Important legal considerations when launching an ETF

1. Vol. 19, No. 1 • January 20123
I
n a typical business venture, the legal review of a proposed product follows
the completion of the product’s business and marketing plans. If a firm seek-
ing to launch an exchange-traded fund (ETF) or another type of exchange-
traded product (ETP) ignores the legal issues at the outset, it may find itself
having to backtrack to modify the ETP structure, revamp its marketing plan or take
other actions that could result in significant delays and a less desirable product. The
better approach is to identify legal issues early in the process and weave them into the
business plan.
Legal Issues Should Not Take a Back Seat to
Business Decisions When Launching an ETF
By Bibb L. Strench and Alexandre V. Rourk
This article highlights the legal issues firms
confront when setting up ETPs and explains
why these issues influence product design,
timing and other critical business decisions.
Addressing legal and business issues concur-
rently will minimize the inevitable twists and
turns associated with launching a product in a
highly regulated environment.
Product Design
It is very important to decide at the out-
set which type of an ETP the firm desires to
launch, a task made all the more complex by a
lack of standardized nomenclature within the
industry.1 “ETPs” generally are all exchange-
traded products that provide investors expo-
sure to a specific benchmark or investment
strategy by investing in securities or other
assets.2 ETPs come in a variety of different
legal forms, including ETFs, exchange-traded
vehicles (ETVs) and exchange-traded notes
(ETNs).
A sponsor designing an ETP immediately
confronts a regulatory structure that forces
it to make compromises. An ETP is a fund
or a pool of instruments owned by investors
who have an undivided interest in the fund
or pool. This pooling results in two tiers
of legal analysis for purposes of the securi-
ties laws, which greatly influence product
design.
The first tier of the analysis addresses the
interests in the ETP that are sold to investors.
These interests, since they are offered and
sold publicly to investors, are securities for
purposes of the securities laws and subject the
ETP to regulation under the Securities Act of
1933, as amended (1933 Act).
The second tier of the analysis addresses
the instruments owned by the fund or pool.
ETFs, which own securities, must register as
investment companies under the Investment
Company Act of 1940, as amended (1940
Act). ETVs, which own commodities, futures
or currency, are subject to different regulatory
schemes. ETNs, unlike ETFs and ETVs, are
not entities but rather obligations of financial
firms. As shown, the nature of these instru-
ments determines which regulatory scheme
applies to the ETP.
Bibb L. Strench is a counsel, and Alexandre V. Rourk
is an associate, in the Investment Management group
of Seward & Kissel LLP in Washington, DC.

2. THE INVESTMENT LAWYER 4
As the last category in the chart on the fol-
lowing page indicates, a firm might desire to
offer an ETP that holds a blend of instrument
types (for example, gold bullion, gold mine
company common stock and futures on gold
indexes). If this is the case, legal issues arise
that will impact the structure of the ETP (as
certain blended structures are impossible under
existing regulatory schemes). For instance, an
ETP that desires to have a portfolio consisting
of gold bullion, gold mine company common
stock and futures on gold indexes may have to
register as an investment company under the
1940 Act, because a portion of its assets will
be common stock. Since only certain types of
financial instruments count as good income
for purposes of receiving pass-through tax
treatment under the Internal Revenue Code,
an ETP registered under the 1940 Act will be
limited to holding only a small percentage of
its assets in gold bullion, which is a hard asset
and does not count as good income.4 Blending
of various types of assets also raises issues
under the 1940 Act.
Entity Choice
A firm starting an ETP may not operate
the ETP within its existing organization as a
division or subsidiary. Rather, the ETP must
be a separate legal entity. The firm should
organize the ETP in a state that has a statute
tailored for regulation of investment compa-
nies and other pooled products and which
is administered by securities administrators
that have extensive experience with corporate
governance matters unique to such entities.
ETFs typically are organized as Delaware
statutory trusts, Maryland corporations or
Massachusetts business trusts. ETFs, as reg-
istered investment companies (or RICs), also
receive favorable pass-through tax treatment
under Subchapter M of the Internal Revenue
Code. ETVs, since they are not RICs, cannot
rely on Subchapter M. They must choose a
form of entity, such as a limited partnership or
trust, that affords favorable pass-through tax
treatment. There are important business impli-
cations when making this choice that relate to
tax reporting to investors.
ETNs are different. ETNs are not entities,
but rather notes constituting the general debt
obligations of the firm issuing them (often a
bank). The amount due at maturity of the note
is a variable amount referenced by the return
of a basket of securities or a specific index.
An investor in such ETN is exposed both to
the market risk of the referenced securities or
index of securities and the credit risk of the
issuer.
Capital
While the investment management business
is less capital-intensive than most bricks-and-
mortar businesses, any ETP venture should be
well capitalized at the outset. The timeframe
from start to finish (SEC effectiveness) can
be a year or longer. It may take several more
years after launch to grow assets to a point
where the firm sponsoring the ETP is turning
a profit.
Copyright © 2012 by CCH Incorporated.
All Rights Reserved
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3. Vol. 19, No. 1 • January 20125
Section 14(a) of the 1940 Act requires an
ETF (but not other ETPs) to have at least
$100,000 of assets (called “seed money”)
before its shares may be offered to the public.
The initial registration statement of an ETF
must contain audited financial statements.
Typically, the investment adviser provides the
seed money. The financial statements con-
tained in the initial registration statement will
reflect the seed money and may also cover
certain liabilities, the most important of which
are organizational expenses and offering costs.
A key business decision is whether the ETF or
the adviser will bear the costs. The party bear-
ing the costs must also take care to account
for them correctly, especially if it wishes to
amortize certain costs instead of immediately
expensing them. A final key business decision
is whether to contractually obligate the adviser
to waive its advisory fee or reimburse ETF
expenses to cap the ETF’s total expense ratio.
Too high of an expense ratio may make the
ETF unmarketable.
Quick Tip: Making Life Easier
As soon as an ETF is formed, the
firm should track offering costs and or-
ganizationalexpensesof theETF,which
are treated differently for accounting
Underlying
Investment
Regulatory Schemes Governing Exchange—Traded Product
Statutes Regulators
ETF Securities Securities Act of 1933
Securities and Exchange
Act of 1934
Investment Company Act
of 1940
SEC (Division of Investment
Management)
SEC (Division of Trading and
Markets)
FINRA
ETV3 Futures Securities Act of 1933
Securities and Exchange
Act of 1934
Commodity Exchange Act
SEC (Division of Corporation
Finance)
SEC (Division of Trading and
Markets)
FINRA
CFTC
NFA
Hard
Assets (eg.,
gold, silver,
etc.)
Securities Act of 1933
Securities and Exchange
Act of 1934
Commodity Exchange Act
SEC (Division of Corporation
Finance)
SEC (Division of Trading and
Markets)
FINRA
CFTC
NFA
Currency Securities Act of 1933
Securities and Exchange
Act of 1934
Commodity Exchange Act
SEC (Division of Corporation Finance)
SEC (Division of Trading and
Markets)
FINRA
CFTC
NFA
ETN Securities Act of 1933
Securities and Exchange
Act of 1934
SEC (Division of Corporation Finance)
SEC (Division of Trading and
Markets)
FINRA
Blended ETP Some or all of the above Some or all of the above

4. THE INVESTMENT LAWYER 6
purposes. The most significant offer-
ing costs will be the preparation of the
registration statement. The sponsor
should request that the outside coun-
sel have separate billing entries for time
entered that is related to offering costs
(for example, drafting the initial regis-
tration statement) and organizational
costs (for example, setting up the trust
or the corporation).
1940 Act Exemptive Relief Barrier
Exemptive relief from the 1940 Act is neces-
sary only for ETFs. Other ETPs, as discussed
above, are not regulated by the 1940 Act. This
is a big business advantage for ETVs and
ETPs.
Probably the single greatest legal obstacle
facing a firm entering the ETF business is the
requirement to obtain exemptive relief from
the SEC, a process that greatly impacts the
launch date of the ETF.5 An ETF has features
common to an open-end fund and a closed-
end fund. Congress enacted the 1940 Act to
regulate four types of investment companies—
mutual (open-end) funds, closed-end funds,
unit investment trusts and face-amount cer-
tificate companies—but not a combination
of these types.6 If not for narrowly-tailored
exemptions from certain prohibitions of the
1940 Act, no ETF could ever operate within
the bounds of the federal securities laws.7
A firm relying on exemptive relief to offer
an ETF must comply with a number of condi-
tions that impact how it manages and offers
the ETF. By far the most important condition,
as discussed below, requires the advisory firm
to reveal the ETF’s portfolio so that arbitrag-
ers, through the create/redeem process, have
the opportunity to drive the market price of
the share of an ETF to the actual NAV per
share of the ETF.
Assuming exemptive relief is necessary, the
timing and complexity of the application for
exemptive relief will be greatly influenced by
how the basket of portfolio securities is man-
aged and the willingness of the advisory firm
to allow transparency of its portfolio manage-
ment process.
There are two basic types of ETFs: index-
based ETFs and actively-managed ETFs. Most
ETFs trading in the marketplace are index-
based ETFs, which seek to track an underly-
ing securities index by achieving returns that
closely correspond to the returns of that index.
This type of ETF primarily invests in equity or
fixed-income securities issued by the compa-
nies that are included in the index or a repre-
sentative sample of those securities. Since the
firms sponsoring these ETFs attempt to track
an index, they have no issue with disclosing the
ETF’s portfolio securities on a real-time basis
and their exemptive application experience will
be relatively smooth.
Actively-managed ETFs are not based on
an index. Rather, they seek to achieve a stated
investment objective by investing in a portfolio
of securities and other assets. This type of ETF
is actively managed because, unlike an index-
based ETF, where the components of an index
are relatively static, an adviser to an actively-
managed fund may buy or sell components in
the portfolio on a daily basis, provided such
tradesareconsistentwiththeoverallinvestment
objective of the fund. To address transparency
concerns, the SEC requires actively-managed
ETFs to publish their holdings daily. Because
there is no underlying index that can serve as
a point of reference for investors and other
market participants as to the fund’s holdings,
disclosing the specific fund holdings ensures
1940 Act Exemptive Relief
ETF Complexity/Length of Process
Index Low/Short
Actively Managed—Significant Transparency Medium/Moderate
Actively Managed—Little/No Transparency Very High/Long
Index or Actively Managed—Significant Use
of Derivatives
Very High/Indefinite

5. Vol. 19, No. 1 • January 20127
that market participants have sufficient infor-
mation to engage in the arbitrage that works
to keep the market price of ETF shares close
to their NAV.8 So long as a firm sponsoring an
actively-managed ETF agrees to full transpar-
ency of its portfolio, its exemptive application
process also will be relatively smooth.
If a firm sponsoring an ETF desires to
mask its investment strategy (sometimes called
its “secret sauce”), it can file for exemptive
relief with some kind of alternative to trans-
parency that nevertheless has a similar effect
as the arbitrage mechanism. It should expect a
very lengthy review process. This is because the
SEC has been reluctant to approve any mecha-
nism other than full portfolio transparency as
a means of ensuring that the arbitrage process
will effectively keep the ETF’s market price in
line with its NAV per share.
A firm may want to launch an ETF with
a strategy based on the use of derivatives. In
March 2010, the SEC Staff determined to
defer consideration of exemptive requests for
those ETFs that fall under the 1940 Act and
intend on making significant investments in
derivatives. Because leveraged and inverse-
leveraged ETFs often make significant use of
derivatives, deferring consideration of exemp-
tive requests related to derivatives necessarily
deferred the issuance of new orders permitting
leveraged and inverse ETFs that would be sub-
ject to the 1940 Act.9 As shown in the 1940 Act
Exemptive Relief table above, a firm will have
an indefinite wait for such relief.
Even if the initial ETF will be “plain
vanilla” (for example an ETF that tracks a
U.S. equity index), the firm filing the exemp-
tive application, for business reasons, should
apply for the broadest type of exemptive relief
granted to date. Otherwise, the firm may have
to return to the SEC for amended exemp-
tive relief, which could significantly delay the
launch of the next-planned ETF (for example,
an ETF that tracks international bonds).
All ETPs, as the first word in their names
suggests trade on an exchange. The listing and
trading of ETF shares on an exchange require
an ETP to comply with a number of provi-
sions of the Securities Exchange Act of 1934,
as amended (1934 Act) and rules thereunder,
with which, because of the structure of the
ETP, it is unable to comply. Therefore, the ETP
must apply for relief from the SEC’s Division
of Trading and Markets from these rules.10 In
order for an exchange to list and trade a new
ETP, the SEC must review and approve the
exchange’s listing proposal. The federal secu-
rities laws require each national exchange to
maintain rules governing the listing and trad-
ing of securities on their markets. Typically,
an exchange may list and trade shares of an
index-based ETP without seeking approval
from the SEC, provided that the ETP meets a
set of listing requirements and the exchange
files a form with the SEC representing to that
effect. In the case of an actively-managed or
an “exotic” ETP, the exchange must file a pro-
posed rule change with, and obtain approval
from, the SEC prior to being able to list and
trade the product. In its analysis, the SEC
Staff considers the structure and description
of the ETP, its investment objective, invest-
ment methodology, permitted investments,
and the availability of key information and
values, including the NAV, intraday indicative
value, and the disclosed portfolio of securities
and other assets. The ETP must comply with
the initial and continued listing requirements
of its listing exchange.11
Quick Tip: Speedy Exemptive
Applications
The quickest way to obtain exemp-
tive relief from the SEC is to copy the
most recent exemptive application and,
along with the formal filing, send to
the SEC a draft version showing dif-
ferences from the existing application.
The fewer the differences, the faster the
grant of relief. A firm may also consid-
er buying an advisory firm that already
has exemptive relief. It is important to
note that the transaction may take lon-
ger to negotiate and close than the time
it would take for the SEC to approve
an application for exemptive relief.
Registration
An ETP, irrespective of whether it is a reg-
istered investment company, must register its
securities with the SEC, which is yet another
process that can delay the launch of the product.

6. THE INVESTMENT LAWYER 8
The SEC Staff’s review of filed registration
statements, including those involving public
offerings of securities of trusts and commodity
pools, aims to ensure complete disclosure.12
Since ETFs are investment companies,
they must wait a year or longer to obtain
the required exemptive relief. A firm start-
ing an ETF, therefore, may desire to delay
preparing and filing a registration statement
until closer to the date of approval of the
exemptive application by the SEC in order
to defer paying legal fees for a registration
statement until closer to the date on which it
will be declared effective. However, delaying
registration is not an option because the ETF
must be a registered investment company
before it files an application for exemptive
relief with the SEC. This is because to regis-
ter as an investment company, an ETF must
notify the SEC of its intention to register
securities by filing Form N-8A. One of the
representations that must be made in Form
N-8A is that the ETF will file a registration
form with the SEC to register its securities
within three months of filing Form N-8A.
As a consequence, the ETF must prepare and
file a registration statement with the SEC a
year or more before it is able to first offer
securities to the public.
The firm managing an ETF must regis-
ter with the SEC as an investment adviser
under the Investment Adviser Act of 1940 (the
Advisers Act). If a firm does not have $100
million of assets under management or does
not already manage a registered investment
company, it should postpone adviser registra-
tion to a date closer to the expected effective
date. Otherwise it will have to deregister as an
investment adviser if the ETF is not launched
and does not have at least one non-organizer
shareholder within 120 days of becoming an
SEC-registered adviser.
Quick Tip: Save a Few Bucks
One way an ETF sponsor can delay
part of the full cost of registration is
to file an abbreviated registration state-
ment that does not contain all of the
disclosure that will appear in the fi-
nal prospectus. Some ETF firms also
only file a prospectus for a single fund,
even though they plan on launching
multiple ETFs. When the approxi-
mate date the exemptive relief will be
granted becomes known, the sponsors
file an amendment to the registration
statement containing full disclosure for
all of the ETFs that will be launched.
Board
A firm that undertakes the expense and time
to organize an ETP will want to control the
affairs of the product of its investment. Section
16 of the 1940 Act, however, requires ETPs that
are formed as investment companies to bring
outsiders, called “independent directors,” into
their organization.13 The independent directors
have the authority under federal and state law,
as well as under the ETF’s governing docu-
ments, through their oversight role to approve
or disapprove most of the important busi-
ness and legal decisions concerning the ETF.
Needless to say, the particular persons selected
to be independent directors can greatly influ-
ence the firm’s management of the ETF.
When selecting independent directors, the
firm should analyze their degree of inde-
pendence. At a minimum, each independent
director may not be an “interested person”
of the firm. Section 2(a)(19) of the 1940 Act
defines an “interested person” generally to
mean persons who are affiliates of the ETF or
an adviser to the ETF, or have had business
relationships with the adviser or its affiliates.
Independent directors must also be indepen-
dent of the ETF’s independent auditor. Firms
should thoroughly vet independent director
candidates through the use of detailed ques-
tionnaires and background checks.
The SEC prefers that advisers to ETFs go
further than the literal requirements of the
1940 Act and select persons entirely indepen-
dent from the adviser and its affiliates, particu-
larly from the adviser’s founder.14 Bringing in
complete strangers to the Board, however, has
the potential to cause significant disruptions
in the long run, particularly since the firm has
very limited ability to remove independent
directors. It is therefore highly advisable that
the persons organizing the ETF have a high
degree of familiarity with independent direc-
tors on a personal level.

7. Vol. 19, No. 1 • January 20129
Quick Tip: Pick Early/Form Later
The directors, especially the inde-
pendent directors, should be selected
early but not be formally appointed di-
rectors until later in the process. There
are many steps that require board ap-
proval prior to the ETF’s registration
statement going effective. During this
period, the ETF may operate with a
single director affiliated with the firm
who can quickly take these steps by ex-
ecuting consents. A firm should post-
pone forming the full board until the
organizational meeting.
Chief Compliance Officer
A firm launching an ETP, especially if it is
an ETF, is entering one of the most regulated
industries in the United States and, conse-
quently, will end up devoting a considerable
amount of resources to compliance. Any devi-
ation from rigid compliance to the pertinent
laws and regulations risks the reputation of
the firm and its principals, and may tarnish the
prospects of the firm’s other business ventures.
Therefore, compliance must be embedded in
the business of operating an ETF.
Rule 38a-1 under the 1940 Act requires an
ETP formed as an investment company to
have a chief compliance officer (CCO). Rule
206(4)-7 under the Advisers Act also requires
an adviser to the ETF to have a CCO. When
selecting a CCO, a firm must decide whether
the person will be someone from within or
outside its organization. Choosing a firm
employee has many advantages. An inside
CCO will be on site while carrying out his or
her compliance functions, thereby putting the
CCO in a better position to detect violations
or problems, as well as administering the com-
pliance program. However, the inside CCO
option tends to be more expensive, especially
in terms of salary and benefits, and it may be
difficult to find a qualified person in the orga-
nization. Third-party CCOs often have excel-
lent compliance experience and are less costly
since they typically serve as CCOs for several
other ETFs or funds. Outsourcing compliance,
however, has its problems. Outside CCOs nor-
mally visit the ETF complex quarterly or less
often and have little day-to-day contact with
adviser’s management and other employees.
Service Providers
Unlike most businesses, the operations of
an ETP are largely outsourced. This includes
fund accounting, custody and certain adminis-
trative functions. An ETP is highly dependent
on its service providers. The operations of an
ETP will run smoothly only to the extent the
adviser and its service providers act in concert.
Because it is so critical, the selection of the
service providers should occur early in the
ETP formation process. The due diligence and
negotiation process can take months.
Quick Tip: Work the Room
One of the best ways to begin a
service provider search is to attend an
ETP conference. Most leading service
providers will be there at their booths
and later in the lounge.
A number of ETP service providers are
unique because the ETP product itself is
unique. An ETP must create its basket of secu-
rities every business day. It therefore needs to
retain an index calculation agent that delivers
to the firm the information about constituent
securities that will make up the ETP basket.
In many cases, the calculation agent will be an
affiliate of the index provider. A firm starting
an ETF will have to negotiate with an index
provider that will allow the ETP to use its
index and its service marks.
The success or failure of an ETP will be
driven, in large part, by how many shares of
the ETP trade on a given day and the spread
between the ask and bid prices.15 The market
maker for the ETP is critical to this pro-
cess since it ultimately maintains the bid/ask
spread.16 Unlike most service providers, how-
ever, a firm starting an ETP typically must
convince the market maker to take it on as a
client and not the other way around.17
A number of financial organizations offer
significant shortcuts to starting an ETP, but
at a cost. For instance, a firm can organize an
ETF as a series of an existing business entity
(sometimes called a shared trust or umbrella

8. THE INVESTMENT LAWYER 10
trust) that is operated by a financial organi-
zation that already received exemptive relief
from the SEC. Since that entity has exemptive
relief, the firm will save considerable time and
money by not having to apply for relief. One
significant drawback to this option is that
directors with no connection to the firm will
ultimately control the ETF and may be more
inclined to side with the financial organization
and not the firm, were an issue ever to rise.
Quick Tip: Outsourcing Can Only
Go So Far
Many firms starting an ETP are for-
mer portfolio managers who have the
next great investment idea. They are
experts at picking stocks or designing
investment models and would prefer to
leave the rest of the operations to oth-
ers. This approach is not advisable for
a sponsor running an ETP. There must
be some person within the organiza-
tion who is capable of orchestrating
the complicated process of running an
ETP on a day-to-day basis. This is most
evident in the basket creation process,
as at the end of each business day a
basket containing the securities or oth-
er instruments makes up the ETP. This
person must coordinate with the index
calculating agent, the administrator
and others to ensure the basket is cor-
rect. One slip (for example, missing the
announcement of a spin-off by one of
the basket constituents) can have dire
financial consequences. It is impera-
tive that someone within the adviser
be well-versed in the ETP business, as
well as be reliable and organized, so
that the basket creation and other criti-
cal processes may be carried out in a
timely and correct manner every busi-
ness day.
Marketing Plan
The success of an ETP, like that of most
business ventures, depends in large part on
how well it is marketed. In the early days of
the ETP industry, the “build it and they will
come” approach worked fairly well, as many
core index strategies lacked corresponding
ETP products. Those days are over, and a deft
marketing plan is critical.
The components of an ETP marketing plan
are greatly impacted by legal factors. While
every sponsor would prefer to market an ETF
as much as possible in advance of the launch,
Section 5 of the 1933 Act greatly limits the
ability to market the ETP during the “waiting
period” (that is, the period after the registra-
tion statement is filed and before it is declared
effective by the SEC). After the ETP is effec-
tive, those persons at the firm marketing the
ETP must thoroughly understand the complex
rules adopted by the SEC and the Financial
Industry Regulatory Authority (FINRA) that
touch on virtually every aspect of marketing.
Any registered representative of an ETF
tasked with the job of marketing an ETF will
want to discuss performance with potential
investors. While a new ETF will not have any
past performance, it may include past per-
formance of certain related accounts of the
adviser in its prospectus, provided the certain
conditions set forth in applicable no-action
letters are met.18 FINRA, which regulates the
form of advertising that its member firms use
with respect to investment companies, prohib-
its ETFs from advertising the performance of
a strategy used by the adviser to manage its
other clients, a model portfolio or back-tested
performance data.
When formulating a marketing plan for an
ETF, the firm should not rely solely on 12b-1
fees even though such fees may likely be the
single most important factor that caused the
mutual fund industry’s tremendous growth
in the last 35 years. While ETFs may have
12b-1 fees, there is one important difference
between how they can potentially benefit an
ETF as compared to a mutual fund. Broker-
dealers and other financial intermediaries are
incentivized to sell mutual fund shares because
they receive the Rule 12b-1 fee, or trail com-
mission, as long as their customers remain
invested in the mutual fund’s shares. Shares of
mutual funds are sold directly by the mutual
fund or financial intermediary to the investors,
while shares of ETFs are sold on a securities
exchange. Consequently, the mutual fund dis-
tributor knows which broker-dealers sold the
fund shares and the ETF distributor does not.

9. Vol. 19, No. 1 • January 201211
Therefore, even with a Rule 12b-1 fee plan in
place, an ETF is not in the same position to
incentivize broker-dealers and their registered
representatives to sell shares as mutual funds
are.
Many firms launching ETFs focus on the
adviser community, which is the same strat-
egy that many mutual funds follow. However,
for legal (including the 12b-1 issue discussed
above) and other reasons, the large fund super-
markets for mutual funds have not developed
for ETFs, making the road for reaching finan-
cial advisers far more challenging.
Avoiding Pitfalls
A firm forming an ETP, like a firm starting
any business venture, hopes to avoid surprises
because most surprises, especially those involv-
ing legal issues, are rarely pleasant. A firm can
limit many potential surprises at the outset
of launching an ETP by being aware of, and
prepared for, the legal issues discussed in this
article. Such advance preparation may result
in the firm recognizing that the ETP it had
hoped to launch may have to have a less desir-
able structure and features. When it comes to
forming ETPs, it is far better to receive bad
news early in the process as compared to weeks
before the ETP’s target launch date.
Notes
1. One financial organization has stated that ETFs that
are highly leveraged should be called “Ultra”funds and not
“ETFs,” because they are intended for short-term instead
of long-term investors.
2. In a recent testimony, Eileen Rominger, the Director
of the SEC’s Division of Investment Management, labeled
ETPs as the broadest category and ETFs as a sub-category
of ETPs—“ETFs are a type of exchange-traded product
or “ETP” that must register as investment companies.” See
Eileen Rominger, Testimony on Market Micro-Structure:
An Examination of ETFs (Oct. 19, 2011).
3. An ETV organized for the purpose of trading in any
commodity for future delivery may also fall under the
definition of a commodity pool operator and may be
required to register with the Commodity Futures Trading
Commission under Section 4(m) of the Commodity
Exchange Act.
4. Internal Revenue Code of 1986, § 851.
5. The SEC issued the first order granting exemptive relief
to an ETF organized as a unit investment trust in 1992, and
began issuing orders to ETF sponsors for ETFs organized
as open-end funds in 1996. The SEC now has issued more
than 100 orders on which ETF sponsors rely to launch
their ETFs.
6. ETFs combine features of a mutual fund, which can
be purchased or redeemed at the end of each trading day
at its net asset value (NAV) per share, with the intra-day
trading feature of a closed-end fund, whose shares trade
throughout the trading day at market prices that may be
more or less than its NAV.
7. All ETFs must request relief from at least Section 17
(transactions with affiliates), Section 18 (establishing dif-
ferent classes of shares), and Section 22 (issuing shares
at a price other than the NAV per share) of the 1940 Act.
The SEC has proposed but not adopted Rule 6c-11, which
would allow a firm to start an ETF immediately by com-
plying with the Rule instead of filing an exemptive applica-
tion. See Exchange-Traded Funds, Investment Company
Act Rel. No. 28193 (March 11, 2008).
8. The creation/redemption process serves as the basis for
the arbitrage mechanism that provides market participants
with an incentive to buy or sell shares of the ETF whenever
sufficient divergence between the market price of the ETF
and the NAV of the underlying components occurs. To
further aid in the process, an estimated NAV, also referred
to as the “intraday indicative value,”is disseminated at least
every 15 seconds throughout the trading day.
9. See Press Release: “SEC Staff Evaluating the Use of
Derivatives by Funds,” 2010-45; March 25, 2010, available
at http://www.sec.gov/news/press/2010/2010-45.htm.
10. These provisions include: Section 11(d)(1) of the 1934
Act, Rules 10a-1, 10b-10, 10b-17, 11d1-2, 143-5, 15c1-5
and 15c1-6 thereunder, Rules 101 and 102 of Regulation
M, and Rule 200(g) of Regulation SHO.
11. Depending on its structure and features, an ETP may
need exemptive relief from Regulation M under the 1934
Act, a regulatory scheme designed to prevent market
manipulation of listed securities.
12. As applied to ETFs generally, the 1933 Act require-
ments relate primarily to disclosures made by the entity
issuing the securities, including disclosures about the issuer,
the securities being issued, and material risks affecting the
investment.
13. ETFs listed on national securities exchanges, irrespec-
tive of whether they are registered investment companies,
are required by the listing standards of the exchanges to
have a majority of their directors be independent directors.
14. See Paul Roye, Director of the SEC’s Division of
Investment Management, Response to a Congressional
Inquiry Regarding Mutual Fund Practices (June 9, 2003).
15. The spread generally widens when there is a lack of
market makers watching the product, which is typical of
new ETFs.
16. Market makers and authorized participants provide
liquidity for ETPs. Authorized participants approved by
the ETP are the only “investors” who can actually trade

10. THE INVESTMENT LAWYER 12
the underlying basket securities, as opposed to the ETF
shares. Through this process, authorized participants are
able to convert shares of the ETF into creation/redemption
baskets and vice versa. Market makers make two-sided
markets, bid-ask, and stand ready to make a price when an
authorized participant comes to them.
17. ETFs may require a certain amount of “seasoning”
to be recognized by the investment community. Not every
market maker will take a product and make a market
for it right away. It is not uncommon to see spreads as
wide as 10 cents in a newer ETF, because there may only
be only a handful of market makers in it. Large ETFs,
on the other hand, may have hundreds of participants
actively involved in and constantly monitoring them.
18. See, e.g., Nicholas-Applegate Mutual Funds (pub.
avail. Aug. 6, 1996 and Feb 7, 1997).