On December 10, 2019, the SEC issued orders to grant exemptive relief requested in applications filed by Blue Tractor Group, LLC, Fidelity Management & Research Company, Natixis Advisors, L.P., and T. Rowe Price Associates, Inc. to launch a type of non-transparent exchange-traded fund (“NT ETF”).¹ These Orders granted relief under the Investment Company Act of 1940, as amended (“1940 Act”). NT ETFs require additional relief from the SEC to list their shares on an exchange. Certain NT ETFs have pending applications for this relief. Precidian Funds LLC (“Precidian”) received such an order on May 21, 2019 to operate NT ETFs-branded as “ActiveShares ETFs”-but to date no ActiveShares ETFs have commenced operations.² The applications for exemptive relief described in the Notices present unique models for disclosing information about the NT ETF’s portfolio to financial intermediaries and the public, which differ, in part, from the Precidian model previously approved by the SEC. The substitute disclosure contained in NT ETF applications for exemptive relief can be described as following two general models: a blind trust model (Precidian’s model) and a proxy portfolio model. This memorandum provides background on NT ETFs and an overview of the significant terms of the applications for exemptive relief that adopt a proxy portfolio model (“Proxy Portfolio Model”).

Background

NT ETFs are registered under the 1940 Act as open-end investment companies that operate as ETFs but substitute an alternative form of public portfolio holdings disclosure in lieu of disclosing their full portfolio positions each day. Because they do not disclose their portfolio daily, NT ETFs cannot rely on Rule 6c-11 under the 1940 Act, which permits exchange-traded funds (“ETFs”) to operate without exemptive relief. NT ETFs following the Proxy Portfolio Model either disclose (i) securities expected to be highly correlated with the NT ETF’s portfolio, which may include securities that are part of the NT ETF’s portfolio that have already been publicly disclosed, or (ii) securities that are in the NT ETF’s portfolio but with different weightings (the “Proxy Portfolio”).

NT ETFs, like ETFs, require relief from Section 22(d) of the 1940 Act and Rule 22c-1 thereunder to permit shares of the NT ETFs (“NT Shares”) to trade at market prices on an exchange. As a condition of this relief, the SEC has historically required ETFs to publicly disclose their portfolios each day to support an arbitrage process that is intended to ensure that their shares trade at, or close to, their net asset value per share (“NAV”). The Notices reflect the SEC’s acceptance of the arguments provided by the NT ETF sponsors that the alternative method for facilitating arbitrage described below can be expected to result in an arbitrage process whose effectiveness is comparable to that of existing ETFs.

Arbitrage Mechanism

NT Shares can trade in the market at prices that represent a premium or a discount to NAV. Arbitrageurs, acting as an authorized participant (“AP”) or through an AP, can buy and sell NT Shares on an exchange and trade directly with the NT ETF in “creation” and “redemption” transactions to take advantage of premiums or discounts to NAV. An arbitrageur would use an NT ETF’s substitute disclosure to hedge its exposure to the NT ETF’s portfolio while executing creations or redemptions with the NT ETF in exchange for a basket of securities and other assets, plus any cash amounts (each, a “basket”).

Under the Proxy Portfolio Model, an NT ETF would disclose a Proxy Portfolio each day that is intended to be highly correlated with the securities in the NT ETF’s portfolio. Arbitrageurs would be able to hedge intraday exposures to the NT ETF’s portfolio by buying the assets represented in the Proxy Portfolio. Both the NT ETF and the Proxy Portfolio will be limited to investments that are liquid, listed on an exchange and traded at the same time as the NT Shares.

Creation and Redemption Process

Similar to ETFs, NT ETFs will only issue or redeem NT Shares with APs in exchange for baskets. The basket will consist of the assets in the Proxy Portfolio. Because the securities in the NT ETF’s Proxy Portfolio may not be held by the NT ETF at all, or only to some extent, the NT ETF may have to purchase or sell some or all of these securities if they are included in its basket. Creations and redemptions of the Proxy Portfolio will generally be in kind, but the NT ETF will be permitted to substitute cash in lieu of particular Proxy Portfolio assets or the entire basket.

Adviser and Board Oversight

The Proxy Portfolio Model would impose special oversight responsibilities on the NT ETF’s adviser and its board with respect to the effectiveness of the arbitrage process. The NT ETF’s adviser would be required to adopt policies and procedures to address arbitrage and pricing issues, including when the prices of the NT Shares breaches certain critical thresholds. Specifically, for the first three years after launch, an NT ETF adviser is required to promptly call a meeting of the NT ETF’s board to consider corrective actions if certain thresholds are breached, which include the following:

• “Tracking Error”³ exceeds 1%; or
• for 30 or more days in any quarter or 15 days in a row,
  • the absolute difference between either the market closing price or the bid/ask price, and the NAV, exceeds 2% or a lower threshold set by the NT ETF, or
  • the bid-ask spread exceeds 2% or a lower threshold set by the NT ETF.

Corrective actions include changing lead market makers, the listing exchange, the size of creation units or the ETF’s investment objective or strategy, or liquidating the NT ETF.

In addition, Proxy Portfolio Model requires the adviser to actively monitor trading in the NT Shares and the securities in the NT ETF’s portfolio to identify circumstances where:

• a board meeting is necessary to determine the continuing viability of the NT ETF in the circumstances described above;
• a trading halt of the NT ETF is necessary when 10% or more of the securities in the NT ETF’s portfolio do not have readily available market quotations; and
• an NT ETF needs to disclose on its website a security in the NT ETF’s portfolio but is not in the Proxy Portfolio that lacks readily available market quotations where it may affect the reliability of the Proxy Portfolio as an arbitrage vehicle.

Intellectual Property and Licensing

Each application following the Proxy Portfolio Model represents that the NT ETF’s sponsor has intellectual property rights (in the form of patents or other rights) over certain aspects of the model described therein and that the sponsor intends to enter into license agreements with other NT ETF sponsors that wish to launch NT ETFs using the sponsor’s model. Licensees can file short-form applications requesting substantially similar relief as the precedent application.

Disclosure in Prospectuses and Marketing Materials

To avoid confusion with traditional ETFs and inform investors of the increased risks associated with the Proxy Portfolio Model, each NT ETF will be required to include in its prospectuses and marketing materials disclosures apprising potential investors about the unique nature of the NT ETF and associated risks. This would include a prominent legend that must appear on the outside front cover of prospectuses, on the NT ETF’s website and in any marketing materials. Prospectuses and marketing materials also are required to disclose information about the nature and purpose of the Proxy Portfolio and the risks of premiums and discounts, wider bid-ask spreads and reverse engineering.

The Proxy Portfolio Model exemptive relief is subject to conditions, which include those listed below.

• As with other ETFs, as long as an NT ETF operates in reliance on the requested order, the NT Shares will be listed on an exchange.
• The NT ETF’s website will contain the information required under Rule 6c-11 for ETFs (e.g., the prior business day’s NAV, closing price of the NT Shares and a calculation of the premium or discount of the closing price against such NAV).
• No adviser or subadviser, directly or indirectly, will cause any AP (or person acting through an AP) to acquire any basket security for an NT ETF through a transaction in which the NT ETF could not engage directly.
• The NT ETF and each person acting on its behalf will comply with and agree to be subject to the requirements of Regulation Fair Disclosure as if it applied to them (except that the exemptions provided in Rule 100(b)(2)(iii) therein shall not apply).⁴
• Each NT ETF will be required to maintain and preserve, for a period of not less than five years, in an easily accessible place, (i) all AP agreements; (ii) a copy of the Proxy Portfolio published on the NT ETF’s website for each business day; and (iii) a list of all baskets exchanged with an AP where cash was included in the basket in lieu of some or all of the Proxy Portfolio securities (except for cash included because the securities are not eligible for trading by the AP or the investor on whose behalf the AP is acting), the amount of any such cash in lieu and the identity of the AP conducting the transaction. These basket requirements are similar to what is required under Rule 6c-11 under the 1940 Act, and reflects the SEC’s historical concern that an AP may try to influence the ETF to provide the AP with preferential treatment. These records will likely be reviewed in examinations to see whether basket procedures were appropriately followed.

S&K Webinar

Christopher D. Carlson from Seward & Kissel’s investment management group presented a webinar that discussed the Proxy Portfolio Model and Precidian’s NT ETF exemptive relief in more detail on November 19, 2019. A link to a recording of the webinar is available here:
https://seward1.s3.amazonaws.com/Non-Transparent+ETFs+11.19.19/Non-Transparent+ETFs+11.19.19/index.html

______________________________________________________

¹ Each The SEC previously issued public notices on the applications soliciting requests for a hearing last month, and no hearings were requested. In the Matter of Blue Tractor ETF Trust and Blue Tractor Group, LLC, File No. 812-14625, SEC Rel. Nos. IC-33682 (Nov. 14, 2019) (notice) and IC-33710 (Dec. 10, 2019) (order); In the Matter of Fidelity Beach Street Trust, Fidelity Management & Research Company, FMR Co., Inc. and Fidelity Distributors Corporation, File No. 812-14364, SEC Rel. Nos. IC-33683 (Nov. 14, 2019) (notice) and IC-33712 (Dec. 10, 2019) (order); In the Matter of Natixis Advisors, L.P. and Natixis ETF Trust II, File No. 812-14870, SEC Rel. Nos. IC-33684 (notice) (Nov. 14, 2019) and IC-33711 (Dec. 10, 2019) (order); and In the Matter of T. Rowe Price Associates, Inc. and T. Rowe Price Equity Series, Inc., File No. 812-14214, SEC Rel. Nos. IC-33685 (Nov. 14, 2019) (notice) and IC-33713 (Dec. 10, 2019) (order) (the notices described above are referred to herein collectively as the “Notices” and the orders described above are referred to herein collectively as the “Orders”).

² In the Matter of Precidian ETFs Trust, et al., SEC Rel. No. IC-33477 (May 20, 2019) (order).

³ “Tracking Error” is defined in the Proxy Portfolio Relief as the standard deviation over the past three months of the daily difference, in percentage terms, between the Proxy Portfolio’s NAV and that of the NT ETF at the end of the trading day.

⁴ Regulation Fair Disclosure generally prohibits the selective disclosure of material non-public information to certain third parties without a confidentiality agreement.