With four months until listing standards change across exchanges, Michael Mundt, Partner at Stradley Ronon Stevens & Young, breaks down what ETF managers need to know.
What are the continued listing standards?
For many years, national securities exchanges have had “generic listing standards” for index-based ETFs. If an index ETF satisfies the relevant generic listing standards, an exchange can list the ETF without seeking specific listing approval from the SEC (Securities and Exchange Commission). Previously, ETFs only had to satisfy the generic listing standards at the time of initial listing. Recently, each of the ETF listing exchanges amended its rules to require that index ETFs satisfy the listing requirements on a continuous basis. In addition, the rule amendments require that any ETFs (both index-based and active) that operate based on specific listing approvals, rather than generic listing approvals, must continuously comply with the various requirements in their specific listing approval orders.
If an ETF does not comply with the continued listing standards, the amended exchange rules require the ETF to provide prompt notification to the exchange regarding any non-compliance. The exchange could then initiate a process to delist the ETF, although an exchange may allow an ETF to have a cure period to regain compliance.
What was the SEC’s rationale in requesting these changes from the exchanges?
The SEC has stated that the listing standards are intended to reduce the potential for manipulation by ensuring that an ETF is sufficiently broad-based, and that the index components are adequately capitalized, sufficiently liquid, and that no one security dominates the index. The SEC believes if these requirements are imposed only at the time of initial listing rather than on a continuous basis, a regulatory gap would exist with respect to the ongoing operations of ETFs.
What are the biggest challenges ETF managers will face when complying with the revised standards?
The most notable challenge that the new standards could present is that the ETF may not have an ability to ensure that the index complies with the listing standards on an ongoing basis when an ETF tracks an index maintained by a third-party index provider. For example, if constituent securities of the index no longer meet requirements such as minimum trading volume or minimum market value, the ETF could fall out of compliance with the continued listing standards even though the ETF has no control over the market circumstances or the index methodology.
The SEC has suggested that an ETF could approach the index provider regarding potential modifications to the index methodology or components to address issues under the continued listing standards. Ironically, the SEC has sought to discourage ETF advisors from having influence over unaffiliated index providers in other regulatory contexts. Alternatively, the SEC suggested an exchange could seek new specific listing approval for the ETF to continue to follow its existing index.
But these possible solutions are not without problems. An ETF may be one of only many products that track an index, and an unaffiliated index provider may not be willing or able to change the index methodology or components at the request of an ETF. The ETF shareholders also may not want the index to change, particularly in the absence of any actual evidence of manipulation. Seeking new specific listing approval for a currently listed ETF would be time-consuming and a drain on the resources of the listing exchanges, ETFs, and ETF advisors just to maintain the status quo.
Have the exchanges interpreted the continued listing standards differently?
An ETF should consult its listing exchange about interpretive issues relating to the continued listing standards. But, my sense is that the SEC would not expect the rules to have different interpretations. If the rules were not interpreted consistently, it would seem to undercut the SEC’s goal of closing regulatory gaps. In fact, the SEC recently approved several specific wording changes for the rules of one of the listing exchanges to align the language more closely with the rules of the other listing exchanges.
This is already a requirement for some active ETFs. What do the rest of ETF managers need to do to get ready?
In 2016, the SEC approved generic listing standards for active ETFs, and those listing standards also have continued listing standard compliance obligations. However, an active manager may be able to reconfigure an ETF portfolio to ensure compliance with the continued listing standards, whereas an index ETF manager may not be able to change the constituents of an index provided by a third party to ensure continued compliance.
As a result, index ETF managers may need to plan ahead to a greater extent. Index ETF advisors may want to evaluate the likelihood that the index methodologies for their ETFs could result in instances of non-compliance with the continued listing standards. For index ETFs that seem at greater risk of non-compliance, ETF advisors may wish to discuss contingencies with their index providers and listing exchanges. ETF advisors and index providers also could consider provisions in index license agreements designed to address communications regarding non-compliance issues and the ability to modify index methodologies to accommodate continued listing requirements, if necessary.
Absent further modifications to the rules, monitoring ongoing compliance with continued listing standards must become part of the compliance framework for ETFs. The SEC recently delayed the implementation date of the new rules for one of the exchanges. As a result, all of the listing exchanges now have the same implementation date of 1 October 2017.
About Michael Mundt
Michael W. Mundt is a partner in the investment management practice group at Stradley Ronon Stevens & Young, LLP. Mike is nationally recognized for his work in the area of exchange-traded funds. He assists clients with all phases of the complex regulatory process required to introduce and operate index-based and actively managed ETFs, as well as next generation exchange-traded products. More generally, he counsels investment advisers and investment companies on a wide range of issues arising under the Investment Company Act of 1940 and other federal securities laws.
Prior to joining Stradley, Mike worked at the U.S. Securities and Exchange Commission for almost 14 years, ultimately serving as an Assistant Director in the Division of Investment Management. While at the SEC, Mike had a leading role in ETF policy issues and received several awards in recognition of his ETF work. He supervised the office that reviewed exemptive applications under the Investment Company Act, including many novel ETF applications. Mike regularly speaks on ETF issues at conferences and in the press. Mike earned BA and MA degrees from Louisiana State University and his JD from the Georgetown University Law Center.
The views expressed in this material are those of the author as of June 16, 2017 and may or may not be consistent with the views of Brown Brothers Harriman & Co. and its subsidiaries and affiliates (“BBH”), and are intended for informational purposes only.
Neither Brown Brothers Harriman nor its affiliates or its financial professionals render tax or legal advice. Please consult with attorney, accountant, and/or tax advisor for advice concerning you particular circumstances.
BBH is not affiliated with Michael Mundt or Stradley Ronon Stevens & Young.