Securities Regulation Daily SEC modernizes ETF regime, extends ‘test-the-waters,’ and proposes limiting OTC ‘piggyback exception’
Thursday, September 26, 2019

SEC modernizes ETF regime, extends ‘test-the-waters,’ and proposes limiting OTC ‘piggyback exception’

By John M. Jascob, J.D., LL.M.

A new Commission rule will allow qualifying ETFs to come to market without having to seek individual exemptive relief while a second new rule permits all issuers to gauge the interest of institutional investors prior to filing a registration statement.

The SEC has adopted seriatim new rules that modernize the regulation of exchange-traded funds (ETFs) and extend the "test-the-waters" accommodation previously available only to emerging growth companies (EGCs). New Investment Company Act Rule 6c-11 seeks to establish a clear and consistent framework governing ETFs while replacing the hundreds of individualized exemptive orders that have allowed ETFs to operate since the SEC approved the first ETF in 1992. New Securities Act Rule 163B will permit any issuer or authorized person to communicate with potential investors that are reasonably believed to Qualified Institutional Buyers (QIBs) or institutional accredited investors to determine whether those investors might have an interest in a registered securities offering (Exchange-Traded FundsRelease No. 33-10695, September 25, 2019; Solicitations of Interest Prior to a Registered Public OfferingRelease No. 33-10699, September 25, 2019).

Separately, the Commission proposed to update Exchange Act Rule 15c2-11, adopted in 1971 and last substantively amended in 1991, which sets forth the requirements for broker-dealers that publish quotations for over-the-counter (OTC) securities. The proposed amendments aim to provide greater transparency to OTC securities investors, which are primarily retail investors, by requiring that information about the issuer and the security be current and publicly available before a broker-dealer can begin quoting that security. Importantly, the proposal limits the eligibility for an existing exception, commonly known as the "piggyback exception," which allows broker-dealers to publish quotations for a security in reliance on the quotations of another broker-dealer that initially performed the review of the issuer’s information (Publication or Submission of Quotations Without Specified InformationRelease No. 34-87115, September 25, 2019).

"These rulemakings share common themes," said SEC Chairman Jay Clayton in a public statement. "They modernize decades-old regulations, taking account of our experience, advances in communications technology and changes in the operation of our markets. Importantly, these common sense actions better align our regulations with the preferences and investor protection interests of our long-term Main Street investors, while also facilitating capital formation."

Exchange-traded funds. In a news release, the Commission states that adoption of Investment Company Act Rule 6c-11 will allow ETFs to come to market more quickly without the time or expense of applying for individual exemptive relief. The new rule will also facilitate greater competition and innovation in the ETF marketplace, leading to more choice for investors, and will reflect the SEC’s 27 years of experience with these investment products. SEC-registered ETFs have now grown to $3.32 trillion in total net assets and account for approximately 16 percent of total net assets managed by investment companies.

Rule 6c-11 will exempt qualifying open-end ETFs from certain provisions of the Investment Company Act and its rules, subject to certain conditions. ETFs that are organized as unit investment trusts (UITs) or are structured as a share class of a multi-class fund, however, will not be able to rely upon the new rule. Leveraged or inverse ETFs and non-transparent ETFs will also not be able to rely on the rule.

The exemptions will permit a qualifying ETF to: (1) redeem shares only in creation unit aggregations; (2) permit ETF shares to be purchased and sold at market prices, rather than NAV; (3) engage in in-kind transactions with certain affiliates; and (4) in certain limited circumstances, pay authorized participants the proceeds from the redemption of shares in more than seven days.

The conditions include the following:

  • An ETF will be required to provide daily portfolio transparency on its website.
  • An ETF will be permitted to use "custom baskets" that do not reflect a pro-rata representation of the fund’s portfolio or that differ from the initial basket used in transactions on the same business day if the ETF adopts written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders.
  • An ETF will be required to disclose certain information on its website, including historical information regarding premiums and discounts and bid-ask spread information.

One year after the effective date of Rule 6c-11, the SEC is rescinding exemptive relief previously granted to ETFs that will be permitted to operate in reliance on the rule in order to create a consistent ETF regulatory framework. The Commission is also rescinding exemptive relief permitting ETFs to operate in a master-feeder structure but is grandfathering certain existing master-feeder arrangements and preventing the formation of new ones. In addition, the SEC is issuing an exemptive order that harmonizes certain related relief under the Exchange Act, including providing exemptive relief to broker-dealers from certain requirements under the Exchange Act with respect to ETFs relying on Rule 6c-11.

The rule, related form amendments, and related exemptive relief will become effective 60 days after publication in the Federal Register.

Extension of "test-the-waters." New Securities Act Rule 163B extends to all issuers the popular "test-the-waters" accommodation that was originally provided only to EGCs with the passage of the JOBS Act in 2012. The new rule allows all issuers to better gauge market interest by permitting any issuer to engage in oral or written communications with potential investors that are, or are reasonably believed to be, QIBs or institutional accredited investors, either prior to or following the filing of a registration statement, to determine whether such investors might have an interest in a registered securities offering. The rule is non-exclusive, and an issuer may rely on other Securities Act communications rules or exemptions when determining how, when, and what to communicate about a contemplated offering.

Under the rule:

  • There are no filing or legending requirements.
  • The communications are deemed to be "offers."
  • Issuers subject to Regulation FD will need to consider whether any information in a test-the-waters communication would trigger disclosure obligations under Regulation FD.

The rule will become effective 60 days after publication in the Federal Register.

Quotations for OTC securities. In a news release announcing the proposed amendments to Exchange Act Rule 15c2-11, the SEC observes that broker-dealers play an integral role in facilitating investor access to OTC securities. As broker-dealers also serve an important gatekeeper, Rule 15c2-11 requires that a broker-dealer review basic information about an issuer before quoting securities to investors in the OTC market. The Commission is concerned, however, that in today’s OTC market, market participants can take advantage of exceptions in the rule to the detriment of retail investors.

Accordingly, the SEC is proposing to limit eligibility for some of the exceptions where an issuer’s information becomes unavailable to the public or is no longer current. The proposedamendments would also add new exceptions for broker-dealers quoting certain OTC securities that may be less susceptible to fraud or manipulation. Specifically, the proposed amendments would:

  • require the documents and information that the Rule requires broker-dealers to obtain and review to be current and publicly available;
  • the piggyback exception would be amended to require, among other things, that issuer information be current and publicly available; and
  • require that certain information be current and publicly available for a broker-dealer to rely on the unsolicited quotation exception to publish quotations by or on behalf of company insiders.

The proposed amendments would also, among other things:

  • limit the piggyback exception only to bid and ask quotations that are published at specified prices;
  • eliminate the piggyback exception during the first 60 calendar days after the termination of a trading suspension under Exchange Act Section 12(k); and
  • eliminate the piggyback exception for securities of "shell companies."

The public comment period will remain open 60 days following publication of the proposal in the Federal Register.

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