Wednesday, 30 November 2005 08:00
Investment Advisers Act of 1940 – Rule 204A-1, 206(4)-7 and Section 204A, 203(e)(6)
Investment Company Act of 1940 – Rule 17j-1
National Compliance Service
November 30, 2005
|RESPONSE OF THE OFFICE OF CHIEF COUNSEL
DIVISION OF INVESTMENT MANAGEMENT
|Our Ref. No.: 20053291111
File No. 132-3
Your letter dated March 10, 2005 generally requests our assurance that we would not recommend enforcement action to the Commission against any registered investment adviser under Rule 204A-1 under the Investment Advisers Act of 1940 (“Advisers Act”) if its written code of ethics treats shares issued by an “exchange traded fund” that is organized as a unit investment trust as securities that are not “reportable securities,” as defined in Rule 204A-1(e)(10). As discussed below, we decline to provide you with the requested assurance.
“Exchange-traded funds,” or “ETFs,” generally have the following characteristics. An ETF is a registered investment company that operates pursuant to an order from the Commission exempting the ETF from certain provisions of the Investment Company Act of 1940 (“Company Act”) so that the ETF may issue securities that trade in a secondary market, and which are redeemable only in large aggregations called creation units.1 An ETF issues and redeems its shares in creation units, at their net asset value. Individual ETF shares are purchased or sold in secondary market transactions at negotiated prices, i.e., at prices that are determined by that market.2 An ETF registers with the Commission under the Company Act either as an open-end management company (an “open-end ETF”) or as a unit investment trust (a “UIT ETF”).
Rule 204A-1(a) under the Advisers Act requires every registered investment adviser to establish, maintain and enforce a written code of ethics that, among other things, requires the reporting of securities transactions by an investment adviser’s access persons.3 Specifically, Rule 204A-1(b) provides, as pertinent here, that the code of ethics must require that access persons submit to the investment adviser’s chief compliance officer, or another person who is designated in the code of ethics, reports of the access persons’ transactions in and holdings of “reportable securities,” as defined in Rule 204A-1(e)(10) (“Reportable Securities”).4 The reporting requirements that are imposed through Rule 204A-1 aid investment advisers and the Commission’s examination staff in identifying conflict of interest situations involving access persons’ personal securities transactions that could harm the interests of advisory clients (for instance, front-running of client trades).5 As most relevant here, Rule 204A-1 also facilitates the monitoring of access persons’ personal trading for potential misconduct that could arise through their relationships with broker-dealers (e.g., obtaining favorable commission rates on their personal securities transactions in return for directing client brokerage to the broker-dealers).6
Rule 204A-1(e)(10)(iv) under the Advisers Act excludes “shares issued by open-end funds” from the definition of Reportable Securities.7 The Commission excluded shares of open-end funds from the definition because, as compared to market-traded securities, they typically present little opportunity for the type of improper trading that the rule is intended to uncover.8
Open-end ETF shares are excluded from the definition of Reportable Securities under Rule 204A-1(e)(10)(iv) because they are shares issued by an open-end fund,9 while UIT ETF shares are Reportable Securities because UITs are not open-end funds.10 You request no-action relief that would, in essence, allow an investment adviser’s access persons to exclude transactions in UIT ETF shares from their holdings and transaction reports because UIT ETFs are similar to open-end ETFs in that, for instance, they both issue and redeem their shares in creation units, at their net asset value.
We decline to provide you with the assurance that you request because we believe that the purchase and sale by access persons of UIT ETF shares in the secondary market – as with any market-traded security – presents the opportunity for conflicts of interest that Rule 204A-1 is intended to reveal, and therefore should be subject to monitoring under investment advisers’ codes of ethics. We also note that trading in open-end ETF shares presents the same opportunity for conflicts of interest as trading in UIT ETF shares because both types of shares are purchased and sold in the secondary market at a negotiated price, unlike traditional open-end funds. We recommend, therefore, that investment advisers consider treating open-end ETF shares as Reportable Securities.11
Also, we take this opportunity to provide similar guidance concerning Rule 17j-1 under the Company Act, which requires access persons of investment advisers to registered investment companies to report their personal transactions and holdings in “covered securities,” as defined in the rule. Rule 204A-1 under the Advisers Act was modeled upon Rule 17j-1 under the Company Act.12 Similar to the definition of Reportable Securities in Rule 204A-1, the definition of “covered securities” in Rule 17j-1(a)(4) excludes shares of open-end ETFs, but includes shares of UIT ETFs. For the reasons set forth in this letter, we also recommend that persons subject to Rule 17j-1’s reporting requirements consider treating open-end ETF shares as “covered securities” when complying with the requirements of the rule.
Eric S. Purple
|1||See, e.g., In re Rydex ETF Trust, SEC Rel. No. IC-25970 (Mar. 25, 2003) (order), SEC Rel. No. IC-25948 (Feb. 27, 2003) (notice) (“Rydex Exemptive Order”).|
|2||An ETF’s Commission exemptive order typically provides relief from the provisions of Section 22(d) of the Company Act and Rule 22c-1 under the Company Act with respect to transactions in ETF shares that occur in a secondary market. See, e.g., Rydex Exemptive Order.|
|3||Rule 204A-1(e)(1) under the Advisers Act defines “access person.”|
|4||Rule 204A-1(e)(10) defines Reportable Securities broadly to include all securities as defined in Section 202(a)(18) of the Advisers Act, with several exceptions.|
|5||SeeInvestment Adviser Codes of Ethics, SEC Rel. No. IA-2209, n.28 (Jan. 20, 2004) (“Proposing Release”) (“[o]ur proposal to have codes of ethics require initial and annual holdings reports would facilitate an adviser’s assessment of whether an individual’s personal securities holdings present a conflict of interest”); Investment Adviser Codes of Ethics, SEC Rel. No. IA-2256 (July 2, 2004) (“Adopting Release”) (“[r]eviewing these reports will allow advisers as well as the Commission’s examination staff to identify improper trades or patterns of trading by access persons”); Proposing Release (“[i]n several of our enforcement cases involving personal trading, advisers profited from “front-running” client trades”). Front-running occurs when a person trades in advance of his or her client in order to take advantage of changes in the market price of a security that will be caused by that client’s trade. See, e.g., In re Roger W. Honour, SEC Rel. No. IA-1527 (Sept. 28, 1995). See generally L. Loss & J. Seligman, Securities Regulation, ¬ß 9-c-1, n.27 (3d ed. 2004) (defining front-running). We note that ETF shares may be susceptible to front running (e.g., when they are thinly traded in the secondary market, and have a market price that does not closely track their net asset value per share).|
|6||We note that Rule 204A-1 requires that an investment adviser’s codes of ethics mandate that access persons identify the brokers with which they maintain their personal securities accounts, and through which they execute personal securities transactions. See Rule 204A-1(b)(1)(i)(B) and (2)(i)(D) under the Advisers Act. An access person may violate the anti-fraud provisions of the Advisers Act by directing client brokerage to a broker-dealer in order to obtain from the broker-dealer favorable commission rates on the access person’s personal securities transactions.|
|7||Rule 204A-1(e)(10)(iv) under the Advisers Act does not exclude shares of open-end funds that are “reportable funds,” as defined in Rule 204A-1(e)(9) under the Advisers Act.|
|8||See Adopting Release (shares of open-end funds “appear to present little opportunity for the type of improper trading that the access person reports are designed to uncover”).
Section 22(d) of the Company Act and Rule 22d-1 thereunder, generally prohibit a registered open-end fund, its principal underwriter, or a dealer from selling the fund’s redeemable shares at a price other than the current public offering price described in the fund’s prospectus. See also NASD Interpretive Memorandum IM-2830-2. Similarly, purchases and sales of open-end fund shares are typically not susceptible to front-running, because open-end funds must sell and redeem their shares at a price based on their net asset value, and not at a negotiated price. See Section 22(c) of the Company Act and Rule 22c-1 thereunder.
|9||Section 5 of the Company Act provides that open-end funds must be management companies, and Section 4(3) of the Company Act provides that UITs are not management companies.|
|10||Butsee Rule 204A-1(e)(10)(v) under the Advisers Act (shares issued by unit investment trusts that are invested exclusively in one or more open-end funds, none of which is a reportable fund, are excluded from the definition of “Reportable Securities”).|
|11||In the Adopting Release, the Commission stated that Rule 204A-1 is designed to prevent fraud generally, and that the rule “establishes only a minimum requirement. Advisers are free to set higher standards for their employees.” We note that investment advisers may wish to consider treating open-end ETF shares as Reportable Securities due to other provisions of the Advisers Act and its rules (e.g., Section 203(e)(6) of the Advisers Act, which provides that procedures reasonably designed to detect and prevent violations of the federal securities laws can serve as a defense against a charge that an investment adviser has failed to reasonably supervise its advisory personnel who have, for instance, violated the anti-fraud provisions of the Advisers Act). In addition, investment advisers may wish to consider treating open-end ETF shares as Reportable Securities because it may be difficult for their access persons to determine whether an ETF is an open-end ETF or a UIT ETF.|
|12||See Adopting Release.|
National Compliance Services, Inc.
355 N.E. 5th Avenue, Suite 4
Delray Beach, Florida 33483
ADVISERS ACT/RULE 204A-1
March 10, 2005
Douglas J. Scheidt, Esq.
Associate Director and Chief Counsel
Division of Investment Management
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: Investment Adviser Codes of Ethics/Rule 204A-1
Dear Mr. Scheidt:
National Compliance Services, Inc. provides registration and compliance services for investment advisers and broker-dealers. In advising our clients on complying with Rule 204A-1 under the Investment Advisers Act of 1940 (the “Advisers Act”), the question has arisen whether a share of an exchange-traded fund (“ETF”) structured as a unit investment trust (“UIT”) is a “reportable security” within the meaning of Rule 204A-1(e)(10). We respectfully request the staff’s assurance that it would not recommend enforcement action to the Commission against our clients that are registered investment advisers if they do not treat ETF shares as reportable securities, unless the ETF would be a “reportable fund” within the meaning of Rule 204A-1(e)(9).
An ETF has shares or other securities that are principally traded on a national securities exchange or through the facilities of a national securities association and reported as a national market security, and that represent an interest in a registered investment company organized as an open-end management investment company, a unit investment trust, or a similar entity which holds securities constituting or otherwise based on or representing an investment in an index or portfolio of securities.1 ETFs sell and redeem their shares at net asset value only in large blocks known as creation units. However, investors can purchase and sell individual ETF shares among themselves at market prices throughout the trading day. Because of arbitrage opportunities inherent in the ETF structure, ETF shares generally have not traded in the secondary market at a significant premium or discount in relation to net asset value.12 The combined assets of the nation’s ETFs were $222.89 billion in January 2005.3
The majority of ETFs are organized as open-end management investment companies. However, some of the largest ETFs are organized as UITs. These include DIAMONDS Trust, Series 1, which had net trust assets of $8.19 billion as of October 31, 2004;4 MidCap SPDR Trust, Series 1, which had net trust assets of $6.54 billion as of September 30, 2004;5 Nasdaq-100 Trust, Series 1, which had net trust assets of $20.38 billion as of September 30, 2004;6 and SPDR Trust, Series 1, which had net trust assets of $45.72 billion as of September 30, 2004.7
Rule 204A-1 provides that every registered investment adviser must establish, maintain and enforce a written code of ethics that requires, inter alia, that access persons must submit reports of their holdings of, and transactions in, reportable securities. A “reportable security” generally is defined by Rule 204A-1(e)(10) as a security as defined in Section 202(a)(18) of the Advisers Act, with certain enumerated exclusions, including an exclusion for shares issued by open-end registered investment companies other than reportable funds (i.e., registered investment companies with which the registered investment adviser has certain relationships).8
The majority of ETFs are open-end registered investment companies and their shares therefore are not reportable securities within the meaning of Rule 204A-1, except for the small number of investment advisers for which the ETF is a reportable fund. However, ETFs organized as UITs do not qualify for any of the exclusions in Rule 204A-1(e)(10), and their shares therefore are reportable securities within the literal meaning of the provision.9
The Commission noted in the Adopting Release that the exceptions to the “reportable security” definition are designed to exclude securities that appear to present little opportunity for the type of improper trading that the access person reports are designed to uncover.10 We submit that ETFs, which are among the most transparent and most liquid of securities, are particularly unlikely to present opportunities for improper trading. In addition, there seems little reason for distinguishing between ETFs organized as UITs and ETFs organized as open-end investment companies. On the whole, ETFs organized as UITs, because of their generally larger size, their generally greater liquidity, and the high degree of transparency and liquidity of their underlying holdings, are even less likely than other ETFs to present opportunities for improper trading. We believe that investment advisers generally consider ETF shares to be a single type of security and would be confused by an arbitrary requirement to distinguish between ETFs organized as open-end investment companies and ETFs organized as UITs.
We should note that the treatment of ETFs under Rule 204A-1 has caused some confusion in the industry. Members of this firm have been to three conferences in recent months at which the question came up. A no-action response, therefore, would provide useful guidance to the industry.
For the foregoing reasons, we request that the staff provide its assurance that it will not recommend enforcement action to the Commission against our clients that are registered investment advisers if they do not treat ETF shares as reportable securities, unless the ETF would be a reportable fund within the meaning of Rule 204A-1(e)(9). Please contact me at (561) 330-7645 ext. 206 if you have any questions concerning this letter. You can also contact our counsel, John M. Baker of Stradley Ronon Stevens & Young, at (202) 419-8413.
Very truly yours,
cc: John M. Baker, Esq.
|1||American Stock Exchange Rule 915.06. This definition excludes issuers of trust-issued receipts, such as HOLDRs, as those issuers are not registered investment companies.|
|2||Actively Managed Exchange-Traded Funds, Release No. IC-25258, 66 Fed. Reg. 57614, 57616 (Nov. 8, 2001).|
|3||Investment Company Institute, Exchange-Traded Fund Assets January 2005 (Feb. 25, 2005), at http://www.ici.org/stats/etf/etfs_01_05.html.|
|4||DIAMONDS Trust, Series 1 Prospectus (Feb. 28, 2005).|
|5||MidCap SPDR Trust, Series 1 Prospectus (Jan. 28, 2005).|
|6||Nasdaq-100 Trust, Series 1 Prospectus (Jan. 31, 2005).|
|7||SPDR Trust, Series 1 Prospectus (Jan. 28, 2005).|
|8||Rule 204A-1(e)(9) defines a “reportable fund” as (i) an investment company for which the registered investment adviser serves as an investment adviser or (ii) an investment company whose investment adviser or principal underwriter controls, is controlled by, or is under common control with the registered investment adviser.|
|9||Rule 204A-1(e)(10(v) provides an exclusion for shares issued by UITs that are invested exclusively in one or more open-end investment companies, none of which are reportable funds. This exclusion is aimed at variable insurance contracts that are funded by insurance company separate accounts organized as UITs. Investment Adviser Codes of Ethics, Release Nos. IA-2256, IC-26492, 69 Fed. Reg. 41696, 41699 n.47 (July 2, 2004) (the “Adopting Release”). It has no application to the relief requested by this letter, except insofar as it further illustrates that certain securities appear to present little opportunity for improper trading.|
|10||Id. at 41699.|