June 17, 2015

Exchange-Traded Products SEC Requests Comments on Topics Related to the Listing and Trading of Exchange-Traded Products on National Securities Exchanges and Sales of Such Products by Broker-Dealers SUMMARY The Securities and Exchange Commission recently published a request for comment on topics relating to its oversight of exchange-traded products under the Securities Exchange Act of 1934, and particularly the listing and trading of exchange-traded products on national securities exchanges and the sales of such products by broker-dealers. In the request for comment, the SEC states that it is soliciting public comment to help inform its review of the listing and trading of new, novel or complex exchange-traded products, including requests for exemptive and no-action relief under the Exchange Act and filings by exchanges to adopt listing standards applicable to exchange-traded products. In addition, the SEC invites views on the manner in which broker-dealers market ETPs to investors and on the extent to which broker-dealers fulfill their obligations to investors when they recommend and sell exchange-traded products, particularly to retail investors. The SEC also seeks comment on investor understanding of the nature and uses of exchangetraded products, particularly that of retail investors. In the Release the SEC focuses particular attention, and requests specific comment, on issues relating to: 

Arbitrage and market pricing of exchange-traded products;

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Exemptions and no-action positions under Regulation M, Section 11(d)(1) of the Exchange Act and Exchange Act Rules 10b-10, 11d1-2, 14e-5, 15c1-5 and 15c1-6;

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Exchange-traded product listing standards;

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Broker-dealer sales practices and investor understanding and use of exchange-traded products; and

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Other topics, including the consequences of closure and liquidation or termination of an exchange-traded product; likely future developments in the market for exchange-traded products; growth of the market capitalization of exchange-traded products; and the research, tools and metrics provided by the SEC on its Market Structure Data and Analysis website.

BACKGROUND 1

According to the SEC’s request for comment (the “Release”), the SEC has determined to “seek public comment on topics associated with its oversight of the listing and trading of [exchange-traded products (“ETPs”)] on national securities exchanges,” because of the increasing number and complexity of requests by issuers of ETPs for exemptive relief under the Exchange Act and proposed rule changes filed by exchanges seeking to establish listing standards for new ETPs. The SEC states in the Release that the increasing number and complexity of such requests arises from the increasing scope and complexity of ETP investment strategies. The SEC further notes that a significant percentage of equity trading in the United States consists of ETP trading. 2

In the SEC’s press release of June 12, 2015, SEC Chair Mary Jo White explained that the SEC is seeking broad public input in light of new products of growing complexity. Concerns regarding the novelty and complexity of ETPs have been raised from time to time by SEC commissioners and members of the SEC staff. For example, Commissioner Kara M. Stein recently dissented from an SEC order approving a proposed rule change relating to the listing and trading of “Paired Class Shares” issued by Accushares exchange-traded funds, opining that “the approval of these novel and complex products is premature.”

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Amy M. Starr, Chief of the Division of Corporation Finance’s Office of Capital Market Trends, recently expressed concerns about disclosure, complexity, suitability and broker-dealer sales of structured notes, including exchange-traded notes (“ETNs”), in a speech before a structured products industry conference.

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The SEC notes in the Release that it has periodically solicited public comment on issues relating to exchange-traded funds (“ETFs”) in the context of exemptive relief provided to such funds under the

1

Request for Comment on Exchange-Traded Products, 80 Fed. Reg. 34729 (June 17, 2015).

2

SEC Publishes Request for Public Comment on Exchange-Traded Products (June 12, 2015), http://www.sec.gov/news/pressrelease/2015-118.html.

3

Dissenting Statement Regarding the Commission’s Order Approving a Proposed Rule Change to ® Adopt New Rule 5713 and List Paired Class Shares Issued by AccuShares Commodities Trust I (February 23, 2015), http://www.sec.gov/news/statement/2015-statement022315kms.html.

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Amy M. Starr, Structured Products – Complexity and Disclosure – Do Retail Investors Really Understand What They Are Buying and What the Risks Are? (May 14, 2015), http://www.sec.gov/news/speech/speech-amy-starr-structured-products-.html. -2-

Exchange-Traded Products June 17, 2015

Investment Company Act of 1940 (“1940 Act”). In 2001, the SEC issued a concept release on actively 5

managed ETFs, and, in 2008, the SEC issued a release proposing new rules relating to ETFs. In contrast, the Release relates to the treatment of ETPs, rather than only ETFs, and its focus is on the SEC’s oversight of ETPs under the provisions of the Exchange Act rather than the 1940 Act.

For

purposes of the Release, the SEC includes a broad array of products under the umbrella of ETPs: ETFs (including open end funds and unit investment trusts, in each case registered under the 1940 Act); pooled investment vehicles, including commodity trusts and partnerships that are registered under the Securities Act but not the 1940 Act; and ETNs, which are senior debt instruments that pay a return based on the performance of a reference asset.

THE RELEASE The Release begins with a lengthy overview of ETPs, including an introduction to the market; the types of ETPs that exist and how they function; information regarding purchases, sales, creations and redemptions of ETP securities that are listed on exchanges (“ETP Securities”); and arbitrage opportunities between an ETP’s market price and its net asset value (“NAV”). The Release then reviews the SEC’s oversight of ETPs, including existing Exchange Act exemptive and no-action relief for ETPs, exchange listing standards and the Rule 19b-4 process for amending listing standards, as well as regulation of broker-dealer sales practices. The SEC states in the Release that it seeks public comment to “inform the Commission’s review of new, novel, or complex ETPs under the Exchange Act,” and seeks views with respect to the listing and trading of ETP Securities, including the manner in which ETP Securities are initially listed on an exchange, the manner in which they trade in the secondary market and the exemptive or no-action relief that has been granted in relation to them under the Exchange Act; how broker-dealers recommend and sell ETPs to investors; how broker-dealers fulfill their obligations to investors when they recommend and sell ETPs; and investors’ understanding and use of ETPs.

In addition, the Release poses specific questions

described in the sections below. Arbitrage and market pricing The Release describes the opportunities presented by ETPs for market participants, market makers and institutional investors to engage in arbitrage. The Release observes that that such arbitrage may help prevent the market price of ETP Securities from diverging significantly from the value of the relevant underlying or reference assets. The Release seeks comment with respect to all aspects of the arbitrage mechanism for ETPs, including the nature, extent and potential causes of premiums and discounts across

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Exchange-Traded Funds, 73 Fed. Reg. 14618 (March 18, 2008). Among other things, the rule proposed in the 2008 release would have exempted ETFs from certain provisions of the 1940 Act and the SEC’s rules thereunder. The SEC has not adopted the rule proposed in the 2008 release. -3-

Exchange-Traded Products June 17, 2015

a wide range of ETP strategies and holdings, as well as trading of ETPs investing in less-liquid assets, including fixed-income instruments, during periods of market stress. The Release seeks comment on a number of issues relating to arbitrage, as well as market pricing more broadly, including: 

The efficacy of arbitrage mechanisms in relation to the different categories of ETPs and throughout periods of market volatility, including market stress;

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Whether there are other mechanisms or factors that could help ensure efficient market pricing of ETPs and whether their effectiveness varies by type of ETP or market conditions;

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Characteristics that affect alignment of secondary market share prices with the value of the underlying or reference assets, including characteristics of the ETPs and characteristics of the underlying or reference assets; and the effect on market pricing and arbitrage of liquidity, current and historical price information, availability of correlated hedges, use of sampling methodologies, use of over-the-counter instruments by the ETP, non-synchronous market hours, cash-only creation or redemption baskets and variable cash fees;

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Expectations of investors or other market participants with respect to the alignment of intraday trading prices with the value of the ETP’s underlying portfolio or reference asset; whether the expectations differ by ETP type, underlying asset type or market conditions; and the method by which investors determine whether the intraday trading prices of their ETPs track the value of the underlying portfolio or reference assets;

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Processes by which market participants analyze the alignment of intraday prices and portfolio or reference asset values and the weight placed thereon;

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Circumstances which may affect the alignment of trading prices and portfolio or reference asset values and the implications thereof;

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Whether and how arbitrage mechanisms may affect trading in underlying or reference assets (including whether this varies by underlying asset type);

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The extent to which ETNs offer opportunities for arbitrage; how market participants engage in arbitrage; whether market participants’ arbitrage opportunities are affected by the possibility or the occurrence of issuer suspensions of issuances and/or redemptions; and whether certain ETNs are more difficult to arbitrage because of the nature of the ETN’s reference asset or index;

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The ways in which the calculation of intraday indicative value (“IIV”) varies among ETPs; whether the calculation varies by class or type of ETP or depends on the nature of the underlying portfolio or reference asset; and whether certain IIV calculation methodologies are more or less useful for investors, market makers or other market participants;

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The usefulness of IIV (i) to market participants for an ETP based on less liquid securities and (ii) to investors and market participants for an ETN, including the relationship among the IIV for an ETN, the market price and the redemption amount;

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The extent of ETP portfolio disclosures necessary for arbitrage to function efficiently;

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Alternatives to daily portfolio disclosure which nonetheless enable the making of efficient markets in an ETP;

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Circumstances under which an ETP may suspend creations or (other than an ETF) suspend redemptions; the effect of such suspensions on arbitrage activity or market value; how suspensions affect the ETP’s continued compliance with existing exemptive and no-action relief; and the ETP’s likely response to suspension of creation or redemption activity by authorized participants; -4-

Exchange-Traded Products June 17, 2015

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The functioning and effectiveness of arbitrage mechanisms in the case of ETPs with less-liquid underlying or reference assets;

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The efficacy of arbitrage mechanisms in helping to ensure efficient market pricing throughout rising and falling markets for ETPs with less-liquid underlying or reference assets, including the effects of market stress on arbitrage mechanisms, and whether market stress could inhibit redemptions;

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The extent to which trading activity in ETP Securities may affect price discovery, price correlation, liquidity or volatility in an ETP’s underlying or reference assets; and

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Whether a listing exchange should have an obligation to monitor the effectiveness of an ETP’s arbitrage mechanism on an ongoing basis.

Regulation M The Release briefly explains the prohibitions of Regulation M as they relate to ETP Securities and seeks comment on “approaches for preventing manipulation of an ETP Securities distribution by persons who may have an incentive to do so in light of the nature, variety and complexity of ETP investment strategies and ETP markets.” The Release indicates that relief granted by the SEC with respect to Regulation M has been based on representations from ETPs regarding the continuing existence of effective and efficient arbitrage mechanisms which make it difficult to manipulate distributions of ETP Securities. The Release also indicates that the SEC relies on representations by ETP issuers that the characteristics of proposed ETPs will mitigate against the types of abuses that Regulation M is intended to address. The Release seeks comment on a number of issues relating to Rules 101 and 102 of Regulation M, including: 

How Rules 101 and 102 of Regulation M apply to ETNs given that the secondary market price of an ETN can vary significantly from the price of the underlying assets when the ETN issuer suspends new issuances. Whether relief from Regulation M for ETNs should (i) be limited to 6 ETNs meeting certain criteria, such as (a) “ETNs where there is a clear, independent index”, (b) no limitation on issuances or redemptions, (c) where an ETN’s secondary market price does not vary substantially from the reference index or (d) other factors; (ii) contain different conditions for relief from other types of ETPs; or (iii) be changed, and the risks and benefits of specified potential changes;

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Options available to an ETP in case it could no longer meet one of the conditions for its Regulation M relief and the likely effects, especially on investors; and

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The types of purchasing activities engaged in by distribution participants during the distribution of ETP Securities and the reasons for engaging in them.

Exchange Act Section 11(d)(1) and Rule 11d1-2 The Release explains that Section 11(d)(1) of the Exchange Act and Exchange Act Rule 11d1-2 generally prohibit broker-dealers that sell ETP Securities from extending or maintaining credit, or arranging for the extension or maintenance of credit, on such ETP Securities. The Release also observes that there is an 6

Release, supra note 1, at 40. -5-

Exchange-Traded Products June 17, 2015

additional risk of authorized participants of an ETF evading restrictions on lending on or arranging for lending on newly issued securities underlying such ETF.

The Release indicates that the SEC has

granted no-action relief when the portfolio underlying an ETP (i) is sufficiently diversified, (ii) is composed of securities that are not subject to Section 11(d)(1) of the Exchange Act or (iii) is not composed of securities. The Release invites comment on the conditions pertaining to the ETPs’ exemptions from Section 11(d)(1) and Rule 11d1-2 thereunder, as well as the criteria relied on by the SEC staff in no-action positions. In particular, the Release seeks comment on the effectiveness of the conditions currently relied upon by the SEC as well as whether different conditions could be more effective. Exchange Act Rule 10b-10 The Release explains that Rule 10b-10 under the Exchange Act would generally require broker-dealers to provide various disclosures to their customers before the completion of any securities transaction. This would require broker-dealers to provide disclosures with respect to each security in the portfolio deposit or redemption basket associated with a purchase or surrender (as applicable) of ETP creation units. The SEC has issued exemptive relief where (i) the relevant creation unit is sufficiently large, (ii) it is probable that the creation and redemption transactions are entered into only by sophisticated investors and (iii) the broker-dealer provides the omitted confirmation information to customers upon request. The Release invites comment on the conditions pertaining to the ETPs’ exemptions from Exchange Act Rule 10b-10 as well as the criteria relied on by the SEC staff in no-action positions. In particular, the Release seeks comment on a number of issues, including: 

The frequency with which investors request detailed information as contemplated by the SEC’s conditions in granting exemptions from Rule 10b-10 and the SEC staff’s no-action positions;

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The costs and benefits of providing such information;

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The effect of eliminating exemptions and no-action relief from Rule 10b-10;

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The effect of eliminating the conditions to such relief; and

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Whether different conditions would be more suitable.

Exchange Act Rule 14e-5 The Release explains in the Release that a person acting as the dealer-manager of a tender offer for a security constituting part of the underlying portfolio of an ETP is a “covered person” under Rule 14e-5 of the Exchange Act and is therefore prohibited from purchasing or arranging to purchase such security other than as part of that tender offer.

The Release indicates that it has granted relief from this

prohibition, conditioned on the issuer’s representation that the redemption of creation units and purchase of ETP Securities does not result in the abuses that Rule 14e-5 was designed to prevent and that the purchases or redemptions would not be used to facilitate a tender offer.

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The Release invites comment on the conditions pertaining to the ETPs’ exemptions from Exchange Act Rule 14e-5 as well as the criteria relied on by the SEC staff in no-action positions. In particular, the Release seeks comment on the ways, if any, in which Rule 14e-5 has affected the structure of ETPs. Exchange Act Rules 15c1-5 and 15c1-6 The Release explains in the Release that Rule 15c1-5 under the Exchange Act requires broker-dealers to disclose any control relationship between itself and an issuer prior to a customer’s purchase or sale of such issuer’s securities and that Rule 15c-6 requires a broker-dealer to disclose that it is participating in the primary or secondary distribution of the securities that it is selling or purchasing for the customer’s account. The Release invites comment on the conditions to ETPs’ exemptions from Exchange Act Rules 15c1-5 and 15c1-6, as well as the criteria relied on by the SEC staff in no-action positions. In particular, the Release seeks comment on a number of issues, including: 

Whether investors would realize any benefit from receiving the information that would be required by Rules 15c1-5 and 15c1-6;

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The cost of providing such information and who would bear it considering the impact of modern information technology; and

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Whether different conditions for “Qualifying ETFs” would be less costly or burdensome to brokerdealers while achieving the purposes of Rules 15c1-5 and 15c1-6, and the related trade-offs.

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Exchange Listing Standards The Release notes the joint responsibility of national securities exchanges and the SEC for determining whether the proposed listing and trading of ETP Securities is consistent with the Exchange Act. The Release requests comment regarding whether the independent obligations complement each other or overlap and, if they overlap, how the responsibilities should be allocated. The Release seeks comment on a number of specific issues, including:

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Whether an exchange’s business practices with respect to ETP Securities differ from its practices with respect to traditional equity listing services and, if different, how those practices align with the existing regulatory framework;

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The effectiveness of current exchange listing standards given the increasing complexity of ETP investment strategies and the expansion of the types of underlying and reference assets and benchmarks, including whether they effectively address the use by ETPs of non-exchange listed derivatives or leverage;

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Given the increasing complexity of ETPs, the types of information that would assist the SEC in evaluating a proposed rule filing by an exchange relating to an ETP;

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Whether the SEC should focus on certain characteristics of an ETP in evaluating a proposed rule filing by an exchange, including characteristics of and availability of information about the underlying assets of the ETP, the effectiveness of creation and redemption in facilitating arbitrage opportunities, or other factors;

See Release, supra note 1, at 24 n.61. -7-

Exchange-Traded Products June 17, 2015

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Whether exchange listing standards always contain both initial and continuing listing criteria, and whether these criteria should be substantially identical to one another;

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The appropriate role of an exchange in monitoring creation and redemption activity with respect to ETP Securities listed on the exchange;

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The appropriate role of an exchange that lists ETP Securities with respect to monitoring or overseeing the calculation of IIV or NAV; and

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Whether certain types of ETPs are more susceptible to manipulation than others.

Broker-dealer sales practices The Release seeks comment on the practices of broker-dealers in recommending or selling ETPs to investors (particularly retail investors), how broker-dealers meet their obligations to customers, and the extent to which investors’ investment decisions are based on such broker-dealer recommendations. The Release also seeks comment on the extent to which individual investors understand the nature and operation of ETPs and on the ways ETPs are used by investors. The Release also seeks comment on a number of related issues, including: 

Whether individual investors tend to buy and hold ETP Securities, whether that behavior varies by ETP type and whether investments by individual investors tend to be solicited or unsolicited;

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With respect to solicitation of individual investors, whether they are limited to certain categories of investors and certain types of ETPs, how those categories are determined, whether recommendations are made and the parameters around those recommendations, and whether individual investors are purchasing on the basis of recommendations;

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Effectiveness of suitability requirements applicable to brokerage accounts in addressing brokerdealer sales practices in respect of ETP Securities, especially in light of growing breadth and complexity;

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Methods employed by or available to broker-dealers to meet their sales-practice and suitability obligations for ETP Securities;

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Sources of information available to investors to help them understand ETPs, how ETP Securities trade, the costs associated with trading ETP Securities and how their prices and valuations are determined, including whether those sources are sufficient and whether better ways exist to enable investors to access information about ETPs;

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The role of exchanges in communicating information about ETP Securities to their members, their members’ customers and the general public;

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How broker-dealers communicate information about ETP Securities to customers, including whether broker-dealers provide information regarding the types of investors for which the product is suitable and restrict or otherwise limit access to information by certain types of investors for certain types of ETP Securities;

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Whether broker-dealers provide sufficient information to investors regarding the facts, risks and benefits of ETPs in an understandable, balanced and effective manner;

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Whether specific aspects of ETP trading, including risks, should be provided to investors, including when, by whom and in what way such information should be provided and whether certain ETPs present risks that should be highlighted;

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Whether broker-dealers should have additional responsibility to provide information with respect to ETPs with complex strategies prior to making a recommendation or accepting a customer’s order, and the costs of providing such information;

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Whether and how broker-dealers present investors with ETP performance data and the types of disclosures that accompany that data;

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Whether and how aspects of ETP arbitrage mechanisms should be prominently disclosed to investors, whether investors understand them and whether they consider the effectiveness of arbitrage mechanisms when making an investment decision;

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Whether broker-dealers use the term “ETF” to describe all types of ETPs (and not only registered investment companies) and, if so, whether this is confusing to investors;

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What uses investors make of public information such as index value, IIV, NAV or portfolio holdings, whether the answer depends on the type of market participant, and whether the type of underlying asset affects such use;

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Whether investors understand what IIV represents and what it does not; and

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Whether investors’ expectations of the liquidity, bid-ask spreads and market prices of an ETP having less-liquid underlying assets differ from their expectations about the underlying assets and, if so, the ways in which investors expect the ETP to trade differently from the underlying assets.

Other issues The Release seeks comment on several additional issues, including (1) the consequences to investors of closure and liquidation or termination of an ETP; (2) likely future developments in the types and complexity of investment strategies and objectives and the nature of the market for ETPs, as well as the effects of these developments on listing and trading of ETPs and underlying assets; (3) the main reasons for the growth of the market capitalization of ETPs, whether such growth is expected to continue and the effects of such continued growth; and (4) the conclusions that commenters have drawn using the research, tools and metrics provided by the SEC on its Market Structure Data and Analysis website, as well as any additional information or data that commenters would like to see maintained. The Release was published in the Federal Register on June 17, 2015, and comments are due August 17, 2015. Questions can be directed to the SEC staff identified in the Release in the Division of Trading and Markets or to any of the lawyers listed below. *

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Copyright © Sullivan & Cromwell LLP 2015

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ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters.

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