[Federal Register: March 18, 2008 (Volume 73, Number 53)]
[Proposed Rules]
[Page 14617-14658]
[DOCID:fr18mr08-30]

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Part III

Securities and Exchange Commission

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17 CFR Parts 239, 270, and 274

Exchange-Traded Funds; Proposed Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 239, 270, and 274

[Release Nos. 33-8901; IC-28193; File No. S7-07-08]
RIN 3235-AJ60

Exchange-Traded Funds

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is proposing a new rule under the Investment Company Act of
1940 that would exempt exchange-traded funds (``ETFs'') from certain
provisions of that Act and our rules. The rule would permit certain
ETFs to begin operating without the expense and delay of obtaining an
exemptive order from the Commission. The rule is designed to eliminate
unnecessary regulatory burdens, and to facilitate greater competition
and innovation among ETFs. The Commission also is proposing amendments
to our disclosure form for open-end investment companies, Form N-1A, to
provide more useful information to investors who purchase and sell ETF
shares on national securities exchanges. In addition, the Commission is
proposing a new rule to allow mutual funds (and other types of
investment companies) to invest in ETFs to a greater extent than
currently permitted under the Investment Company Act.

DATES: Comments should be received on or before May 19, 2008.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>Please include
File Number S7-07-08 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.

All submissions should refer to File Number S7-07-08. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: With respect to proposed rule 6c-11
and amendments to Form N-1A, Dalia Osman Blass, Senior Counsel, or
Penelope Saltzman, Acting Assistant Director,<PHONE_NUMBER>, with
respect to proposed rule 12d1-4 and proposed amendments to rule 12d1-2,
Adam Glazer, Senior Counsel, or Penelope Saltzman, Acting Assistant
Director,<PHONE_NUMBER>, Office of Regulatory Policy, Division of
Investment Management, Securities and Exchange Commission, 100 F
Street, NE., Washington, DC 20549-5041.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public
comment new rules 6c-11 [17 CFR 270.6c-11] and 12d1-4 [17 CFR 270.12d1-
4] and amendments to rule 12d1-2 [17 CFR 270.12d1-2] under the
Investment Company Act of 1940 (``Investment Company Act'' or
``Act''),\1\ and amendments to Form N-1A \2\ under the Investment
Company Act and the Securities Act of 1933 (the ``Securities Act'').\3\
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    \1\ 15 U.S.C. 80a. Unless otherwise noted, all references to
rules under the Investment Company Act will be to Title 17, Part 270
of the Code of Federal Regulations [17 CFR 270], and all references
to statutory sections are to the Investment Company Act.
    \2\ 17 CFR 239.15A, 17 CFR 274.11A.
    \3\ 15 U.S.C. 77a.

Table of Contents

I. Introduction
II. Operation of Exchange-Traded Funds
III. Exemptions Permitting Funds to Form and Operate as ETFs
    A. Scope of Proposed Rule 6c-11
    1. Index-Based ETFs
    2. Actively Managed ETFs
    3. Organization as an Open-End Investment Company
    B. Conditions
    1. Transparency of Index and Portfolio Holdings
    2. Listing on a National Securities Exchange and Dissemination
of Intraday Value
    3. Marketing
    4. Conflicts of Interest
    5. Affiliated Index Providers
    C. Exemptive Relief
    1. Issuance of ``Redeemable Securities''
    2. Trading of ETF Shares at Negotiated Prices
    3. In-Kind Transactions Between ETFs and Certain Affiliates
    4. Additional Time for Delivering Redemption Proceeds
    D. Disclosure Amendments
    1. Delivery of Prospectuses to Investors
    2. Amendments to Form N-1A
    E. Amendment of Previously Issued Exemptive Orders
IV. Exemption for Investment Companies Investing in ETFs
    A. Background
    B. Proposed Rule 12d1-4 Conditions
    1. Control
    2. Redemptions
    3. Complex Structures
    4. Layering of Fees
    C. Scope of Proposed Rule 12d1-4
    1. Acquiring Funds and ETFs Eligible for Relief
    2. Investments in Affiliated ETFs Outside the Fund Complex
    3. Use of Affiliated Broker To Effect Sales
V. Exemption for Affiliated Fund of Funds Investments
    A. Affiliated Fund of Funds Investments in ETFs
    B. Affiliated Fund of Funds Investments in Other Assets
VI. Request for Comment
VII. Paperwork Reduction Act
VIII. Cost-Benefit Analysis
IX. Consideration of Promotion of Efficiency, Competition and
Capital Formation
X. Initial Regulatory Flexibility Analysis
XI. Statutory Authority
    Text of Proposed Rules and Form Amendments

I. Introduction

    Exchange-traded funds are an increasingly popular investment
vehicle.\4\ Last year, the number of ETFs

traded in U.S. markets increased by 67 percent, from 357 to 601, and
the assets held by ETFs increased by about 42 percent, to approximately
$580 billion.\5\ Although aggregate ETF assets are less than seven
percent of assets held by traditional mutual funds (i.e., open-end
investment companies),\6\ they are growing more rapidly.\7\
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    \4\ When we refer to an ETF in this release, we refer to an ETF
that meets the definition of ``investment company'' and is
registered under the Investment Company Act generally because it
issues securities and is primarily engaged or proposes to primarily
engage in the business of investing in securities. Some other types
of exchange-traded funds, which we will not discuss in this release,
invest primarily in commodities or commodity-based instruments, such
as crude oil and precious metal (``commodity ETFs''). Commodity ETFs
are typically organized as trusts, and issue shares that trade on a
securities exchange like other ETFs, but they are not ``investment
companies'' under the Investment Company Act. See section 3(a)(1)
(defining the term ``investment company'' as a company that ``(A) is
or holds itself out as being engaged primarily, or proposes to
engage primarily, in the business of investing, reinvesting, or
trading in securities; (B) is engaged or proposes to engage in the
business of issuing face-amount certificates of the installment
type, or has been engaged in such business and has any such
certificate outstanding; or (C) is engaged or proposes to engage in
the business of investing, reinvesting, owning, holding, or trading
in securities, and owns or proposes to acquire investment securities
having a value exceeding 40 per centum of the value of such issuer's
total assets (exclusive of Government securities and cash items) on
an unconsolidated basis.''). 15 U.S.C. 80a-3(a)(1).
    \5\ Investment Company Institute (``ICI''), Outline of
Supplemental Tables for Exchange-Traded Fund Report (http://
members.ici.org/stats/etfdata.xls (``ICI ETF Statistics 2007'')),
Exchange-Traded Fund Assets December 2007, Jan. 30, 2008 (``ICI ETF
Assets 2007''). ICI statistics cited in this release may be found
at: http://www.ici.org/stats/etf/index.html and exclude commodity
ETFs. By comparison, 153 ETFs were introduced in 2006, 50 were
introduced in 2005, and 32 ETFs were introduced in 2004. ICI, 2007
Investment Company Fact Book, May 2007.
    \6\ In 2007, net new investment in ETFs was approximately $142
billion compared to $212 billion in traditional mutual funds, or 67
percent of net new investment in traditional mutual funds. ICI ETF
Statistics 2007, supra note 5; ICI, Trends in Mutual Fund Investing
December 2007, Jan. 30, 2008 (``ICI Trends December 2007'').
    \7\ ICI ETF Assets 2007, supra note 5. As of December 2007,
assets held by traditional equity and bond mutual funds were $8.9
trillion. ICI Trends December 2007, supra note 6. In 2007, ETF
assets grew 42 percent (from $407.9 billion to $579.5 billion) while
traditional equity and bond mutual fund assets grew 9.7 percent
(from $8.06 trillion to $8.9 trillion). See ICI ETF Statistics 2007,
supra note 5; ICI Trends December 2007, supra note 6.
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    ETFs offer public investors an undivided interest in a pool of
securities and other assets and thus are similar in many ways to
traditional mutual funds, except that shares in an ETF can be bought
and sold throughout the day like stocks on an exchange through a
broker-dealer.\8\ ETFs therefore possess characteristics of traditional
mutual funds, which issue redeemable shares, and of closed-end
investment companies, which generally issue shares that trade at
negotiated market prices on a national securities exchange and are not
redeemable.\9\
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    \8\ ETF shares represent an undivided interest in the portfolio
of assets held by the fund. ETFs are registered with the Commission
and are organized either as open-end investment companies or unit
investment trusts (``UITs''). See section 5(a)(1) of the Investment
Company Act (defining ``open-end company'' as a management company
that is offering for sale or has outstanding any redeemable security
of which it is the issuer); section 4(2) of the Act (defining ``unit
investment trust'' as an investment company that (A) is organized
under a trust indenture, contract of custodianship or agency, or
similar instrument, (B) does not have a board of directors, and (C)
issues only redeemable securities, each of which represents an
undivided interest in a unit of specified securities, but does not
include a voting trust). 15 U.S.C. 80a-5(a)(1).
    \9\ ETFs today have certain characteristics that have made them
attractive to investors. Many have lower expense ratios and certain
tax efficiencies compared to traditional mutual funds, and they
allow investors to buy and sell shares at intra-day market prices.
Moreover, investors can sell ETF shares short, write options on
them, and set market, limit, and stop-loss orders on them. The
shares of many ETFs often trade on the secondary market at prices
close to the net asset value (``NAV'') of the shares, rather than at
discounts or premiums.
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    Since they were first developed in the early 1990s, ETFs have
evolved. The first ETFs held a basket of securities that replicated the
component securities of broad-based stock market indexes, such as the
S&P 500.\10\ Many of the newer ETFs are based on more specialized
indexes,\11\ including indexes that are designed specifically for a
particular ETF,\12\ bond indexes,\13\ and international indexes.\14\
Originally marketed as opportunities for investors to participate in
tradable portfolio or basket products, ETFs are held today in
increasing amounts by institutional investors (including mutual funds)
and other investors as part of sophisticated trading and hedging
strategies.\15\ Shares of ETFs can be bought and held (sometimes as a
core component of a portfolio),\16\ or they can be traded frequently as
part of an active trading strategy.\17\
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    \10\ See, e.g., SPDR Trust, Series 1, Investment Company Act
Release Nos. 18959 (Sept. 17, 1992) [57 FR 43996 (Sept. 23, 1992)]
(notice) and 19055 (Oct. 26, 1992) (order) (``SPDR Order'');
Diamonds Trust, Investment Company Act Release Nos. 22927 (Dec. 5,
1997) [62 FR 65453 (Dec. 12, 1997)] (notice) and 22979 (Dec. 30,
1997) (order). The S&P 500 stands for the Standard & Poor's 500
Composite Stock Price Index.
    \11\ ETF providers offer ETFs that track the performance of
indexes related to particular industries or market sectors. In 2007,
domestic sector/industry ETFs increased by 62% from 135 to 219. ICI
ETF Assets 2007, supra note 5.
    \12\ Many of these indexes are essentially portfolios of assets
that are compiled (and change) on the basis of criteria that the
index provider has designed for the particular ETF. Some indexes,
for example, are ``fundamental'' indexes or rules-based indexes, in
which the securities are chosen on criteria such as dividends and
core earnings. See, e.g., PowerShares Exchange-Traded Fund Trust,
Investment Company Act Release Nos. 25961 (Mar. 4, 2003) [68 FR
11598 (Mar. 11, 2003)] (notice) (``PowerShares 2003 Notice'') and
25985 (Mar. 28, 2003) (order) (``PowerShares 2003 Order'')
(PowerShares offers ETFs that mirror custom-built indexes based on
``Intellidexes,'' which were created by a quantitative unit of the
American Stock Exchange). A few of the index providers that compile
and revise the indexes are affiliated with the sponsor of the ETF.
See, e.g., WisdomTree Investments, Investment Company Act Release
Nos. 27324 (May 18, 2006) [71 FR 29995 (May 24, 2006)] (notice)
(``WisdomTree Notice'') and 27391 (June 12, 2006) (order)
(``WisdomTree Order'') (WisdomTree's ETFs seek to track the price
and yield performance of domestic and international equity
securities indexes provided by an affiliate).
    \13\ As of December 2007, 49 ETFs track bond indexes. ICI,
Exchange-Traded Fund Assets December 2007, Jan. 30, 2008. See, e.g.,
Ameristock ETF Trust, Investment Company Act Release Nos. 27847 (May
30, 2007) [72 FR 31113 (June 5, 2007)] (notice) (``Ameristock
Notice'') and 27874 (June 26, 2007) (order); Vanguard Bond Index
Funds, Investment Company Act Release Nos. 27750 (Mar. 9, 2007) [72
FR 12227 (Mar. 15, 2007)] (notice) and 27773 (Apr. 2, 2007) (order);
Barclays Global Fund Advisors, Investment Company Act Release Nos.
27608 (Dec. 21, 2006) [71 FR 78235 (Dec. 28, 2006)] (notice)
(``Barclays High Yield Notice'') and 27661 (Jan. 17, 2007) (order).
    \14\ The first international equity ETFs were introduced in
1996. As of December 2007, there were 159 ETFs that provide exposure
to international equity markets. ICI, Exchange-Traded Fund Assets
December 2007, Jan. 30, 2008. International index-based ETFs
increased by 87% from 85 in 2006 to 159 in 2007. Id.
    \15\ David Hoffman, Funds' grip loosens as ETFs gain,
InvestmentNews, Apr. 28, 2006 (reporting that in 2004, 44% of 821
advisory firms polled by Financial Research Corp. of Boston said
they collectively allocated an average of 12% of total assets under
management to ETFs as compared with 2003, in which only 34% used
ETFs and collectively allocated an average of 8% of assets under
management).
    \16\ See, e.g., iShares Trust, Investment Company Act Release
No. 25969 (Mar. 21, 2003) [68 FR 15010 (Mar. 27, 2003)].
    \17\ See Gary L. Gastineau, Exchange-Traded Funds Manual, 2
(2002) (``Gastineau'') (ascribing the popularity of ETFs among
active traders to high trading volume, competitive market makers,
and active arbitrage pricing.). Morgan Stanley, Exchange-Traded
Funds Quarterly Report, Nov. 16, 2006, at 13 (``They can be used by
market timers wishing to gain or reduce exposure to entire markets
or sectors throughout the trading day.'').
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    Like money market funds first offered in the 1970s, ETFs represent
a new type of registered investment company (``fund''). And like money
market funds, they have required exemptions from certain provisions of
the Act before they can commence operations.\18\ Since 1992, the
Commission has issued 61 orders to ETFs and their sponsors.\19\
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    \18\ See rule 2a-7 under the Act, which codified the standards
for granting the applications filed by money market funds for
exemptions from the pricing and valuation provisions of the Act. For
a discussion of the administrative history of rule 2a-7, see
Valuation of Debt Instruments and Computation of Current Price per
Share by Certain Open-End Investment Companies (Money Market Funds),
Investment Company Act Release No. 12206 (Feb. 1, 1982) [47 FR 5428
(Feb. 5, 1982)].
    \19\ Since 2000, the Commission has provided ETF sponsors relief
for any ETFs created in the future in connection with their
exemptive orders so that the sponsors can introduce new ETFs if the
ETFs meet the terms and conditions contained in the exemptive
orders. See, e.g., Barclays Global Fund Advisors, Investment Company
Act Release Nos. 24394 (Apr. 17, 2000) [65 FR 21219 (Apr. 20, 2000)]
(notice) and 24451 (May 12, 2000) (order).
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    In this release, we propose a new rule that would codify the
exemptive orders we have issued to ETFs. Proposed rule 6c-11 would
allow new competitors (i.e., those sponsors who do not already have
exemptive orders) to enter the market more easily. We also are
proposing amendments to our registration form for open-end funds, Form
N-1A, to provide more useful information to individual investors who
purchase and sell ETF shares on national securities exchanges. Finally,
we are proposing a new rule to allow funds to invest in ETFs to a
greater extent than currently permitted under the Act and our rules.

II. Operation of Exchange-Traded Funds

    All ETFs trading today operate in a similar way.\20\ Unlike
traditional mutual funds, ETFs do not sell or redeem their individual
shares (``ETF shares'') at net asset value (``NAV''). Instead,
financial institutions purchase and redeem ETF shares directly from the
ETF, but only in large blocks called ``creation units.'' \21\ A
financial institution that purchases a creation unit of ETF shares
first deposits with the ETF a ``purchase basket'' of certain securities
and other assets identified by the ETF that day, and then receives the
creation unit in return for those assets. The basket generally reflects
the contents of the ETF's portfolio and is equal in value to the
aggregate NAV of the ETF shares in the creation unit. After purchasing
a creation unit, the financial institution may hold the ETF shares, or
sell some or all in secondary market transactions.\22\
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    \20\ Until recently, all ETFs had an investment objective of
seeking returns that are correlated to the returns of a securities
index, and in this respect operated much like traditional index
funds. Recently, we issued orders approving actively managed ETFs.
See WisdomTree Trust, et al., Investment Company Act Release Nos.
28147 (Feb. 6, 2008) [73 FR 7776 (Feb. 11, 2008)] (notice)
(``WisdomTree Actively Managed ETF Notice'') and 28174 (Feb. 27,
2008) (order) (``WisdomTree Actively Managed ETF''); Barclays Global
Fund Advisors, et al., Investment Company Act Release Nos. 28146
(Feb. 6, 2008) [73 FR 7771 (Feb. 11, 2008)] (notice) and 28173 (Feb.
27, 2008) (order) (``Barclays Actively Managed ETF''); Bear Sterns
Asset Management, Inc., et al., Investment Company Act Release Nos.
28143 (Feb. 5, 2008) [73 FR 7768 (Feb. 11, 2008)] (notice) and 28172
(Feb. 27, 2008) (order) (``Bear Sterns Actively Managed ETF'');
PowerShares Capital Management LLC, et al., Investment Company Act
Release Nos. 28140 (Feb. 1, 2008) [73 FR 7328 (Feb. 7, 2008)]
(notice) (``PowerShares Actively Managed ETF Notice'') and 28171
(Feb. 27, 2008) (order) (``PowerShares Actively Managed ETF'' and
collectively, ``Actively Managed ETF Orders'').
    \21\ As discussed further below, creation units typically
consist of at least 25,000 ETF shares. See infra note 113.
    \22\ We note that depending on the facts and circumstances,
broker-dealers that purchase a creation unit and sell the shares may
be deemed to be participants in a distribution, which could render
them statutory underwriters and subject them to the prospectus
delivery and liability provisions of the Securities Act. See 15
U.S.C. 77b(a)(11).
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    Like operating companies and closed-end funds, ETFs register
offerings and sales of ETF shares under the Securities Act and list
their shares for trading under the Securities Exchange Act of 1934
(``Exchange Act'').\23\ As with any listed security, investors may
trade ETF shares at market prices. ETF shares purchased in secondary
market transactions are not redeemable from the ETF except in creation
units.
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    \23\ 15 U.S.C. 78a.
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    The redemption process is the reverse of the purchase process. The
financial institution acquires (through purchases on national
securities exchanges, principal transactions, or private transactions)
the number of ETF shares that comprise a creation unit, and redeems the
creation unit from the ETF in exchange for a ``redemption basket'' of
securities and other assets.\24\ An investor holding fewer ETF shares
than the amount needed to constitute a creation unit (most retail
investors) may dispose of those ETF shares by selling them on the
secondary market. The investor receives market price for the ETF
shares, which may be higher or lower than the NAV of the shares, and
pays customary brokerage commissions on the sale.
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    \24\ ETFs sometimes provide cash-in-lieu payments on some (or
all) purchases or redemptions. See infra notes 120-121 and
accompanying text.
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    The ability of financial institutions to purchase and redeem
creation units at each day's NAV creates arbitrage opportunities that
may help keep the market price of ETF shares near the NAV per share of
the ETF. For example, if ETF shares begin trading on national
securities exchanges at a price below the fund's NAV per share,
financial institutions can purchase ETF shares in secondary market
transactions and, after accumulating enough shares to comprise a
creation unit, redeem them from the ETF in exchange for the more
valuable securities in the ETF's redemption basket. Those purchases
create greater market demand for the ETF shares, and thus tend to drive
up the market price of the shares to a level closer to NAV.\25\
Conversely, if the market price for ETF shares exceeds the NAV per
share of the ETF itself, a financial institution can deposit a basket
of securities in exchange for the more valuable creation unit of ETF
shares, and then sell the individual shares in the market to realize
its profit. These sales would increase the supply of ETF shares in the
secondary market, and thus tend to drive down the price of the ETF
shares to a level closer to the NAV of the ETF share.\26\
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    \25\ The purchase of the ETF shares on the secondary market
combined with the sale of the redemption basket securities also may
create upward pressure on the price of ETF shares and/or downward
pressure on the price of redemption basket securities, driving the
market price and ETF NAV closer together.
    \26\ The institution's purchase of the purchase basket
securities combined with the sale of ETF shares also may create
downward pressure on the price of ETF shares and/or upward pressure
on the price of purchase basket securities, driving the market price
and the ETF's NAV closer together.
    ETF sponsors and market participants report that the average
deviation between the daily closing price and the daily NAV of ETFs
that track domestic indexes is generally less than 2%. See, e.g.,
Vanguard U.S. Stock ETFs, Prospectus 56-59 (Apr. 27, 2007). ETFs
that track foreign indexes may have a more significant deviation.
See, e.g., iShares FTSE/Xinhua China 25 Index Fund, Prospectus 19
(Dec. 1, 2006).
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    Arbitrage activity in ETF shares is facilitated by the transparency
of the ETF's portfolio. Each day, the ETF publishes the identities of
the securities in the purchase and redemption baskets, which are
representative of the ETF's portfolio.\27\ Each exchange on which the
ETF shares are listed typically discloses an approximation of the
current value of the basket on a per share basis (``Intraday Value'')
\28\ at 15 second intervals throughout the day and, for index-based
ETFs, disseminates the current value of the relevant index.\29\ This
transparency can contribute to the efficiency of the arbitrage
mechanism because it helps arbitrageurs determine whether to purchase
or redeem creation units based on the relative values of ETF shares in
the secondary market and the securities contained in the ETF's
portfolio.
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    \27\ With respect to index-based ETFs, portfolio transparency is
enhanced by the transparency of the underlying index. Index
providers publicly announce the components of their indexes. Because
an index-based ETF seeks to track the performance of an index, often
by replicating the component securities of the index, the
transparency of the underlying index results in a high degree of
transparency in the ETF's investment operations. Similarly, each of
the actively managed ETFs operating under the recent exemptive
orders approved by the Commission is required to make public each
day the securities and other assets in its portfolio. See Actively
Managed ETF Orders, supra note 20.
    \28\ The Intraday Value also is referred to as the Intraday
Indicative Value, Indicative Optimized Portfolio Value, Indicative
Fund Value, Indicative Trust Value, or Indicative Partnership Value.
    \29\ National securities exchanges are permitted to disseminate
this information at 60 second intervals for ETFs that track non-U.S.
indexes. See, e.g., Commentary .01(b)(2) to NYSE Acra Equities Rule
5.2(j)(3); Commentary 0.2(a)(C)(c) to American Stock Exchange
Constitution and Rules & Arbitration Awards Rule 1000A.
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    Arbitrage activity in ETF shares also appears to be affected by the
liquidity of the securities in an ETF's portfolio. Most ETFs represent
in their applications for exemptive relief that they invest in highly
liquid securities.\30\

Effective arbitrage depends in part on the ability of financial
institutions to readily assemble the basket for purchases of creation
units and to sell securities received upon redemption of creation
units, and liquidity appears to be a factor in this process. An ETF's
investment in less liquid securities may reduce arbitrage efficiency
and thereby increase both the likelihood that a deviation between ETF
share market price and NAV per share may occur and the amount of any
deviation that does occur.
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    \30\ Index-based ETFs track indexes that have specified
methodologies for selecting their component securities. The
methodologies generally ensure that an index consists of securities
that will be highly liquid. See, e.g., Barclays High Yield Notice,
supra note 13 (``The Underlying Index is a rules-based index
designed to reflect the 50 most liquid U.S. dollar-denominated high-
yield corporate bonds registered for sale in the U.S. or exempt from
registration.''). Because index-based ETFs either replicate or
sample the indexes, their portfolio securities also should possess
these characteristics. The actively managed ETFs also appear to
invest in highly liquid securities. See WisdomTree Actively Managed
ETF, supra note 20 (investing in U.S. and foreign money market
securities); Barclays Actively Managed ETF, supra note 20 (investing
in foreign money market securities); Bear Sterns Actively Managed
ETF, supra note 20 (investing primarily in investment-grade fixed
income securities); PowerShares Actively Managed ETF, supra note 20
(investing in large cap companies or U.S. government and corporate
debt securities).
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III. Exemptions Permitting Funds To Form and Operate as ETFs

    Today we are proposing for public comment a new rule that would
codify much of the relief and many of the conditions of orders that we
have issued to index-based ETFs in the past, and more recently to
certain actively managed ETFs. The proposed rule is designed to enable
most ETFs to begin operations without the need to obtain individual
exemptive relief from the Commission.

A. Scope of Proposed Rule 6c-11

1. Index-Based ETFs
    Proposed rule 6c-11, like our orders, would provide exemptions for
ETFs that have a stated investment objective of maintaining returns
that correspond to the returns of a securities index whose provider
discloses on its Internet Web site the identities and weightings \31\
of the component securities and other assets of the index.\32\ In this
respect, the rule would codify our previous exemptive orders. Our
experience is that the conditions included in the index-based ETF
orders have effectively preserved the statutory purposes of the Act.
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    \31\ Proposed rule 6c-11(e)(9) defines ``weighting of the
component security'' as ``the percentage of the index's value
represented, or accounted for, by such component security.''
    \32\ Proposed rule 6c-11(e)(4)(v)(B) (defining ``exchange-traded
fund''); see infra Section III.B.1 for a discussion of this index
transparency requirement. Index-based ETFs obtain returns that
correspond to those of an underlying index by replicating or
sampling the component securities of the index. An ETF that uses a
replicating strategy generally invests in the component securities
of the underlying index in the same approximate proportions as in
the underlying index. See, e.g., First Trust Exchange-Traded Fund,
Investment Company Act Release No. 27051 (Aug. 26, 2005) [70 FR
52450 (Sept. 2, 2005)] (``First Trust Notice'') at n.1. If, however,
there are practical difficulties or substantial costs involved in
holding every security in the underlying index, the ETF may use a
representative sampling strategy pursuant to which it will invest in
some but not all of the relevant component securities. An ETF that
uses a sampling strategy includes in its portfolio securities that
are designed, in the aggregate, to reflect the underlying index's
capitalization, industry, and fundamental investment
characteristics, and to perform like the index. The ETF implements
the sampling strategy by acquiring a subset of the component
securities of the underlying index, and possibly some securities
that are not included in the corresponding index that are designed
to help the ETF track the performance of the index. See, e.g., id.
---------------------------------------------------------------------------

    The proposed rule would not limit the types of indexes that an ETF
may track or the types of securities that comprise any index. Thus, the
rule would not limit the exemption to ETFs investing in liquid
securities or assets, although existing ETFs generally have represented
to us that their portfolios are comprised of highly liquid
securities,\33\ and, as open-end funds, are required to comply with the
liquidity guidelines applicable to all open-end funds.\34\
---------------------------------------------------------------------------

    \33\ See supra note 30 and accompanying and following text. See
also WisdomTree Notice, supra note 12 at n.8 and accompanying text.
    \34\ Long-standing Commission guidelines have required open-end
funds to hold no more than 15% of their net assets in illiquid
securities and other illiquid assets. See Statement Regarding
``Restricted Securities,'' Investment Company Act Release No. 5847
(Oct. 21, 1969) [35 FR 19989 (Dec. 31, 1970)]; Revisions of
Guidelines to Form N-1A, Investment Company Act Release No. 18612
(Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)]. A fund's portfolio
security is illiquid if it cannot be disposed of in the ordinary
course of business within seven days at approximately the value
ascribed to it by the ETF. See Acquisition and Valuation of Certain
Portfolio Instruments by Registered Investment Companies, Investment
Company Act Release No. 14983 (Mar. 12, 1986) [51 FR 9773 (Mar. 21,
1986)] (adopting amendments to rule 2a-7 under the Act); Resale of
Restricted Securities; Changes to Method of Determining Holding
Period of Restricted Securities under Rules 144 and 145, Investment
Company Act Release No. 17452 (Apr. 23, 1990) [55 FR 17933 (Apr. 30,
1990)] (adopting Rule 144A under the Securities Act).
---------------------------------------------------------------------------

    We request comment regarding the effect of portfolio liquidity on
the potential for deviation between ETF share market price and NAV and
the amount of any deviation. In addition to the liquidity guidelines
applicable to all open-end funds, should the Commission include
additional liquidity requirements as a condition of the exemptions? If
so, what additional requirements and why? Should the chance (or
likelihood) that substantial discounts or premiums may occur if an ETF
portfolio contains less liquid securities or assets be a regulatory
concern for the Commission, or should it be treated as a material risk
to be disclosed to prospective investors, permitting them to evaluate
whether the risk makes the ETF an appropriate investment in light of
the investor's investment objectives? \35\ We note that currently there
is substantially more market interest in ETFs that track broad-based
indexes that are comprised of highly liquid securities than ETFs that
track more specialized indexes.\36\ How would liquidity or illiquidity
of securities or other assets in an ETF's portfolio affect the ability
of financial institutions to assemble securities for a purchase basket
and thus the arbitrage mechanism and operation of the ETF? Would
liquidity requirements preclude the development of specialty ETFs that
serve narrow investment purposes but which may satisfy particular
investment needs of certain investors?
---------------------------------------------------------------------------

    \35\ The Commission is proposing an amendment to Form N-1A that
would codify the condition in our orders that ETFs disclose the
extent and frequency with which market prices have tracked their
NAV. See infra notes 169-170 and accompanying text.
    \36\ See ICI ETF Statistics 2007, supra note 5.
---------------------------------------------------------------------------

2. Actively Managed ETFs
    We recently issued exemptive orders to several actively managed
ETFs and their sponsors.\37\ Like our orders, proposed rule 6c-11 would
provide an exemption for an actively managed ETF that discloses on its
Internet Web site each business day the identities and weightings of
the component securities and other assets held by the ETF.\38\ Unlike
index-based ETFs, an actively managed ETF does not seek to track the
return of a particular index. Instead, an actively managed ETF's
investment adviser, like an adviser to any traditional actively managed
mutual fund, generally selects securities consistent with the ETF's
investment objectives and policies without regard to a corresponding
index.
---------------------------------------------------------------------------

    \37\ See Actively Managed ETF Orders, supra note 20.
    \38\ Proposed rule 6c-11(e)(4)(v)(A); see infra Section III.B.1
for a discussion of this requirement.
---------------------------------------------------------------------------

    In 2001, we sought comment on the concept of an actively managed
ETF (``2001 Concept Release'').\39\ We requested comment on a broad
number of questions that we felt were important to consider before
expanding the scope of the exemptive orders we had issued. We wanted to
know how investors would use an actively managed ETF because it seemed
that, unlike an investment in an index-based ETF, an investment in an
actively managed ETF could not be used, for example, to implement a
hedging strategy. We questioned whether an actively managed ETF would
provide investors with the same or similar benefits as

index-based ETFs, including potential tax efficiencies and low expense
ratios.
---------------------------------------------------------------------------

    \39\ See Actively Managed Exchange-Traded Funds, Investment
Company Act Release No. 25258 (Nov. 8, 2001) [66 FR 57614 (Nov. 15,
2001)] (``2001 Concept Release'').
---------------------------------------------------------------------------

    Our 2001 Concept Release also asked more focused questions about
the structural and operational differences between the two types of
ETFs and how those differences might affect the market value of ETF
shares. We inquired whether as a matter of public policy an ETF must be
designed to enable efficient arbitrage and thereby minimize the
probability that ETF shares would trade at a material premium or
discount.\40\ We asked, for example, whether actively managed ETFs must
have the same degree of portfolio transparency as index-based ETFs, a
factor that appeared to contribute significantly to arbitrage
efficiency.\41\ It was unclear to us at that time whether an adviser to
actively managed ETFs would be willing to provide the same degree of
transparency as an adviser to index-based ETFs because, for example,
disclosure could allow market participants to access the fund's
investment strategy.\42\ We were concerned that reduced transparency
could expose arbitrageurs to greater investment risk and result in a
less efficient arbitrage mechanism, which in turn could lead to more
significant premiums and discounts than experienced by index-based
ETFs.
---------------------------------------------------------------------------

    \40\ Id. at text following n.35.
    \41\ See supra note 27 and accompanying text.
    \42\ We also noted concerns that full disclosure could permit
market participants to ``front-run'' portfolio trades. See infra
text accompanying and preceding note 84. In addition, because
actively managed portfolios likely would change more frequently and
in less foreseeable ways than a portfolio of index-based ETFs, we
were unclear how or whether an actively managed ETF would
communicate intra-day portfolio changes to investors. See generally,
Russ Wermers, The Potential Effects of More Frequent Portfolio
Disclosure on Mutual Fund Performance, Investment Company Institute
Perspective, June 2001, Vol. 7, No. 3, at http://www.ici.org/
perspective/per07-03.pdf. (examining the potential effects of more
frequent portfolio disclosure on the performance of mutual funds and
concluding that, with more frequent disclosure, shareholders would
likely receive lower total returns on their investments due to,
among other things, front-running and free-riding).
---------------------------------------------------------------------------

    We received 20 comments from market participants, many of which
supported the introduction of actively managed ETFs.\43\ Many
commenters stated that actively managed ETFs would have the potential
to provide investors with uses and benefits similar to index-based
ETFs. For example, commenters maintained that, like index-based ETFs,
actively managed ETFs could potentially serve as short-term or long-
term investment vehicles, allow investors to gain exposure to an asset
category such as value, growth or income, and play a significant role
in an investor's hedging strategies.\44\ Commenters also asserted that
actively managed ETFs have the potential for providing investors
benefits similar to index-based ETFs, including low expense ratios and
intra-day exchange trading.\45\ Other commenters, however, questioned
whether some of the investor benefits traditionally associated with
index-based ETFs would be present with actively managed ETFs.\46\
---------------------------------------------------------------------------

    \43\ The comment letters to the 2001 Concept Release are
available for public inspection and copying in the Commission's
Public Reference Room, 100 F Street, NE., Washington, DC 20549 (File
No. S7-20-01), and are available on the Commission's Internet Web
site: (http://www.sec.gov/rules/concept/s72001.shtml.)
    \44\ See, e.g., Comment Letter of the American Stock Exchange
LLC, File No. S7-20-01 (Mar. 5, 2002) (``For example, an investor
may find that a particular actively managed ETF more closely tracks
his securities holdings, and therefore may be a more effective
hedge.''); Comment Letter of State Street Bank and Trust Company,
File No. S7-20-01 (Jan. 14, 2002). One commenter asserted, however,
that actively managed ETFs would be of greater interest to retail
investors; institutional investors would not use active fund
products for hedging, cash equitization or other strategies. Comment
Letter of Barclays Global Investors, File No. S7-20-01 (Jan. 11,
2002).
    \45\ See, e.g., Comment Letter of the American Stock Exchange
LLC, File No. S7-20-01 (Mar. 5, 2002); Comment Letter of State
Street Bank and Trust Company, File No. S7-20-01 (Jan. 14, 2002).
    \46\ One commenter, for example, asserted that an actively
managed ETF would likely not experience similar tax efficiency
because that is predominantly a function of the low portfolio
turnover of index-based ETFs. The commenter also noted that actively
managed ETFs are unlikely to have the low expenses associated with
index-based ETFs, which result primarily from lower advisory fees
associated with the passive management of those funds. Comment
Letter of the Vanguard Group, File No. S7-20-01 (Feb. 14, 2002).
---------------------------------------------------------------------------

    Commenters agreed that actively managed ETFs should be designed,
like index-based ETFs, with an arbitrage mechanism intended to minimize
the potential deviation between market price and NAV of ETF shares.\47\
Not all commenters agreed, however, on whether we should be concerned
with the extent of premiums or discounts and, therefore, whether we
should require full portfolio transparency. Some asserted that the
amount of any discount or premium that might develop ought not to be a
consideration for us in determining whether to grant exemptive
relief.\48\ One commenter argued that ETFs with share prices that
significantly deviate from NAV would likely not attract the interest of
investors and would ultimately fail if they did not provide information
necessary for market participants to make knowledgeable investment
decisions.\49\ Other commenters asserted that it is important to
require that ETFs provide all investors with the same information about
portfolio holdings \50\ and to require clear fund disclosures regarding
the risks associated with the level of transparency provided.\51\ These
commenters stressed the need, however, for sufficient market
information to

value the fund's portfolio.\52\ Others argued that portfolio
transparency is essential to support effective arbitrage.\53\ One
commenter asserted that any lack of transparency would negatively
impact an ETF's arbitrage mechanism and would likely result in ETF
shares trading at secondary market prices that do not reflect the value
of the ETF's underlying portfolio.\54\ The commenter noted that to the
extent an ETF operates with less than full transparency during periods
of market volatility, this would likely result in some individual
investors buying or selling ETF shares at secondary market prices
moving in the opposite direction of the ETF's NAV. The commenter urged
us to consider carefully the consequence of granting an exemption that
might yield such a result.\55\ The Investment Company Institute
asserted that to the extent that all or part of an ETF's portfolio is
not transparent, it could raise significant investor protection
concerns including the potential for disparate treatment of investors
and the potential for the ETF to trade at significant premiums and
discounts.\56\
---------------------------------------------------------------------------

    \47\ See, e.g., Comment Letter of the Vanguard Group, File No.
S7-20-01 (Feb. 14, 2002); Comment Letter of Barclays Global
Investors, File No. S7-20-01 (Jan. 11, 2002).
    \48\ See, e.g., Comment Letter of the American Bar Association,
Committee on Federal Regulation of Securities, File No. S7-20-01
(Feb. 1, 2002) (``We believe that the Commission should not mandate
the level of transparency in ETFs' portfolios, but rather should
allow fully informed demand in the financial markets to determine
the proper levels. Different segments of the market with different
needs might demand investment vehicles with different variation. To
prevent market demand from determining the structure of investment
vehicles would retard efficiency, competition, and capital
formation.''); Comment Letter of State Street Bank and Trust
Company, File No. S7-20-01 (Jan. 14, 2002) (``* * *[A] non-
transparent actively managed ETF will be no worse off than closed-
end funds trading today. In fact, the premium/discount of a non-
transparent ETF should be narrower due to the ETF's open-ended
qualities.''); Comment Letter of the Vanguard Group, File No. S7-20-
01 (Feb. 14, 2002) (``While [spreads] may be higher for actively
managed ETFs than for index ETFs, we do not believe that the
discounts between market price and NAV will approach those seen in
closed-end funds.'').
    \49\ See Comment Letter of State Street Bank and Trust Company,
File No. S7-20-01 (Jan. 14, 2002); see also Comment Letter of the
American Bar Association, Committee on Federal Regulation of
Securities, File No. S7-20-01 (Feb. 1, 2002) (``Ultimately it is in
the interest of the sponsor and investment adviser to provide for
effective arbitrage opportunities. It is unlikely that an actively
managed ETF sponsor would be able to convince the critical market
participants such as specialists, market makers, arbitragers and
other Authorized Participants to support a product that contained
illiquid securities to a degree that would affect the liquidity of
the ETF, making it difficult to price, trade and hedge, ultimately
leading to its failure in the marketplace.'').
    \50\ See, e.g., Comment Letter of the Vanguard Group, File No.
S7-20-01 (Feb. 14, 2002) (``Sponsors of actively managed ETFs should
not be permitted to provide more information about portfolio
holdings to the exchange specialist and market makers than they
provide to other investors. Vanguard believes, as a matter of
fundamental fairness, that all investors in a fund must be treated
equally. Providing information only to a favored few is inconsistent
with the foundation of our capital markets--full and fair disclosure
to all investors.'').
    \51\ See, e.g., Comment Letter of Morgan Stanley & Co., File No.
S7-20-01 (May 3, 2002) (``Even if the Commission were to determine
that new forms of ETFs do pose a significant risk of trading at a
discount or premium to NAV, we do not believe that the Commission
should delay approval of the product for this reason. Instead, we
would urge the Commission to address any perceived investor risks by
requiring additional risk disclosure.''); Comment Letter of the
Vanguard Group, File No. S7-20-01 (Feb. 14, 2002) (``Investors in an
actively managed ETF must receive adequate disclosure about the
risks associated with the level of the ETF's transparency (and other
risks unique to actively managed ETFs) * * * if the ETF has limited
transparency, the fund's disclosure documents should discuss the
possibility that the spreads between bid and asked prices and
between the market price and NAV of the fund's exchange-traded
shares may be higher than is typically the case of index ETFs.'').
    \52\ See, e.g., Comment Letter of the American Stock Exchange
LLC, File No. S7-20-01 (Mar. 5, 2002) (asserting that non-
transparent actively managed ETFs need not disclose the full
contents of their portfolios ``so long as there is sufficient market
information available to value the portfolio or a creation unit (or
if different, the Redemption Basket) on an intra-day basis so as to
facilitate secondary market trading and hedging.''); Comment Letter
of State Street Bank and Trust Co., File No. S7-20-01 (``While the
importance of an effective arbitrage mechanism is clear, there are
potential ways to achieve an effective arbitrage mechanism with less
than full transparency, and, potentially, with no portfolio
transparency. This may be accomplished with proper disclosure of an
actively managed ETF's investment strategy and portfolio
characteristics.'').
    \53\ See, e.g., Comment Letter of Barclays Global Investors,
File No. S7-20-01 (Jan. 11, 2002) (``It is generally accepted that
portfolio transparency is the key to effective arbitrage. Therefore,
the most significant issue for the Commission * * * is whether
[actively managed ETFs] would provide the necessary level and
frequency of portfolio disclosure to support efficient
arbitrage.'').
    \54\ Id.
    \55\ Id.
    \56\ Comment Letter of the Investment Company Institute, File
No. S7-20-01 (Jan. 14, 2002).
---------------------------------------------------------------------------

    Today we propose exemptions applicable to both index-based and
actively managed ETFs that provide portfolio transparency to market
participants. The comments we received, together with subsequent
developments, address the principal concerns we raised in the 2001
Concept Release with respect to actively managed ETFs. We have received
a number of applications from actively managed ETFs whose sponsors are
interested in offering fully transparent, actively managed ETFs, and
recently we have issued orders approving several of these ETFs.\57\ As
described in these applications, an actively managed ETF would operate
in the same manner as an index-based ETF.\58\ Each would be registered
under the Act as an open-end fund and would redeem shares in creation
units in exchange for basket assets. Each would be listed on a national
securities exchange, and investors would trade the ETF shares
throughout the day at market prices in the secondary market.\59\ The
national securities exchange typically would disseminate the Intraday
Value of ETF shares at 15-second intervals throughout the trading
day,\60\ thereby providing institutional investors and other
arbitrageurs the information necessary to engage in ETF share purchases
and sales on the secondary market, and purchases and redemptions with
the fund, which should help keep ETF share prices from trading at a
significant discount or premium.\61\ Finally, the actively managed ETFs
represent that they would provide ETF investors with uses and benefits
similar to index-based ETFs.\62\
    We believe that permitting fully transparent, actively managed ETFs
would provide additional investment choices for investors and that
exemptions necessary to permit the operation of these ETFs would be in
the public interest and consistent with the policies and purposes of
the Act. By proposing this rule we are not, however, suggesting that we
will not consider applications for exemptive orders for actively
managed ETFs that do not satisfy the proposed rule's transparency
requirements. Rather, we are at this time proposing to permit fully
transparent, actively managed ETFs to be offered without first seeking
individual exemptive orders from the Commission.
    We request comment on allowing actively managed ETFs with fully
transparent portfolios to rely on the exemptions provided by the
proposed rule. We only recently approved orders to allow certain
actively managed ETFs and have not had the opportunity to observe how
they operate in the markets over a significant period of time. Should
we wait until we have gained greater experience with the operation of
actively managed ETFs before adopting a final rule applicable to them?
Is there any concern that a fully transparent actively managed ETF
would not facilitate an efficient arbitrage mechanism? Would actively
managed ETFs provide investors with uses and benefits similar to or
different than their index-based counterparts? Do these or any other
concerns regarding the operation of a fully transparent actively
managed ETF warrant limiting the rule to index-based ETFs and
considering exemptions for actively managed ETFs on a case by case
basis through the exemptive applications process? Should we consider
exemptions for other types of actively managed ETFs? If so, how would
the arbitrage mechanism work in these ETFs? What kinds of conditions
should we consider in order to facilitate an arbitrage mechanism?
3. Organization as an Open-End Investment Company
    Our proposed rule would be available only to ETFs that are
organized as open-end funds.\63\ We have provided similar exemptions to
unit investment trusts (``UITs'') in the past.\64\ However, because we
have not received an exemptive application for a new ETF to be
organized as a UIT since 2002, there does not appear to be a need to
include UIT relief in the proposed rule.\65\ We understand that ETF
sponsors prefer the open-end fund structure because it allows more
investment flexibility.\66\ In

addition, unlike an ETF that is a UIT, an open-end fund ETF may
participate in securities lending programs and has greater flexibility
in reinvesting dividends received from portfolio securities. Of the 601
ETFs in existence as of December 2007, 593 were organized as open-end
funds.\67\
---------------------------------------------------------------------------

    \57\ See Actively Managed ETF Orders, supra note 20.
    \58\ See id.
    \59\ See infra notes 88-94 and accompanying text for a
discussion of the proposed rule's condition that ETF shares be
approved for listing and trading on a national securities exchange.
    \60\ See infra notes 92-94 and accompanying text for a
discussion of the proposed rule's condition that ETFs be listed on
an exchange that disseminates the Intraday Value of ETF shares on a
regular basis.
    \61\ See supra notes 27-29 and accompanying and following text.
See also Actively Managed ETF Orders supra note 20.
    \62\ See, e.g., In re PowerShares Capital Management LLC, et
al., Fifth Amendment, File No. 812-13386, filed Jan. 7, 2008
(``PowerShares Actively Managed ETF Application''), at 12-13
(available for public inspection and copying in the Commission's
Public Reference Room, 100 F Street, NE., Washington, DC 20549).
    \63\ Proposed rule 6c-11(e)(4).
    \64\ See, e.g., SPDR Order, supra note 10. See supra note 8 for
a definition of UITs.
    \65\ Although two exemptive applications for ETFs organized as
UITs were filed in 2007, the applications were occasioned by the
transfer of the sponsorship from Nasdaq Financial Products Services,
Inc. to PowerShares Capital Management, LLC and did not result in
new ETFs. See BLDRs Index Funds Trust, Investment Company Act
Release No. 27745 (Feb. 28, 2007) [72 FR 9787 (Mar. 5, 2007)]
(``BLDRs Notice''); Nasdaq-100 Trust, Series 1, Investment Company
Act Release No. 27740 (Feb. 27, 2007) [72 FR 9594 (Mar. 2, 2007)].
    \66\ A UIT portfolio is fixed, and substitution of securities
may take place only under certain circumstances. As a result, an ETF
organized as a UIT typically replicates the holdings of the index it
tracks. By contrast, existing ETFs organized as open-end funds may
employ investment advisers and use a ``sampling'' strategy to track
the index. Using a sampling strategy, an investment adviser can
construct a portfolio that is a subset of the component securities
in the corresponding index, rather than a replication of the index.
The investment adviser also may invest a specific portion of the
ETF's portfolio in securities and other financial instruments that
are not included in the corresponding index if the adviser believes
the investment will help the ETF track its underlying index. See,
e.g., First Trust Notice, supra note 32, at. n.1.
    \67\ The number of ETFs organized as UITs is based on
information in the Commission's database of Form N-SAR filings.
---------------------------------------------------------------------------

    We request comment on whether we should include ETFs organized as
UITs in the definition of ETF under the proposed rule. If so, should
they be subject to the same conditions set forth in the proposed rule?

B. Conditions

    ETF sponsors have sought exemptions from certain provisions of the
Act and our rules so that they may register ETFs as open-end funds. The
principal distinguishing feature of open-end funds is that they offer
for sale redeemable securities.\68\ The Act defines ``redeemable
security'' as any security that allows the holder to receive his or her
proportionate share of the issuer's current net assets upon
presentation to the issuer.\69\
---------------------------------------------------------------------------

    \68\ 15 U.S.C. 80a-5(a)(1); see infra notes 109-121 and
accompanying text.
    \69\ 15 U.S.C. 80a-2(a)(32).
---------------------------------------------------------------------------

    Section 22(d) of the Act prohibits any dealer in redeemable
securities from selling open-end fund shares at a price other than a
current offering price described in the fund's prospectus.\70\ Rule
22c-1 under the Act requires funds, their principal underwriters, and
dealers to sell and redeem fund shares at a price based on the current
NAV next computed after receipt of an order to buy or redeem.\71\
Together, these provisions are designed to require that fund
shareholders are treated equitably when buying and selling their fund
shares.\72\
---------------------------------------------------------------------------

    \70\ 15 U.S.C. 80a-22(d).
    \71\ 17 CFR 270.22c-1(a). The rule requires that funds calculate
their NAV at least once daily Monday through Friday (with certain
exceptions, including days on which no securities are tendered for
redemption and the fund receives no orders to purchase or sell
securities). See 17 CFR 270.22c-1(b)(1). Today, most funds calculate
NAV as of the time the major U.S. stock exchanges close (typically
at 4 p.m. Eastern Time). Thus, a fund's NAV generally reflects the
closing prices of the securities it holds. Under rule 22c-1, an
investor who submits an order before the 4:00 p.m. pricing time
receives that day's price, and an investor who submits an order
after the pricing time receives the next day's price.
    \72\ See generally, H.R. Rep. No. 2639, 76th Cong., 3d Sess., 8
(1940). See also Investment Trusts and Investment Companies, Report
of the Securities and Exchange Commission, H.R. Doc. No. 279, 76th
Cong., 1st Sess., pt. 3, at 860-874 (1939).
---------------------------------------------------------------------------

    ETFs seeking to register as open-end funds under the Act require
exemptions from these provisions because certain investors may purchase
and sell individual ETF shares on the secondary market at current
market prices, i.e., at prices other than those described in the ETF's
prospectus or based on NAV. As discussed above, investors (typically
financial institutions) can purchase and redeem shares from the ETF at
NAV only in creation units.\73\ Because these financial institutions
can take advantage of disparities between the market price of ETF
shares and NAV, they may be in a different position than investors who
buy and sell individual ETF shares only on the secondary market.\74\
The disparities in market price and NAV, however, provide those
institutional investors with opportunities for arbitrage that would
tend to drive the market price in the direction of the ETF's NAV to the
benefit of retail investors.\75\
---------------------------------------------------------------------------

    \73\ See supra Section II for a discussion on the operation of
ETFs.
    \74\ See, e.g., Comment Letter of Barclays Global Investors,
File No. S7-20-01 (Jan. 11, 2002) (``[D]uring periods of market
volatility * * * it is not unreasonable to assume that some retail
investors would buy or sell ETF shares at secondary market prices
moving in the opposite direction of a fund's NAV.'').
    \75\ See supra notes 25-26 and accompanying text.
---------------------------------------------------------------------------

    Today, we propose a rule with certain conditions that may permit
the ETF structure to operate within the scope of the Act without
sacrificing appropriate investor protection, and is designed to be
consistent with the purposes fairly intended by the policy and
provisions of the Act.\76\ Our orders have provided exemptions from the
definition of ``redeemable security'' and section 22(d) and rule 22c-1
for ETFs with an arbitrage mechanism that helps maintain the
equilibrium between market price and NAV. Our proposed rule would
codify these exemptions subject to three conditions that appear to have
facilitated the arbitrage mechanism: Transparency of the ETF's
portfolio, disclosure of the ETF's Intraday Value, and listing on a
national securities exchange.
---------------------------------------------------------------------------

    \76\ Section 6(c) of the Act permits the Commission,
conditionally or unconditionally, to exempt by rule any person,
security, or transaction (or classes of persons, securities, or
transactions) from any provision of the Act ``if and to the extent
that such exemption is necessary or appropriate in the public
interest and consistent with the protection of investors and the
purposes fairly intended by the policy and provisions'' of the Act.
15 U.S.C. 80a-6(c).
---------------------------------------------------------------------------

1. Transparency of Index and Portfolio Holdings
    To take advantage of the proposed exemption, an ETF must either (i)
disclose on its Internet Web site each business day the identities and
weightings of the component securities and other assets held by the
fund, or (ii) have a stated investment objective of obtaining returns
that correspond to the returns of a securities index, whose provider
discloses on its Internet Web site the identities and weightings of the
component securities and other assets of the index.\77\ The Web page of
the ETF or the index provider, as the case may be, must be publicly
accessible at no charge.\78\ Thus, the proposed rule would allow for an
actively managed ETF provided that the actively managed ETF discloses
its portfolio assets each business day.\79\
---------------------------------------------------------------------------

    \77\ Proposed rule 6c-11(e)(4)(v).
    \78\ Id.
    \79\ See supra discussion at Section III.A.2. An index-based ETF
that has the investment objective of obtaining returns that
correspond to the returns of multiple securities indexes may rely on
the proposed rule provided that it discloses its portfolio in the
same manner as a fully transparent actively managed ETF.
---------------------------------------------------------------------------

    We seek comment on these transparency conditions. In particular, we
request comment on the proposed provision requiring that an ETF that
tracks an index and does not disclose its portfolio each business day
must track an index whose provider discloses on an Internet Web site
the component securities and other assets of the index it tracks.\80\
Is it necessary for the rule to include this option instead of simply
requiring daily portfolio disclosure by the ETF? What circumstances, if
any, would prevent an index-based ETF from disclosing its portfolio
holdings? \81\ Would Internet Web site disclosure of portfolio holdings
be sufficient? If not, what other means of disclosure should the ETF or
the index provider use?
---------------------------------------------------------------------------

    \80\ The proposed rule defines an ``index provider'' to mean the
person that determines the securities and other assets that comprise
a securities index. See proposed rule 6c-11(e)(7).
    \81\ See supra note 27.
---------------------------------------------------------------------------

    We also seek comment on whether we should require ETFs to disclose
daily on their Internet Web sites liabilities (as well as portfolio
holdings) to permit investors, particularly arbitrageurs, to evaluate
the impact of leverage from borrowings on the fund's portfolio.\82\

Should we limit such a requirement to certain kinds of ETFs that may
have significant liabilities? If so, how should we identify the ETFs
that would be subject to the condition?
---------------------------------------------------------------------------

    \82\ For example, if an ETF enters into a written call to hedge
the fair value exposure of an equity security in its portfolio, it
would sacrifice any unrealized gains caused by the price of the
equity security increasing above the price at which the call may be
exercised (i.e. the strike price). Unless the ETF discloses the
presence of these and similar liabilities, investors may not be able
to evaluate the impact of leverage on the NAV of the ETF.
---------------------------------------------------------------------------

    One of the issues we discussed in the 2001 Concept Release was that
full portfolio transparency could give market participants an ability
to access the fund's market strategies (i.e., ``free-riding'') and, in
some cases, the ability to trade ahead of the ETF (i.e., ``front-
running'').\83\ Those commenters who addressed the issue generally
agreed that intra-day or advance portfolio disclosure may be
detrimental to an actively managed ETF because it could enable third
parties to front-run the fund.\84\ Therefore, the proposed rule does
not require disclosure of intra-day changes in the portfolio of the
ETF, because currently, intra-day changes do not affect the composition
of the ETF's basket assets until the next trading day.\85\ The proposed
rule also does not require advance disclosure of portfolio trades.\86\
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    \83\ Market participants could trade ahead of an ETF if it
disclosed portfolio assets in advance of the trades, rather than
after the assets were acquired.
    \84\ See, e.g., Comment Letter of the Vanguard Group, File No.
S7-20-01 (Feb. 14, 2002); Comment Letter of the Investment Company
Institute, File No. S7-20-01 (Jan. 14, 2002).
    \85\ Applicants seeking exemptions for actively managed ETFs
noted that under accounting procedures followed by the funds,
portfolio trades made on the prior business day (``T'') would be
booked and reflected in the fund's NAV on the current business day
(``T+1''). See, e.g., WisdomTree Actively Managed ETF Notice, supra
note 20, at n.5. As a result, these funds will not have to announce
trades before they are made. In addition, the funds will be able to
disclose at the beginning of each trading day the portfolio that
will form the basis of the NAV calculation at the end of the day.
Id.
    \86\ See proposed rule 6c-11(e)(4)(v)(A). Under the proposed
rule, an ETF could disclose its portfolio at the end of the day on
which relevant portfolio trades occurred (i.e., after the portfolio
assets are acquired) or the beginning of the following day, which
would eliminate the potential for front-running.
---------------------------------------------------------------------------

    We request comment on these aspects of the proposal. Should the
rule require disclosure of portfolio changes more often than once a
day? How would more frequent disclosure affect the arbitrage mechanism?
Would more frequent disclosure increase the likelihood of free-riding
or front-running? The rule does not limit ETFs to tracking specialized
indexes that change their assets at or below a specified frequency. How
might this affect the transparency of the portfolios of ETFs that would
rely on index rather than portfolio disclosure? \87\
---------------------------------------------------------------------------

    \87\ See supra note 77 and accompanying text.
---------------------------------------------------------------------------

    Should the proposed rule prohibit advance portfolio disclosure?
Would advance portfolio disclosure increase the likelihood of free-
riding or front-running? If so, should the risk that participants may
engage in these activities be treated as a material risk to be
disclosed to prospective investors permitting them to evaluate whether
the risk makes the ETF an appropriate investment in light of the
particular investor's investment objectives? How would advance
disclosure affect the arbitrage mechanism? If the portfolio disclosed
in advance differed from the actual portfolio acquired, would that
affect the market's ability to price the ETF's shares?
2. Listing on a National Securities Exchange and Dissemination of
Intraday Value
    An ETF that relies on rule 6c-11 would need to satisfy two
additional conditions set forth in the paragraph defining ``exchange-
traded fund.'' \88\ First, shares issued by the ETF would have to be
approved for listing and trading on a national securities exchange.\89\
We have premised our previous exemptive orders on the ETF listing its
shares for trading on a national securities exchange.\90\ Listing on an
exchange would provide an organized and continuous trading market for
the ETF shares at negotiated prices. Applicants for exemptive relief
have noted that this intra-day trading, combined with the arbitrage
mechanism inherent in the ETF structure, should prevent significant
premiums and discounts between the market price of ETF shares and the
Intraday Value.\91\
---------------------------------------------------------------------------

    \88\ Proposed rule 6c-11(e)(4) (defining ``exchange-traded
fund'').
    \89\ Proposed rule 6c-11(e)(4)(iii).
    \90\ See, e.g., HealthShares, Inc., Investment Company Act
Release No. 27553 (Nov. 16, 2006) [71 FR 67404, 67408 (Nov. 21,
2006)] (``HealthShares Notice'').
    \91\ See, e.g., Amended and Restated Application of Ziegler
Exchange Traded Trust, File No. 812-13224, filed Dec. 19, 2006
(``Ziegler Application''), at 10; PowerShares Actively Managed ETF
Notice, supra note 20.
---------------------------------------------------------------------------

    Second, an ETF could rely on the rule only if a national securities
exchange disseminates the Intraday Value at regular intervals during
the trading day.\92\ Applications for exemptive relief have noted that
exchanges typically disseminate the Intraday Value every 15 seconds
during trading hours.\93\ They have also asserted that this regular
dissemination of the Intraday Value enables market makers to engage in
the arbitrage activities that determine the market price for ETF
shares.\94\
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    \92\ Proposed rule 6c-11(e)(4)(i).
    \93\ See, e.g., Van Eck, Van Eck Associates Corp., Investment
Company Act Release No. 27283 (Apr. 7, 2006) [71 FR 19214 (Apr. 13,
2006)], at n.3; PowerShares Actively Managed ETF Notice, supra note
20, at n.2.
    \94\ See, e.g., Ziegler Application, supra note 91, at 26-27.
---------------------------------------------------------------------------

    We request comment on these two conditions. Should the rule require
that ETF shares be listed on a national securities exchange? Should the
rule make allowance for shares that are delisted for a short time, or
for suspensions in listing? If an ETF's shares were not listed for
trading on a national securities exchange (even on a temporary basis),
would the ETF structure permit the arbitrage mechanism to function
appropriately? Should the rule require an ETF to liquidate or take
other steps in the event of delisting? Should the proposed rule
condition relief on listing exchanges disseminating the Intraday Value?
If not, are there other means for market makers to receive the Intraday
Value? Are there alternatives to using the basket as the basis for the
Intraday Value calculation? For example, should the rule require the
entity calculating the Intraday Value to use the ETF's portfolio (as
opposed to the basket)? Should the calculation method be prescribed?
    The proposed rule does not require the dissemination of an ETF's
Intraday Value at specific intervals because the rules of national
securities exchanges, as approved by the Commission, establish the
frequency of disclosure.\95\ Should the rule specify a minimal
frequency? For example, should the rule prohibit an ETF from relying on
the exemption if it is listed on an exchange that permits dissemination
at intervals longer than the current 15 or 60-second intervals?
---------------------------------------------------------------------------

    \95\ An ETF's Intraday Value is disseminated every 15 seconds
(or 60 seconds in the case of ETFs that track foreign indexes). See
supra note 29 and accompanying text.
---------------------------------------------------------------------------

3. Marketing
    Our exemptive orders included a condition requiring each ETF to
agree not to market or advertise the ETF as an open-end fund or mutual
fund and to explain that ETF shares are not individually
redeemable.\96\ This condition was designed to help prevent retail
investors from confusing ETFs with traditional mutual funds. Similarly,
the proposed rule would require each ETF relying on the rule to
identify itself in any sales literature as an ETF that does not sell or
redeem individual shares, and explain that investors may purchase or
sell individual ETF shares in secondary market transactions that do not
involve

the ETF.\97\ This condition, like the prior condition in our orders, is
designed to help prevent retail investors from confusing ETFs with
traditional mutual funds.
---------------------------------------------------------------------------

    \96\ See, e.g., WisdomTree Order, supra note 12.
    \97\ Proposed rule 6c-11(e)(4)(ii). The term sales literature is
defined in the proposed rule to mean any advertisement, pamphlet,
circular, form letter, or other sales material addressed to or
intended for distribution to prospective investors other than a
registration statement filed with the Commission under section 8 of
the Act. Proposed rule 6c-11(e)(8). An ETF would have to make
similar disclosures in its prospectus under the proposed amendments
to Form N-1A. See proposed Item 6(h)(3) of Form N-1A, and infra text
accompanying note 159.
---------------------------------------------------------------------------

    We request comment on whether the proposed condition is likely to
provide a benefit for investors with respect to ETF marketing and
advertising materials. Are investors confused about the distinction
between ETFs and traditional mutual funds? Should any confusion be
addressed through rule requirements? Should the rule require ETFs to
identify themselves as either index-based or actively managed ETFs?
4. Conflicts of Interest
    Section 1(b)(2) of the Investment Company Act states that the
public interest and the interest of investors are adversely affected
when investment companies are organized, operated, managed, or their
portfolio securities are selected, in the interest of directors,
officers, investment advisers, or other affiliated persons, and
underwriters, brokers, or dealers rather than in the interest of
shareholders.\98\ The operation of an ETF--specifically, the process in
which a creation unit is purchased by delivering basket assets to the
ETF, and redeemed in exchange for basket assets--may lend itself to
certain conflicts for the ETF's investment adviser, which has
discretion to specify the securities included in the baskets. For
example, the adviser could direct creation unit purchasers to purchase
securities from affiliates of the adviser for subsequent presentation
to the ETF. As we noted in the 2001 Concept Release, these conflicts
would appear to be minimized in the case of an index-based ETF because
the universe of securities that may be included in the ETF's portfolio
generally is restricted by the composition of its corresponding
index.\99\ We also noted that the same would not appear to be the case
for an actively managed ETF. Because the adviser to an actively managed
ETF would have greater discretion to designate securities to be
included in the basket assets, a greater potential for conflicts
appears to exist.
---------------------------------------------------------------------------

    \98\ 15 U.S.C. 80a-1(b)(2).
    \99\ See 2001 Concept Release, supra note 39, at Section IV.E.2.
---------------------------------------------------------------------------

    Commenters generally stated that actively managed ETFs would not be
faced with conflicts that are different from those that currently exist
for actively managed mutual funds.\100\ One commenter, however,
recommended that the Commission impose any prohibitions or conditions
under the Act that would apply to transactions directly effected by the
adviser on any transactions effected at the adviser's discretion.\101\
The commenter noted that, for example, an ETF that is prohibited from
acquiring a security in certain underwritings (under section 10(f) of
the Act) \102\ should be prohibited from circumventing this prohibition
by including the security in the ETF's basket assets. Similarly, an
adviser could attempt to circumvent section 17(a) restrictions on
principal transactions between a registered fund and its affiliates by
designating a security for the basket assets that a creation unit
purchaser would have to purchase from an affiliate of the adviser.\103\
---------------------------------------------------------------------------

    \100\ See, e.g., Comment Letter of the American Stock Exchange
LLC, File No. S7-20-01 (Mar. 5, 2002); Comment Letter of State
Street Bank and Trust Company, File No. S7-20-01 (Jan. 14, 2002);
Comment Letter of Nuveen Investments, File No. S7-20-01 (Jan. 14,
2002).
    \101\ Comment Letter of the Investment Company Institute, File
No. S7-20-01 (Jan. 14, 2002).
    \102\ Section 10(f) of the Act prohibits a fund from purchasing
any security during an underwriting or selling syndicate if a
principal underwriter of the security is an officer, director,
member of an advisory board, investment adviser, or employee of the
fund or if any of these persons is an affiliate of the principal
underwriter. 15 U.S.C. 80a-10(f). This section protects fund
shareholders by preventing an affiliated underwriter from placing or
``dumping'' unmarketable securities in the fund.
    \103\ Section 17(a) generally prohibits affiliated persons of a
registered fund (``first-tier affiliates'') or affiliated persons of
the fund's affiliated persons (``second-tier affiliates'') from
selling securities or other property to the fund (or any company the
fund controls). 15 U.S.C. 80a-17(a).
---------------------------------------------------------------------------

    We have not included a condition in the proposed rule prohibiting
an actively managed ETF's adviser, directly or indirectly, from causing
a creation unit purchaser to acquire a security for the ETF through a
transaction in which the ETF could not engage directly. An adviser to
an actively managed ETF already is subject to section 48(a) of the Act,
which prohibits a person from doing indirectly, through another person,
what that person is prohibited by the Act from doing directly. An
adviser, therefore, would be prohibited from causing an institution
that transacts directly with the ETF (or any investor on whose behalf
the institution may transact with the ETF) to acquire any security for
the ETF through a transaction in which the ETF could not engage
directly.\104\
---------------------------------------------------------------------------

    \104\ See Lessler v. Little, 857 F.2d 866, 873-874 (1st Cir.
1988) (reversing dismissal of a claim that principals of a
registered investment company and its adviser had violated sections
17(a)(2) and 48(a) of the Act by purchasing the fund's assets
indirectly by arranging for sale of the fund to a third party in
conjunction with an arrangement whereby the adviser obtained
excessive interest in the transferred assets); SEC v. Commonwealth
Chemical Securities, 410 F. Supp 1002, 1018 (S.D.N.Y. 1976) (finding
violations of sections 17(a) and 48(a) of the Act by directors of a
registered investment company who caused a third party to purchase
shares in an offering underwritten by an affiliated broker-dealer
and sold the shares to the registered investment company).
---------------------------------------------------------------------------

    We request comment on whether it would be useful to include a
condition in the proposed rule reminding ETFs relying on the rule of
the prohibitions contained in section 48(a) of the Act. We also request
comment on potential conflicts of interest for an ETF's investment
adviser. Does an adviser to a fully transparent, actively managed ETF
face different conflicts of interest from the conflicts of an adviser
to a traditional mutual fund? If so, what are those conflicts and how
could the rule address them?
5. Affiliated Index Providers
    Federal securities laws and the rules of national securities
exchanges require funds and their advisers to adopt measures reasonably
designed to prevent misuse of non-public information.\105\ Funds are
likely to be in a position to well understand the potential
circumstances and relationships that could give rise to the misuse of
non-public information, and can develop appropriate measures to address
them. We believe these requirements should be sufficient to protect
against the abuses addressed by the terms in the exemptive applications

of ETF sponsors that represented they would use an affiliated index
provider. The proposed rule, therefore, does not include terms from
previous applications that are designed to prevent the communication of
material non-public information between the ETF and the affiliated
index provider.\106\
---------------------------------------------------------------------------

    \105\ See rule 38a-1 (requiring funds to adopt policies and
procedures reasonably designed to prevent violation of federal
securities laws); rule 17j-1 (requiring funds to adopt a code of
ethics containing provisions designed to prevent certain fund
personnel (``access persons'') from misusing information regarding
fund transactions); Section 204A of the Investment Advisers Act of
1940 (``Advisers Act'') (15 U.S.C. 80b-204A) (requiring an adviser
to adopt policies and procedures that are reasonably designed,
taking into account the nature of its business, to prevent the
misuse of material, non-public information by the adviser or any
associated person, in violation of the Advisers Act or the Exchange
Act, or the rules or regulations thereunder); Section 15(f) of the
Exchange Act (15 U.S.C. 78o(f)) (requiring a registered broker or
dealer to adopt policies and procedures reasonably designed, taking
into account the nature of the broker's or dealer's business, to
prevent the misuse of material, nonpublic information by the broker
or dealer or any person associated with the broker or dealer, in
violation of the Exchange Act or the rules or regulations
thereunder).
    See, e.g. Rule Commentary .02(b)(i) of American Stock Exchange
Rule 1000A (requiring ``firewalls'' between an ETF and an affiliated
index provider).
    \106\ The terms are intended to address the potential conflicts
of interest between the ETF adviser and its affiliated index
provider, and include: (i) All of the rules that govern inclusion
and weighting of securities in each index are made publicly
available; (ii) the ability to change the rules for index
compilation is limited and public notice is given before any changes
are made; (iii) ``firewalls'' exist between (A) the staff
responsible for the creation, development and modification of the
index compilation rules and (B) the portfolio management staff; (iv)
the calculation agent, who is responsible for all index maintenance,
calculation, dissemination, and reconstitution activities, is not
affiliated with the index provider, the ETF or any of their
affiliates; and (v) the component securities of the index may not be
changed more frequently than on a specified periodic basis. See
HealthShares Notice, supra note 90; WisdomTree Notice, supra note
12.
---------------------------------------------------------------------------

    We request comment on our proposal to eliminate these terms. Should
the rule include any of the terms included in previous exemptive
applications for affiliated index providers? If so, which terms and
why?

C. Exemptive Relief

    The unique structure of ETFs has required ETF sponsors to seek
relief from certain provisions of the Act and our rules in order to
form and operate. Proposed Rule 6c-11 would permit an ETF that meets
the conditions of the rule to redeem shares in creation unit
aggregations, to trade at current market prices, to engage in in-kind
transactions with certain affiliates and, in certain circumstances, to
pay the proceeds from the redemption of shares in more than seven days.
The proposed exemptions would be subject to certain conditions that are
designed to address the concerns underlying the statute and thereby
satisfy the requirement that exemptions from statutory provisions are
in the public interest and consistent with the protection of investors
and the purposes fairly intended by the policy of the Act.\107\
---------------------------------------------------------------------------

    \107\ See 15 U.S.C. 80a-6(c).
---------------------------------------------------------------------------

1. Issuance of ``Redeemable Securities''
    Our exemptive orders have provided ETFs with relief from sections
2(a)(32) and 5(a)(1) \108\ of the Act so that they may register under
the Act as open-end funds while issuing shares that are redeemable in
creation units only.\109\ In support of the relief, ETF sponsors have
noted that because the market price of ETF shares is disciplined by
arbitrage opportunities, investors in ETF shares generally should be
able to sell the shares in secondary market transactions at
approximately their NAV.\110\
---------------------------------------------------------------------------

    \108\ 15 U.S.C. 80a-2(a)(32) (defining ``redeemable security''
as any security the terms of which permit the holder upon
presentation to receive the holder's proportionate share of the
issuer's current net assets, or the cash equivalent); 15 U.S.C. 80a-
5(a)(1).
    \109\ These exemptions are granted under section 6(c) of the
Act. See supra note 76.
    \110\ See, e.g., Ziegler Exchange Traded Trust, Investment
Company Act Release No. 27610 (Dec. 22, 2006) [72 FR 163 (Jan. 3,
2007)] (``Ziegler Notice''); PowerShares Actively Managed ETF
Notice, supra note 20, at text following n.5.
---------------------------------------------------------------------------

    Proposed rule 6c-11 would deem an equity security issued by an ETF
to be a ``redeemable security'' for purposes of section 2(a)(32) of the
Act.\111\ This provision would permit an ETF to register with the
Commission as an open-end fund, which the Act defines as an investment
company that issues redeemable securities,\112\ even though ETF shares
are issued and redeemed in creation unit aggregations.\113\ This
approach would provide ETFs with the same relief contained in our
exemptive orders without exempting ETFs from other requirements imposed
under the Act and our rules that apply to funds that issue redeemable
securities.\114\
---------------------------------------------------------------------------

    \111\ Proposed rule 6c-11(a). Our orders provided an exemption
from sections 2(a)(32) and 5(a)(1) to allow ETFs to redeem
securities in creation unit aggregations rather than individually.
    \112\ See 15 U.S.C. 80a-5(a)(1).
    \113\ ETF creation units have ranged from 25,000 to 200,000 ETF
shares. See, e.g., PowerShares Actively Managed ETF Notice, supra
note 20 (creation units are blocks of 50,000 to 100,000 ETF shares);
ProShares Trust, Investment Company Act Release No. 27323 (May 18,
2006) [71 FR 29991 (May 24, 2006)] (notice) (``ProShares Notice'')
(creation units are blocks of 25,000 to 50,000 ETF shares);
WisdomTree Notice, supra note 12 (creation units are blocks of
25,000 to 200,000 ETF shares).
    \114\ See, e.g., 15 U.S.C. 80a-22; 17 CFR 270.22c-1. In
addition, the rules under the Exchange Act that apply to redeemable
securities issued by a mutual fund would apply to ETFs. See, e.g.,
17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    We request comment on this aspect of the proposed rule. Are there
differences in ETFs and other funds that would justify not applying any
provision of the Act or our rules that applies to funds that issue
redeemable securities?
    As discussed above, ETFs today operate with an arbitrage mechanism
designed to minimize the potential deviation between the market price
and NAV of ETF shares. The proposed rule would require that an ETF
establish creation unit sizes the number of shares of which are
reasonably designed to facilitate arbitrage, which is described in the
proposed definition of creation unit as the purchase (or redemption) of
shares from the ETF with an offsetting sale (or purchase) of shares on
a national securities exchange at as nearly the same time as
practicable for the purpose of taking advantage of a difference in the
Intraday Value and the current market price of the shares.\115\ The
proposed rule also would require an ETF to disclose in its prospectus
and any sales literature the number of ETF shares for which it will
issue or redeem a creation unit to alert investors that they cannot
purchase or redeem individual ETF shares directly from or with the
ETF.\116\
---------------------------------------------------------------------------

    \115\ Proposed rule 6c-11(e)(3). We note that the Board of
Governors of the Federal Reserve defines ``arbitrage'' in a similar
manner in section 220.6(b) of Regulation T (``Arbitrage. A creditor
may effect and finance for any customer bona fide arbitrage
transactions. For the purpose of this section, the term ``bona fide
arbitrage'' means: (1) A purchase or sale of a security in one
market together with an offsetting sale or purchase of the same
security in a different market at as nearly the same time as
practicable for the purpose of taking advantage of a difference in
prices in the two markets; or (2) A purchase of a security which is,
without restriction other than the payment of money, exchangeable or
convertible within 90 calendar days of the purchase into a second
security together with an offsetting sale of the second security at
or about the same time, for the purpose of taking advantage of a
concurrent disparity in the prices of the two securities.''). 12 CFR
220.6.
    \116\ Proposed rule 6c-11(e)(4)(ii); Proposed Item 6(h)(3) to
Form N-1A.
---------------------------------------------------------------------------

    The proposed condition regarding creation unit size is intended to
require ETFs that rely on the proposed rule to choose creation unit
sizes that promote an arbitrage mechanism and to preclude ETFs from
setting very low or high thresholds, such as one ETF share per creation
unit or one million ETF shares per creation unit. A low creation unit
size could, as a practical matter, make the use of creation unit
redemption irrelevant. The ETF would, in effect, be issuing and
redeeming ETF shares like a traditional mutual fund, but the shares
would trade on an exchange. Conversely, a high creation unit size could
reduce the willingness or ability of institutional arbitrageurs to
engage in creation unit purchases or redemptions. Impeding the ability
of arbitrageurs to purchase and redeem ETF shares could disrupt the
arbitrage pricing discipline, which could lead to more frequent
occurrences of pricing premiums or discounts.
    We request comment on the proposed requirement for creation unit
size, which is included in the proposed rule's definition of ``creation
unit.'' Does the requirement that an ETF establish creation unit sizes
the number of which is reasonably designed to facilitate arbitrage
provide the sponsor or adviser of the ETF with sufficient guidance in
setting appropriate thresholds? Should we include other elements in our
description of arbitrage, which is included in the definition of
creation

unit? If so, what elements? Should the proposed rule instead require
the board of directors of the ETF to make a finding that the ETF is
structured in a manner reasonably intended to facilitate arbitrage?
This finding could require the board, for example, to look at the
number of shares in each creation unit and the liquidity of the
portfolio securities and other assets. What other elements, if any,
should the board be required to review in making this finding?
    The proposed rule does not include numerical thresholds for the
number of ETF shares in each creation unit. Should the proposed rule
include minimum or maximum numerical thresholds? If so, what would be
appropriate thresholds and why? For example, should the rule set a
minimum of 100 ETF shares, and/or a maximum of 500,000 ETF shares, per
creation unit? Are our concerns with respect to smaller-or larger-sized
creation units addressed by requiring ETFs to establish creation unit
sizes that facilitate arbitrage? If the rule does not include any
thresholds, would any of the exemptions provided by the proposed rule
be inappropriate for an ETF with smaller-or larger-sized creation
units? If so, which exemptions?
    ETF applicants represent that ETF share prices are disciplined by
arbitrage opportunities created by the ability to purchase and redeem
creation units at NAV on a daily basis.\117\ Would this pricing
mechanism function differently for smaller-or larger-sized creation
units? Because ETFs charge transaction fees for direct purchases and
redemptions from the fund, ETF applicants have asserted that the
interests of long-term shareholders should not be diluted by frequent
traders, if those transaction fees accurately reflect the costs to the
fund.\118\ Are smaller-sized creation units likely to cause the
transaction fees charged by ETFs to be insufficient to protect the
long-term shareholders in the event of more frequent purchases and
redemptions? If so, should an ETF relying on the proposed exemption be
required to take additional measures designed to protect long-term
shareholder interests from being diluted by frequent traders? If so,
what measures?
---------------------------------------------------------------------------

    \117\ See, e.g., Zeigler Application, supra note 91, at 52-53;
see also supra notes 25-26 and accompanying and preceding text.
    \118\ See Zeigler Application, supra note 91, at 23; PowerShares
Actively Managed ETF Application, supra note 62, at 17-18.
---------------------------------------------------------------------------

    As discussed above, ETFs issue and redeem shares in creation unit
aggregations in exchange for the deposit or delivery of a basket of
securities and other assets. The proposed rule defines ``basket
assets'' to mean the securities or other assets specified each business
day in name and number by the ETF as the securities or assets in
exchange for which it will issue, or in return for which it will
redeem, ETF shares.\119\ The rule does not require that the basket
mirror the portfolio of the ETF because in some circumstances it may
not be practicable, convenient or operationally possible for the ETF to
operate on an in-kind basis.\120\ The rule, like our orders, allows an
ETF to require or permit a purchasing or redeeming shareholder to
substitute cash for some or all of the securities in the basket
assets.\121\
---------------------------------------------------------------------------

    \119\ Proposed rule 6c-11(e)(1). Under the proposed rule, the
term ``business day'' with respect to an ETF would mean any day that
the fund is open for business, including any day on which it is
required to make payment under section 22(e) of the Act. Section
22(e) of the Act prohibits registered funds from suspending the
right of redemption or postponing the date of payment upon
redemption of any redeemable security for more than seven days
except for certain periods specified in the provision. See 15 U.S.C.
80a-22(e). Proposed rule 6c-11(e)(2).
    \120\ The ETF and its adviser may decide to permit cash-only
purchases of creation units to minimize transaction costs or enhance
the ETF's operational efficiency. For example, on a day when a
substantial rebalancing of an index-based ETF's portfolio is
required, the adviser might prefer to receive cash rather than in-
kind securities so that it has the liquid resources at hand to make
the necessary purchases. If the ETF received in-kind securities on
that day, it might have to sell some securities and acquire new ones
to properly track its underlying index, incurring transaction costs
that could have been avoided if the ETF had received cash instead.
See, e.g., Ziegler Application, supra note 91, at 21-22. For some
ETFs that track country-specific equity securities indexes, it is
operationally necessary to engage in cash-only transactions because
of local law restrictions on transferability of securities. See
iShares, Inc., Investment Company Act Release Nos. 25595 (May 29,
2002) [67 FR 38684 (June 5, 2002)] (notice) and 25623 (June 25,
2002) (order) (certain iShares ETFs that invest in certain foreign
markets currently effect purchases and redemptions through cash
transactions).
    \121\ Proposed rule 6c-11(e)(1). Though the standard operations
of most existing ETFs involve in-kind purchases and redemptions, the
Commission has consistently permitted the substitution of cash for
certain securities in the basket assets. See, e.g., WisdomTree
Notice, supra note 12 at text preceding n.9. In addition, the
Commission has permitted ETFs that primarily hold financial
instruments, cash and cash equivalents in their portfolios to
operate on a cash-only basis because of the limited transferability
of financial instruments. See, e.g., ProShares Notice, supra note
113, at n.2 and accompanying text. See also SPDR Lehman Municipal
Bond ETF, Prospectus 19-22 (Sept. 10, 2007) (ETF generally sells
creation units for cash only and redeems creation units in-kind
only).
---------------------------------------------------------------------------

    We request comment on the proposed definition of basket assets. Are
there any reasons why an ETF should not be permitted to substitute cash
for some or all of the assets in the basket? Should the proposed rule
include any conditions for when an ETF may require or permit cash
substitutions? If so, what conditions should be included? Should the
rule specify how the ETF would announce the composition of the basket?
For example, should the rule mandate that the ETF post the information
on its Internet Web site? Should the rule specify the frequency with
which the ETF must announce the composition of the basket? If so, how
often?
2. Trading of ETF Shares at Negotiated Prices
    As noted above, section 22(d), among other things, prohibits a
dealer from selling a redeemable security that is being offered
currently to the public by or through an underwriter, except at a
current public offering price described in the prospectus.\122\ Rule
22c-1 generally requires that a dealer selling, redeeming, or
repurchasing a redeemable security do so only at a price based on its
NAV.\123\ Because secondary market trading in ETF shares takes place at
current market prices, and not at the current offering price described
in the prospectus or based on NAV, ETFs have obtained exemptions from
section 22(d) and rule 22c-1.
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    \122\ 15 U.S.C. 80a-22(d).
    \123\ 17 CFR 270.22c-1.
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    The provisions of section 22(d), as well as rule 22c-1, are
designed to prevent dilution caused by certain riskless trading schemes
by principal underwriters and dealers, and to prevent unjust
discrimination or preferential treatment among investors purchasing and
redeeming fund shares.\124\ The proposed rule would exempt a dealer in
ETF shares from section 22(d) of the Act and rule 22c-1(a) with regard
to purchases, sales and repurchases of ETF shares in secondary market
transactions at current market prices.\125\ As discussed above, we have
provided exemptions from section 22(d) and rule 22c-1 in our orders
because the arbitrage function appears to address the potential
concerns regarding shareholder dilution and unjust discrimination that
these provisions

were designed to address.\126\ In addition, secondary market trading
should not cause dilution for ETF shareholders because those
transactions do not directly involve ETF portfolio assets (the
transactions are with other investors, not the ETF), and thus have no
direct impact on the NAV of ETF shares held by other investors.
Moreover, to the extent that different prices for ETF shares exist
during a given trading day, or from day to day, these variations occur
as a result of third-party market forces, such as supply and demand,
and not as a result of discrimination or preferential treatment among
purchasers.
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    \124\ For a complete legislative history of section 22(d), see
Exemption from Section 22(d) to Permit the Sale of Redeemable
Securities at Prices that Reflect Different Sales Loads, Investment
Company Act Release No. 13183 (Apr. 22, 1983) [44 FR 19887 (May 10,
1983)]. See also Adoption of Rule 22c-1 under the Investment Company
Act of 1940 Prescribing the Time of Pricing Redeemable Securities
for Distribution, Redemption, and Repurchase and Amendment of Rule
17a-3(a)(7) under the Securities Exchange Act of 1934 Requiring
Dealers to Time Stamp Orders, Investment Company Act Release No.
5519 (Oct. 16, 1968) [33 FR 16331 (Nov. 7, 1968)].
    \125\ Proposed rule 6c-11(b).
    \126\ See supra notes 71-7573 and accompanying text.
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    We request comment on this proposed relief. Should the relief also
apply to parties other than dealers in ETF shares? If so, which other
parties require similar relief, and why? Do dealers (or others) need
relief from other provisions to facilitate transactions in ETF shares
on the secondary market?
3. In-Kind Transactions Between ETFs and Certain Affiliates
    Section 17(a) of the Act generally prohibits an affiliated person
of a registered investment company, or an affiliated person of such
person, from selling any security to or purchasing any security from
the company.\127\ Purchases and redemptions of ETF creation units are
typically in-kind rather than cash transactions,\128\ and section 17(a)
prohibits these in-kind purchases and redemptions by persons who are
affiliated with the ETF, including those affiliated because they own 5
percent or more, and in some cases more than 25 percent, of the ETF's
outstanding securities (``first-tier affiliates''), and by persons who
are affiliated with the first-tier affiliates or who own 5 percent or
more, and in some cases more than 25 percent, of the outstanding
securities of one or more funds advised by the ETF's investment adviser
(``second-tier affiliates'').\129\
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    \127\ 15 U.S.C. 80a-17(a).
    \128\ ETFs must comply with the federal securities laws in
accepting and satisfying redemptions with basket assets, including
the registration provisions of the Securities Act. See, e.g.,
Ameristock Notice, supra note 13, at n.3.
    \129\ An affiliated person of a fund includes, among others: (i)
Any person directly or indirectly owning, controlling, or holding
with power to vote, five percent or more of the outstanding voting
securities of the fund; (ii) any person five percent or more of
whose outstanding voting securities are directly or indirectly
owned, controlled, or held with power to vote by the fund; and (iii)
any person directly or indirectly controlling, controlled by, or
under common control with such other person. 15 U.S.C. 80a-
2(a)(3)(A), (B) and (C). A control relationship will be presumed
where one person owns more than 25 percent of another person's
outstanding voting securities. 15 U.S.C. 80a-2(a)(9).
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    We have granted exemptions from sections 17(a)(1) and (a)(2) \130\
of the Act to allow these first- and second-tier affiliates of the ETF
to purchase and redeem creation units through in-kind
transactions.\131\ In seeking this relief, applicants have submitted
that because the first- and second-tier affiliates are not treated
differently from non-affiliates when engaging in purchases and
redemptions of creation units, there is no opportunity for these
affiliated persons to effect a transaction detrimental to the other ETF
shareholders. The securities to be deposited for purchases of creation
units and to be delivered for redemptions of creation units are
announced at the beginning of each day. All purchases and redemptions
of creation units are at an ETF's next-calculated NAV (pursuant to rule
22c-1), and the securities deposited or delivered upon redemption are
valued in the same manner, using the same standards, as those
securities are valued for purposes of calculating the ETF's NAV.
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    \130\ 15 U.S.C. 80a-17(a)(1), 80a-17(a)(2).
    \131\ See, e.g., HealthShares Notice, supra note 90, at text
following n.10.
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    The proposed rule would permit first- and second-tier affiliates of
the ETF to purchase and redeem creation units through in-kind
transactions.\132\ The proposed exemption would not, however, apply to
a specific category of redemptions that would be addressed in new rule
12d1-4, which we also are proposing today. Section 12(d)(1) of the Act
imposes substantial limitations on the ability of investment companies
to invest in other investment companies.\133\ As discussed in Section
IV of this release, proposed rule 12d1-4 would permit investment
companies to acquire shares of ETFs in excess of the limitations on
those investments under section 12(d)(1) of the Act subject to certain
conditions intended to address the concerns underlying those
limitations. One of the proposed conditions would prohibit investment
companies from redeeming certain ETF shares acquired in reliance on
proposed rule 12d1-4.\134\ In order to make proposed rule 6c-11
consistent with the conditions in proposed rule 12d1-4, we propose to
exclude investment companies that acquire ETF shares in reliance on
proposed rule 12d1-4 from relying on proposed rule 6c-11(d) to redeem
those ETF shares in kind.\135\
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    \132\ Proposed rule 6c-11(d).
    \133\ See infra note 194 and accompanying text.
    \134\ As discussed in Section IV.B.2, infra, this condition is
designed to prevent a fund that relies on the proposed rule to
acquire ETF shares in excess of the limits of section 12(d)(1)(A)(i)
from unduly influencing the ETF by the threat of a large-scale
redemption.
    \135\ The proposed rule would not permit an investment company
that has acquired ETF shares in excess of the limits in section
12(d)(1)(A)(i) of the Act in reliance on proposed rule 12d1-4(a) to
rely on proposed rule 6c-11(d) with regard to the purchase of basket
assets (i.e., the purchase of securities identified in the basket
when redeeming ETF shares). Proposed rule 6c-11(d).
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    We request comment on this proposed exemption. Does the proposed
exemption raise any risks with regard to affiliated transactions with
the ETF? If so, should the exemption include any conditions to minimize
those risks? Should the relief extend to parties that are affiliated
persons of an ETF for other reasons? For example, should a broker-
dealer that is affiliated with the ETF's adviser be allowed to transact
in-kind with the ETF?
4. Additional Time for Delivering Redemption Proceeds
    Section 22(e) of the Act generally prohibits a registered open-end
investment company from suspending the right of redemption, or
postponing the date of satisfaction of redemption requests more than
seven days after the tender of a security for redemption.\136\ Some
ETFs that track foreign indexes have stated that local market delivery
cycles for transferring foreign securities to redeeming investors,
together with local market holiday schedules, require a delivery
process in excess of seven days. These ETFs have requested, and we have
granted, relief from section 22(e) so that they may satisfy redemptions
up to a specified maximum number of calendar days depending upon
specific circumstances in the local markets, as disclosed in the ETF's
prospectus or statement of additional information (``SAI''). Other than
in the disclosed situations, these ETFs satisfy redemptions within
seven days.\137\
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    \136\ 15 U.S.C. 80a-22(e).
    \137\ In their applications, ETFs acknowledge that no relief
obtained from the requirements of section 22(e) will affect any
obligations that they may otherwise have under rule 15c6-1 under the
Exchange Act. See, e.g., In re Barclays Global Fund Advisors, Second
Amended and Restated Application, File No. 812-11598, filed May 11,
2000 (``Barclays Foreign Application''), at 76 (available for public
inspection and copying in the Commission's Public Reference Room,
100 F Street, NE., Washington, DC 20549). Rule 15c6-1 requires that
most securities transactions be settled within three business days
of the trade date. 17 CFR 240.15c6-1.
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    Section 22(e) of the Act is designed to prevent unreasonable delays
in the satisfaction of redemptions, and ETF sponsors have asserted that
the requested relief will not lead to the problems that section 22(e)
was

designed to prevent.\138\ They have represented that the ETF's SAI
would disclose those local holidays (over the period of at least one
year following the date of the SAI) that are expected to prevent the
satisfaction of redemptions in seven days and the maximum number of
days needed to satisfy redemption requests with respect to the foreign
securities at issue.\139\
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    \138\ See Investment Trusts and Investment Companies: Hearings
on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and
Currency, 76th Cong., 3d Sess. 291-293 (statements of David
Schenker).
    \139\ See, e.g., Barclays Foreign Application, supra note 137,
at 76-84.
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    The delay in satisfying redemption requests seems reasonable under
the circumstances described by the ETF sponsors because it is for a
limited period of time and disclosed to investors. The proposed rule,
therefore, would codify the relief from section 22(e) of the Act
previously provided to ETFs. If an ETF has a foreign security in its
basket assets and a foreign holiday prevents timely delivery of the
foreign security, the ETF would be exempt from the prohibition in
section 22(e) against postponing the date of satisfaction upon
redemption for more than seven days. To rely on this exemption, the ETF
would be required to disclose in its SAI the foreign holidays it
expects to prevent timely delivery of the foreign securities and the
maximum number of days it anticipates it would need to deliver the
foreign securities. Finally, the delivery would have to take place no
more than 12 calendar days after the tender of ETF shares (in a
creation unit).\140\
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    \140\ Proposed rule 6c-11(c). Applicants requesting this
exemptive relief generally have represented that they would be able
to deliver redemption proceeds within 12 calendar days. See, e.g.,
WisdomTree Notice, supra note 12. An ETF relying on this exemption
would disclose the information in the SAI. See Item 18 of Form N-1A
(requiring disclosures regarding purchase, redemption, and pricing
of shares).
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    We request comment on this relief in the proposed exemption. Is the
relief necessary? We specifically request comment from ETFs regarding
the frequency with which they have relied on this exemption. Could an
ETF pay cash (as part of the basket assets) in lieu of foreign
securities in the case of delays in settlement? Should the relief be
limited to ETFs that satisfy redemptions entirely through in-kind
transactions? Is the number of days in the proposed rule sufficient or
is it too long? Should the rule refer to the applicable local market's
settlement cycle without specifying a number of days? Should the
disclosure be included in the prospectus of the ETF instead of the SAI,
which is only delivered upon request? Should the disclosure be included
in any sales literature of the ETF?
    The rule would provide relief if the ETF's basket assets include a
foreign security. Should the rule also provide relief if an ETF has
foreign securities included in its portfolio and, if so, why? Would
actively managed ETFs present any issues with respect to this exemption
that do not exist with respect to index-based ETFs? Could the
investment adviser to an actively managed ETF manage the ETF so as to
comply with section 22(e)?
    The proposed rule defines ``foreign security'' to mean any security
issued by a government or any political subdivision of a foreign
country, a national of any foreign country, or a corporation or other
organization incorporated or organized under the laws of any foreign
country, and for which there is no established United States public
trading market as that term is used in Item 201 of Regulation S-K under
the Exchange Act. Use of the phrase ``established United States public
trading market'' is designed to limit this relief to ETFs that invest
in securities that do not have an active trading market in the United
States. The rule does not rely on registration status because an
unregistered large foreign private issuer may have an active U.S.
market for its securities, in which case the ETF should be able to meet
redemption requests in a timely manner.\141\
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    \141\ See Termination of a Foreign Private Issuer's Registration
of a Class of Securities Under Section 12(g) and Duty To File
Reports Under Section 13(a) or 15(d) of the Securities Exchange Act
of 1934, Securities Exchange Act Release No. 55540 (Mar. 27, 2007)
[72 FR 16934 (Apr. 5, 2007)] (adopting rule 12h-6 under the Exchange
Act, which permits a foreign issuer to terminate its Exchange Act
registration and reporting obligations regarding a class of equity
securities if the average daily trading volume (``ADTV'') of the
securities in the United States has been 5 percent or less of the
ADTV of that class of securities in the issuer's principal trading
market during a recent 12-month period, regardless of the size of
its U.S. public float).
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    We request comment on the definition of ``foreign security.''
Should the definition provide any additional exceptions?

D. Disclosure Amendments

    Congress enacted the federal securities laws to promote fair and
honest securities markets, and an important purpose of these laws is to
promote full and fair disclosure of important information by issuers of
securities to the investing public. The Securities Act and the Exchange
Act, as implemented by Commission rules and regulations, provide for
systems of mandatory disclosure of certain material information in
securities offerings and in periodic reports. Accordingly, the
Securities Act requires delivery of a prospectus meeting the
requirements of section 10(a) to each investor in a registered
offering.\142\ The Securities Act also requires dealers in a security,
for a specified period of time after the registration statement for the
security becomes effective, to deliver a final prospectus to
purchasers, including to most persons purchasing shares in secondary
market transactions.\143\ The Investment Company Act, however, requires
dealers to continue prospectus delivery to investors in open-end funds,
including ETFs, which continuously offer their securities to the
public.\144\
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    \142\ 15 U.S.C. 77j(a). This is known as a ``final prospectus.''
In 2005, the Commission adopted rule 172 under the Securities Act
which generally deems final prospectus delivery satisfied when the
prospectus is filed with the Commission (``access equals
delivery''). 17 CFR 230.172. The Commission, however, specifically
excluded registered investment companies from rule 172. See
Securities Offering Reform, Securities Act Release No. 8591 (July
19, 2005) [70 FR 44722 (Aug. 3, 2005)]. For a detailed discussion on
the prospectus delivery requirements and related liabilities with
respect to open-end investment companies, see Enhanced Disclosure
and New Prospectus Delivery Option for Registered Open-End
Management Investment Companies, Investment Company Act Release No.
28064 (Nov. 21, 2007) [72 FR 67790 (Nov. 30, 2007)] (``Enhanced
Disclosure Proposing Release'') at sections II.B.1 and II.B.4.
    \143\ Under section 4(3) of the Securities Act, dealers must
deliver a prospectus in connection with original sales by the dealer
of securities obtained from or through an underwriter, and resales
by the dealer occurring during the 40 days (90 days for first-time
issuers) after the effective date of the registration statement (or,
under certain circumstances, a different date). This aftermarket
delivery obligation applies to all dealers, whether or not they
participated in the offering itself. 15 U.S.C. 77d(3). See also rule
174 under the Securities Act, which provides an exception from the
requirement in section 4(3) that a prospectus be delivered prior to
the expiration of the applicable 40-day or 90-day period. 17 CFR
230.174.
    \144\ Section 24(d) of the Act eliminates the dealer's exception
with respect to securities issued by funds and UITs on the theory
that, because those issuers continuously offer their securities to
the public, all dealers should be compelled to use the statutory
prospectus. See H.R. Rep. No. 1542, 83d Cong., 2d Sess. 29-30
(1954).
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1. Delivery of Prospectuses to Investors
    Our orders generally have exempted broker-dealers selling ETF
shares from the obligation to deliver prospectuses in most secondary
market transactions.\145\

Applicants have represented that broker-dealers would instead deliver a
``product description'' containing basic information about the ETF and
its shares.\146\ Proposed rule 6c-11 would not include a similar
exemption, and thus broker-dealers would be required to deliver a
prospectus meeting the requirements of section 10(a) of the Securities
Act to investors purchasing ETF shares.\147\
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    \145\ Most of the orders have granted exemptions from section
24(d) of the Act, which makes inapplicable the dealer exception in
section 4(3) of the Securities Act to transactions in redeemable
securities issued by an open-end fund. 15 U.S.C. 80a-24(d); 15
U.S.C. 77(d)(3); see, e.g., WisdomTree Notice, supra note 12, at
n.14. ETFs that have this relief continue to be subject to
prospectus delivery requirements in connection with sales of
creation units and other non-secondary market transactions. Our most
recent orders permitting certain actively managed ETFs do not,
however, provide this exemption. See Actively Managed ETF Orders,
supra note 20.
    \146\ See, e.g., Ziegler Notice, supra note 110. The product
description provides a summary of the salient features of the ETF
and its shares, including the investment objectives of the fund, the
manner in which ETF shares trade on the secondary market, and the
manner in which creation units are purchased and redeemed. National
securities exchanges on which ETFs are listed have adopted rules
requiring the delivery of product descriptions. See, e.g., American
Stock Exchange Rules 1000 and 1000A.
    \147\ 15 U.S.C. 77j(a). This prospectus delivery requirement
would apply to all ETFs, including ETFs operating under current
exemptive orders. Therefore, we propose to amend orders we issued to
open-end ETFs to exclude the section 24(d) exemption we have issued
to existing ETFs. See infra Section III.E for a discussion of this
proposed amendment to existing orders.
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    We understand that many, if not most, broker-dealers selling ETF
shares in secondary market transactions do, in fact, transmit a
prospectus to purchasers, and thus they have not relied on the
exemptions we have provided in our orders. More important, we believe
an exemption allowing dealers to deliver product descriptions would be
unnecessary given our proposal regarding summary prospectus disclosure.
As discussed below,\148\ we recently proposed amendments to Form N-1A
and to rule 498 under the Securities Act,\149\ in order to enhance the
disclosures that are provided to mutual fund investors (``Enhanced
Disclosure Proposing Release'').\150\ The proposed amendments, if
adopted, would require key information to appear in plain English in a
standardized order at the front of the mutual fund prospectus
(``summary section'').\151\ A person could satisfy its mutual fund
prospectus delivery obligations under section 5(b)(2) of the Securities
Act by sending or giving this key information directly to investors in
the form of a summary prospectus and providing a prospectus that meets
the requirements of section 10(a) of the Securities Act (``statutory
prospectus'') on an Internet Web site.\152\ If adopted, broker-dealers
selling ETF shares could deliver a summary prospectus in secondary
market transactions. We believe the summary prospectus would contain
material information that may not be included in a product description,
but, like the product description, would be in a form that would be
easy to use and readily accessible.
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    \148\ See infra notes 176-185 and accompanying text.
    \149\ 17 CFR 230.498.
    \150\ See Enhanced Disclosure Proposing Release, supra note 142.
    \151\ See id., at Section II.A.
    \152\ 15 U.S.C. 77j(a). The fund also would be required to
provide additional information on its Web site. See Proposed rule
498(c).
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    We request comment on this approach. Are we correct in our
understanding that many, if not most, broker-dealers deliver a
prospectus instead of a product description in connection with sales of
ETF shares in secondary market transactions? If so, why?
    If we were to adopt rule 6c-11 before the amendments proposed in
the Enhanced Disclosure Proposing Release, we would expect to permit
delivery of a product description in lieu of a prospectus, pending
final determination of that proposal by the Commission. We request
comment on this approach. Should we permit all ETFs, including actively
managed ETFs and index-based ETFs that rely on the rule instead of an
exemptive order to deliver product descriptions? Should we prescribe