal market is a member of the Intermarket Surveillance Group or a market with which NYSE Arca has a comprehensive surveillance sharing agreement. In addition, certain information must be disclosed on an ETF’s website including a description of the ETF’s holdings, identity of the asset upon which the derivative is based, the strike price for options, the quantity of derivatives held, maturity date, coupon rate, effective date, market value and the percentage weight of the derivatives in the ETF’s portfolio. Finally, under the proposed rule Managed Fund Shares must have (i) a stated investment objective that must be adhered to under normal market conditions and (ii) its Portfolio Indicative Value widely disseminated by one or more major market data vendors at least every 15 seconds during the “Core Trading Session.”
Outlook
The SEC Staff has noted on several occasions that a rule permitting ETFs to launch without exemptive relief is a priority, although it seems to have been de-prioritized in recent months. While such a rule, at least for traditional ETFs, is long overdue, the SEC’s approval of non-transparent actively managed ETFs, “Paired Class Shares” and NYSE Arca’s rule proposal suggest that regulators are becoming more familiar and comfortable with actively-managed ETFs. In contrast, Commissioner Stein’s dissent regarding paired class ETFs is a sign that proposals for new and complex ETF products may face some resistance from the SEC if they expose investors to higher risks than traditional ETFs.