SEC Expands Class Relief for Trading in Exchange Traded Funds

On October, 24, 2006, the SEC’s Division of Market Regulation issued class relief from certain rules under the Securities Exchange Act of 1934 (the Exchange Act) for Exchange Traded Funds (ETFs). The class relief expands the scope of previous class relief that the Division issued in 2001 and applies to both Creation Unit transactions and secondary market transactions in ETFs. Specifically, the class relief provides exemptive and no-action relief, as well as interpretive advice, with respect to Rules 10a-1, 10b-17, and 14e-5 under the Exchange Act; Rules 101 and 102 of Regulation M; and Rule 200(g) of Regulation SHO for ETFs that meet certain conditions.

The class relief applies to ETFs that meet the following conditions:

1. The ETF shares are issued by an openend investment company or unit investment trust registered with the SEC under the Investment Company Act of 1940 (1940 Act);
2. The ETF consists of a basket of 20 or more “Component Securities,” with no one Component Security constituting more than 25% of the total value of the ETF;
3. At least 70% of the ETF must be composed of Component Securities that meet the minimum public float and minimum average daily trading volume thresholds under the “actively-traded securities” definition in Regulation M for excepted securities during each of the previous two months of trading prior to formation of the relevant ETF (if the ETF has 200 or more Component Securities, then 50% of the Component Securities must meet the actively-traded securities thresholds);
4. The ETF shares are issued and redeemed in Creation Unit aggregations of 50,000 shares or such other amount in which the value of a Creation Unit is at least $1 million at the time of issuance; and
5. The ETF is managed to track a particular index, all of the components of which have publicly available last sale trade information. The intra-day proxy value of the ETF per share and the value of the “benchmark” index must be publicly disseminated by a major market data vendor throughout the trading day.

The class relief is also subject to certain “rule specific” terms as follows:

Regulation M

• The ETF must be registered under the 1940 Act to issue shares that are redeemable only in Creation Unit aggregations.

Rule 101 of Regulation M

• ETFs satisfying the conditions are generally excepted under Rule 101(c)(4) of Regulation M. As a result, persons who may be deemed to be participating in a distribution of ETF shares will be permitted to bid for or purchase shares during their participation in such a distribution.
• The creation and redemption of Creation Units of ETF shares by a participant in a distribution of ETF shares will not constitute an “attempt to induce any person to bid for or purchase a covered security during the applicable restricted period” under Regulation M.

Rule 102 of Regulation M

• ETFs satisfying the conditions and that are registered as openend management investment companies will be excepted under Rule 102(d)(4) of Regulation M. As a result, such ETFs will be permitted to redeem shares during the continuous offering of shares.

Rule 10a-1

• Where the composite and derivative nature of an ETF is such that it appears that trading in an ETF’s shares would not be susceptible to the short selling practices that Rule 10a-1 is designed to prevent, the ETF will be exempted from the “tick test” under Rule 10a-1. However, the exemption does not apply to secondary market portfolio sales made in connection with the redemption of ETF shares.

Rule 200(g) of Regulation SHO

• Broker-dealers trading ETFs that satisfy the conditions may mark short sales in the ETF “short,” rather than “short exempt,” subject to the following conditions:

1. For each exempt short sale, the various market centers that execute such sales have instituted procedures to “mask” the short sale character of the transaction so that they are executed as short exempt;
2. The market centers monitor on a regular basis to confirm that any such product or transaction continues to meet the conditions for exemptive relief and reinstitute the price test for any product or transaction that fails to satisfy the conditions;
3. A broker-dealer executing exempt short sales will mark such sales as “short,” and in no event will such sales be marked as “long”; and
4. The market centers maintain an audit trail of all such trade executions that is capable of being produced and subject to review upon request by the SEC and other appropriate regulatory authorities.

Rule 10b-17

• RETFs that satisfy the conditions are excepted from the applicable notice requirements of Rule 10b-17.

Rule 14e-5

• Where purchases or redemptions of ETF shares do not appear to result in the abuses in tender offers at which Rule 14e-5 is directed, and as long as any bids or purchases by dealers or managers are not effected for the purpose of facilitating a tender offer, the class relief permits any person acting as dealer-manager of a tender offer for a Component Security to: (1) redeem ETF shares in Creation Unit size aggregations for Component Securities that may include a security subject to the tender offer, and (2) purchase ETF shares during the tender offer.

View the Class Relief

Investment Management FYI is a service of the Investment Management Practice Group of Morgan Lewis. If you have any questions concerning these important legal developments reflected herein, please contact either of the following Morgan Lewis attorneys:

John McGuire
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Ave, NW
Washington, D.C. 20004
Telephone: 202.739.5654
Fax: 202.739.3001
jmcguire@morganlewis.com

Jack Drogin
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Ave, NW
Washington, D.C. 20004
Telephone: 202.739.5380
Fax: 202.739.3001
jdrogin@morganlewis.com