There are a number of steps any issuer must go through in order to successfully launch a new ETF.  One step that some find to be somewhat mysterious, particularly new issuers, is the process of requesting “exemptive relief” from the SEC. Exactly what is “exemptive relief”?

Most ETFs are registered under the Investment Act of 1940 – often referred to as the ’40 Act – as open-end investment companies. As such, they are subject to the specific provisions of the ’40 Act as they pertain to open-end funds. However, several of the customary features of an ETF are not consistent with the requirements of the ’40 Act. Thus, a key part of the process in launching any ETF is to receive the required exemptions from these provisions of the ’40 Act. To request the exemptions, the issuer files an application for exemptive relief with the Division of Investment Management of the SEC. (Some ETFs, such as commodity funds, are not required to register under the ’40 Act and so are not required to seek these exemptions.)

The typical exemptive application will include requests for relief relating to the following issues:

Redeemable Securities

An “open-end” investment company is defined by the ’40 Act as a fund that issues redeemable securities. And under the ’40 Act, redeemable securities are defined as those securities which, when presented by a shareholder to the issuer, will be redeemed by the issuer for a proportionate share of issuer’s net assets. The ETF structure by design does not allow individual shares to be redeemed directly, rather, redemption can only occur when a holder (usually called an Authorized Participant) aggregates a set minimum number of shares (for example, 50,000 shares). Thus, individual shares of an ETF may not meet the statutory requirement for “redeemable security”.  And so an exemption is required.

Trading Only At NAV

The ’40 Act only contemplates the issuance of securities directly by the issuer to the security holders and specifies that that the all transactions in redeemable securities must be done at the next computed Net Asset Value (NAV). Since a fundamental characteristic of an ETF is that its shares trade in the market at negotiated prices, not at NAV, an exemption from ’40 Act provisions relating to the pricing of ETF securities is required.

Fund Transactions by Affiliated Persons

The ’40 Act generally restricts Affiliated Persons (as further defined in the Act) to transacting with a registered fund using only securities issued by the fund. Most ETF issuers want to use an in-kind creation and redemption process – meaning that when they create or redeem securities with Authorized Participants, they in-kind basket of securities specified by the Issuer to be used as payment for the ETF shares will contain securities not issued by the Fund.  As a result, by definition, Authorized Participants, who may be deemed to be Affiliated Persons, will be transacting with the ETF using securities not issued by the Fund, and an exemption is required.

You should note that, separate and distinct from these exemptions, issuers will also need to seek relief from various rules in the Securities Exchange Act of 1934 and Regulation M. However, there are existing “No-Action” letters which may, depending on the specific ETF structure, be relied on for relief from these provisions.