On December 6, 2012, Norm Champ, Director of the Division of Investment Management of the Securities and Exchange Commission ("SEC"), announced an end to the moratorium on issuing exemptive orders to non-leveraged, actively managed exchange traded funds ("ETFs") that use derivatives.1 The lifting of the moratorium will permit actively managed, non-leveraged ETFs that use derivatives to actively pursue certain exemptions necessary to offer shares of such funds. Because of the SEC’s and the staff’s continued concerns over the use of leverage by investment companies, the staff will maintain the moratorium for leveraged ETFs.
By way of background, most ETFs track securities indices like conventional mutual funds. However, in the past several years, the ETF marketplace has witnessed the advent of "actively managed" ETFs, as well as ETFs that track specified commodities or currencies. ETFs generally have become popular with investors because they offer greater transparency and liquidity than mutual funds. They may be used in sophisticated trading and hedging strategies and, in many cases, offer lower expenses and certain tax advantages.
Most ETFs are subject to regulation as "investment companies" under the Investment Company Act of 1940 (the "Investment Company Act"). Unlike conventional mutual funds, though, they must apply to the SEC to obtain special exemptions to operate. Importantly, there is also a growing subset of ETFs—primarily ETFs that track specified commodities or currencies—that are not subject to the Investment Company Act (although their shares must be registered under the Securities Act of 1933).
This diverse marketplace and regulatory landscape has led to what some industry observers have characterized as an unlevel playing field. For example, some actively managed ETFs that use derivatives obtained their exemptive relief from the SEC before the moratorium was imposed. The moratorium also did not apply to conventional mutual funds that use derivatives, nor by definition did it apply to non-Investment Company Act regulated ETFs.2
Importantly, even though the moratorium on actively managed ETFs that use derivatives has been lifted, future exemptive requests will require ETF sponsors to make two important representations:
(i) that the ETF’s Board of Directors periodically will review and approve the ETF’s use of derivatives and how the ETF’s investment adviser assesses and manages risk with respect to the ETF’s use of derivatives; and
(ii) that the ETF’s disclosure of its use of derivatives in its offering documents and periodic reports is consistent with relevant SEC and staff guidance.3
Potential Impact on New ETFs
Lifting the moratorium will allow ETF sponsors to register new actively managed ETFs that can use derivatives. New ETFs, however, will have to go through the rigorous process of seeking and obtaining exemptive relief.4 The end of the moratorium also does not change the requirement that actively managed ETFs must receive individual listing authority from the New York Stock Exchange. Nevertheless, lifting the moratorium represents a significant development that may potentially impact the competitive landscape of the ETF industry.
If you have any questions regarding these proposed changes or any other investment-management-related questions, please contact one of the authors or the Reed Smith attorney with whom you usually work.
1. Remarks to the ALI CLE 2012 Conference on Investment Adviser Regulation: Legal and Compliance Forum on Institutional Advisory Services (December 6, 2012), available at http://www.sec.gov/news/speech/2012/spch120612nc.htm; see also SEC Staff Evaluating the Use of Derivatives by Funds (March 25, 2010), available at http://www.sec.gov/news/press/2010/2010-45.htm (announcing the imposition of the moratorium).
2. When the SEC announced the staff moratorium on ETFs that use derivatives, it explained that the use and complexity of derivatives had grown significantly over the past two decades, and that it was consequently appropriate to review the use of derivatives by ETFs and mutual funds. The SEC did not explain why the moratorium was not applied to conventional funds, despite such funds’ use of derivatives having been subject to extensive regulation historically under the leverage, concentration, and diversification provisions of the Investment Company Act.
3. Remarks to the ALI CLE 2012 Conference on Investment Adviser Regulation, supra note 1.
4. It is not clear whether actively managed ETFs that had exemptive applications pending when the moratorium was imposed will experience any sort of accelerated review and approval. In any case, ETFs that had applications pending will need to file amended applications to specifically include the two required representations.
Client Alert 2012-279