By Michael W. Mundt, Michael D. Mabry and Fabio Battaglia
UPDATED: The SEC staff has lifted its almost three-year moratorium on the consideration of exemptive applications to permit actively managed exchange-traded funds (ETFs) that would invest in derivatives. In a speech at an ALI CLE Conference on Investment Adviser Regulation in New York City on Dec. 6, 2012, Norm Champ, the Director of the Division of Investment Management at the SEC, announced that “Division staff will no longer defer consideration of exemptive requests under the Investment Company Act relating to actively managed ETFs that make use of derivatives.”1
The moratorium on the use of derivatives by active ETFs was first announced publicly in an SEC press release on March 25, 2010.2 The press release stated that the Division was conducting a review to evaluate the use of derivatives by mutual funds, ETFs and other investment companies, and indicated that, pending completion of this review, the Division would defer consideration of exemptive applications relating to actively managed and leveraged ETFs that would make significant investments in derivatives. Subsequent to the press release, the SEC only granted exemptive relief to actively managed ETFs that would agree not to invest in any options contracts, futures contracts or swap agreements.
On Aug. 31, 2011, the SEC issued a Concept Release on the use of derivatives by investment companies.3 Despite the ongoing prohibition on the use of derivatives in new orders for active ETFs, the Concept Release only presented three questions specific to ETFs: “How do ETFs use derivatives? Do they use derivatives for the same purposes that other open-end funds use them? Does an ETF’s use of derivatives raise unique investor protection concerns under the Investment Company Act?”
In his speech, Mr. Champ noted that the SEC had received more than fifty comment letters on the Concept Release.4 He reported that “[s]ince the comment period ended about a year ago, the staff has been actively analyzing the comments, following up with certain commenters on the issues or suggestions they have raised, and formulating initial recommendations for potential further guidance.” He added that the review is still ongoing, citing “the complexity and significance of the issues relating to funds’ use of derivatives, both for the fund industry and for the protection of investors.”
Despite the continuing derivatives review, Mr. Champ stated that the Division would resume consideration of exemptive applications for active ETFs that intend to use derivatives. Those applications would require two new representations, however, “to address some of the concerns that led to the Division’s decision to defer consideration of these types of applications.” The first representation is that “the ETF’s board 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.” In addition, active ETFs must represent that “the ETF’s disclosure of its use of derivatives in its offering documents and periodic reports is consistent with relevant Commission and staff guidance.” Mr. Champ went on to note that active ETFs may also be subject to restrictions on derivatives imposed by the rules of their listing exchange as well as conditions of regulatory relief granted by the Division of Trading and Markets at the SEC.
The derivatives moratorium has not been lifted for all ETFs, however. The deferral of exemptive applications for “leveraged” ETFs remains in place. The SEC press release announcing the moratorium in 2010 described “leveraged” ETFs as index-based ETFs that seek to deliver multiples or inverse multiples of the daily performance of the selected index using swaps and other derivatives. Without citing any specific issues, Mr. Champ concluded that “[b]ecause of concerns regarding leveraged ETFs . . . we continue not to support new exemptive relief for such ETFs.”
Applicants with currently pending active ETF applications are expected to receive comments that will implement the newly required representations in lieu of the representation prohibiting the use of derivatives. With respect to active ETFs that previously obtained orders subject to the derivatives prohibition, the SEC staff has issued a no-action position that it would not recommend enforcement action if ETFs operating in reliance on such orders invest in options contracts, futures contracts or swap agreements provided that they comply with the new representations.5
1 Champ, Norm, Remarks to the ALI CLE 2012 Conference on Investment Adviser Regulation: Legal and Compliance Forum on Institutional Advisory Services, http://www.sec.gov/news/speech/2012/spch120612nc.htm (Dec. 6, 2012).
2 SEC Staff Evaluating the Use of Derivatives by Funds, Press Release, http://www.sec.gov/news/press/2010/2010-45.htm (March 25, 2010).
3 Use of Derivatives by Investment Companies under the Investment Company Act of 1940, SEC Release No. IC 29776, http://www.sec.gov/rules/concept/2011/ic-29776.pdf (Aug. 31, 2011).
4 See, e.g., Letter from Alison M. Fuller and E. Carolan Berkley of Stradley Ronon Stevens & Young, LLP to Elizabeth M. Murphy, Secretary, U.S. Securities and Exchange Commission, http://www.sec.gov/comments/s7-33-11/s73311-27.pdf (Nov. 7, 2011).
5 Derivatives Use by Actively Managed ETFs, SEC No-Action Letter, http://www.sec.gov/divisions/investment/noaction/2012/moratorium-lift-120612-etf.pdf (publicly available Dec. 6, 2012).
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