SEC seeks public comment on novel ETFs: signals potential reassessment of ETF regulatory framework

What sponsors and advisers should be watching

The RFC raises a number of issues that could reshape the regulatory framework applicable to Novel ETFs for years to come. Sponsors, advisers and other market participants should consider the extent to which potential changes in the following areas could affect existing products and future product development initiatives:

• Investment company status. The SEC is raising the question of whether Novel ETFs that invest primarily in assets that are not securities fit within the Investment Company Act framework. The SEC is also asking whether sponsors that invest in assets that are not securities through wholly owned subsidiary structures qualify as investment companies. If a sponsor’s product is determined not to qualify, it could need to be restructured as an exchange-traded commodity trust or other form of ETP, with fundamentally different regulatory treatment and investor protections. 
• Potential amendments to Rule 6c-11. Changes to Rule 6c-11—including portfolio requirements, minimum holdings in securities, diversification standards, concentration limits or restrictions on particular asset classes or strategies—could affect product design, exchange listing eligibility and future ETF development efforts. Sponsors that have built product pipelines around the current open architecture could face potential roadblocks, including the need to seek individual exchange listing relief, which could bring back pre-2019 costs and delays. 
• The treatment and regulation of Novel ETFs. The SEC is evaluating whether investors adequately understand the distinctions between Novel ETFs and traditional ETFs and whether additional measures are needed to address investor confusion. As part of that review, the SEC is considering questions relating to the use of terms, such as “ETF” and “fund” by products that are not investment companies, as well as whether enhanced disclosures, investor education initiatives or product-specific risk disclosures may be warranted. Sponsors should consider whether future regulatory changes could affect product naming conventions, branding, marketing practices and disclosure obligations. Such changes could require revisions to existing products and marketing materials, increase compliance and marketing costs, lengthen registration review periods and create additional complexity for sponsors seeking to differentiate their products in the marketplace.
• Registration and launch timing considerations. The SEC is evaluating whether to extend the time for staff to review Novel ETFs and whether changes to the registration process may be warranted for products that raise novel legal or policy issues. Potential outcomes could include additional pre-effective engagement with SEC staff, longer and less predictable review periods, delayed effectiveness or enhanced scrutiny of novel products before launch. The SEC is also considering whether certain filings should be permitted to remain non-public for part of the review period. Sponsors should evaluate whether pre-filing consultations could reduce the risk of post-filing delays and also assess the impact of longer and less predictable review periods on product launch schedules, carrying costs and commercialization timelines.
• Participation in the comment process. Given the breadth of questions raised by the SEC, sponsors, advisers, exchanges and other market participants should consider whether to submit comments addressing the practical implications of the SEC's proposals for product development, investor protection, market efficiency and innovation.

A central question: when is a novel ETF an investment company?

The Investment Company Act contains multiple tests for determining whether an issuer is an investment company. Among the most significant for purposes of the RFC are the so-called "Objective Test" and "Subjective Test." The Objective Test generally focuses on whether an issuer owns investment securities exceeding 40% of its total assets, excluding government securities and cash items. The Subjective Test, by contrast, examines whether an issuer is engaged primarily in the business of investing, reinvesting or trading in securities. Unlike the Objective Test, which focuses primarily on the composition of an issuer's assets, the Subjective Test focuses on the overall nature of an issuer's business and activities.

One of the most consequential aspects of the RFC involves the SEC’s discussion of investment company status under Section 3 of the Investment Company Act. The SEC specifically asks whether a product whose principal investment strategy involves assets that are not securities nevertheless should be permitted to register and operate as an investment company. The RFC asks why such products would seek to register as investment companies, rather than as another type of exchange-traded product, and whether additional regulatory distinctions may be warranted.

The RFC also devotes attention to ETFs that obtain exposure to commodities, digital assets, event contracts and other non-security assets through wholly owned subsidiaries. Such structures have been used by certain funds to gain exposure to non-security assets indirectly in order to satisfy certain conditions of applicable tax law. The SEC asks whether these arrangements are consistent with the purposes of the Investment Company Act and whether additional limitations, conditions or interpretive guidance may be appropriate. As a result, sponsors that rely on wholly owned subsidiary structures should closely monitor the SEC's review, as any changes to the existing framework could affect product design, registration strategy and the viability of certain Novel ETF structures.

The SEC devotes substantial attention to the long-standing “Subjective Test” and the related five-factor analysis derived from In re Tonopah Mining Co., suggesting that the SEC may be reevaluating how those concepts apply to innovative ETF structures. The RFC may be particularly important for sponsors developing Novel ETFs tied to assets or contracts that do not fall neatly within traditional securities classifications. The SEC expressly asks whether additional clarity is needed regarding the application of these tests and whether alternative or supplemental factors should be considered when evaluating Novel ETFs. 

Potential changes to Rule 6c-11

As discussed above, Rule 6c 11 provides the principal regulatory framework under which most ETFs operate without obtaining individualized exemptive relief. The RFC asks whether that framework should be modified to address Novel ETFs. Notably, the SEC asks whether amendments could include minimum holdings of securities, diversification requirements, concentration limits, restrictions on particular strategies or asset classes or other portfolio-related conditions. Although the SEC does not propose specific amendments, the RFC indicates a willingness to revisit assumptions that have underpinned ETF regulation since Rule 6c-11 was adopted.

Sponsors considering innovative products should pay close attention to this portion of the release. Any changes to Rule 6c-11 could have implications not only for product design, but also for exchange listing eligibility and launch timing. 

Registration process under review

Another significant aspect of the RFC concerns ETF registration mechanics. The SEC notes that many Novel ETFs are registered through post-effective amendments that become automatically effective under Rule 485 after a period for review and comment by the SEC staff. The SEC expressly asks whether the time to review registration statements should be extended. 

The SEC’s questions in this area are quite granular and seem to indicate an openness to reconsidering the entire launch process for Novel ETFs. Specifically, the SEC is asking: (i) whether the 75-day and 60-day automatic effectiveness periods should be extended for Novel ETFs, and if so, for how long; (ii) whether effectiveness should be automatically tolled if a registrant fails to respond to staff comments within a specified period; (iii) whether the SEC should have authority to delay the effectiveness of a Novel ETF registration statement; (iv) whether Rule 485(a)(2) filings should be permitted to remain nonpublic for a portion of the 75 day period; (v) whether funds should be required to disclose material unresolved staff comments, analogous to requirements applicable to certain closed-end funds and operating company filers; and (vi) whether additional clarity is needed about how the rules apply when an investment strategy change is made during the review process or before launch.

This line of inquiry ultimately could be as important as any substantive investment company analysis. If the SEC concludes that innovative products warrant enhanced review, sponsors could face longer regulatory timelines and additional engagement with staff before product launches. 

Investor protection and disclosure considerations

The SEC also solicits comment on whether investors adequately understand how Novel ETFs differ from traditional ETFs and whether additional disclosures or other investor-protection measures may be warranted. The SEC asks whether certain products that are not investment companies, but market themselves using ETF terminology, create investor confusion. These questions reflect a broader concern that investor familiarity with the ETF wrapper may obscure important differences among products. 

Takeaways

The RFC may represent the most comprehensive review of the regulatory framework applicable to Novel ETFs since the adoption of Rule 6c-11. Importantly, the SEC is not merely asking how specific products should be treated; it is asking broader questions about whether existing ETF regulatory frameworks remain appropriate for products that invest in emerging asset classes or employ novel investment strategies. Given the SEC’s focus on investment company status, registration procedures and investor protection considerations, sponsors, advisers, exchanges and service providers should carefully evaluate whether to submit comments during the 60-day comment period and consider how potential changes could affect future product development pipelines. 

___________

If you have any questions about this Legal Briefing, please feel free to contact any of the attorneys listed or the Eversheds Sutherland attorney with whom you regularly work.