Document ID: SEC-2008-0415-0001
Agency: sec
Document Type: Proposed Rule
Title: Exchange-Traded Funds
Posted Date: 2008-03-18T04:00Z

[Federal Register: March 18, 2008 (Volume 73, Number 53)]
[Proposed Rules]               
[Page 14617-14658]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr18mr08-30]                         

[[Page 14617]]

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Part III

Securities and Exchange Commission

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17 CFR Parts 239, 270, and 274

Exchange-Traded Funds; Proposed Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 239, 270, and 274

[Release Nos. 33-8901; IC-28193; File No. S7-07-08]
RIN 3235-AJ60

 
Exchange-Traded Funds

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is proposing a new rule under the Investment Company Act of 
1940 that would exempt exchange-traded funds (``ETFs'') from certain 
provisions of that Act and our rules. The rule would permit certain 
ETFs to begin operating without the expense and delay of obtaining an 
exemptive order from the Commission. The rule is designed to eliminate 
unnecessary regulatory burdens, and to facilitate greater competition 
and innovation among ETFs. The Commission also is proposing amendments 
to our disclosure form for open-end investment companies, Form N-1A, to 
provide more useful information to investors who purchase and sell ETF 
shares on national securities exchanges. In addition, the Commission is 
proposing a new rule to allow mutual funds (and other types of 
investment companies) to invest in ETFs to a greater extent than 
currently permitted under the Investment Company Act.

DATES: Comments should be received on or before May 19, 2008.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number S7-07-08 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-07-08. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments 
are also available for public inspection and copying in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549, on official business days between the hours of 10 a.m. and 3 
p.m. All comments received will be posted without change; we do not 
edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: With respect to proposed rule 6c-11 
and amendments to Form N-1A, Dalia Osman Blass, Senior Counsel, or 
Penelope Saltzman, Acting Assistant Director, (202) 551-6792, with 
respect to proposed rule 12d1-4 and proposed amendments to rule 12d1-2, 
Adam Glazer, Senior Counsel, or Penelope Saltzman, Acting Assistant 
Director, (202) 551-6792, Office of Regulatory Policy, Division of 
Investment Management, Securities and Exchange Commission, 100 F 
Street, NE., Washington, DC 20549-5041.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public 
comment new rules 6c-11 [17 CFR 270.6c-11] and 12d1-4 [17 CFR 270.12d1-
4] and amendments to rule 12d1-2 [17 CFR 270.12d1-2] under the 
Investment Company Act of 1940 (``Investment Company Act'' or 
``Act''),\1\ and amendments to Form N-1A \2\ under the Investment 
Company Act and the Securities Act of 1933 (the ``Securities Act'').\3\
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    \1\ 15 U.S.C. 80a. Unless otherwise noted, all references to 
rules under the Investment Company Act will be to Title 17, Part 270 
of the Code of Federal Regulations [17 CFR 270], and all references 
to statutory sections are to the Investment Company Act.
    \2\ 17 CFR 239.15A, 17 CFR 274.11A.
    \3\ 15 U.S.C. 77a.

Table of Contents

I. Introduction
II. Operation of Exchange-Traded Funds
III. Exemptions Permitting Funds to Form and Operate as ETFs
    A. Scope of Proposed Rule 6c-11
    1. Index-Based ETFs
    2. Actively Managed ETFs
    3. Organization as an Open-End Investment Company
    B. Conditions
    1. Transparency of Index and Portfolio Holdings
    2. Listing on a National Securities Exchange and Dissemination 
of Intraday Value
    3. Marketing
    4. Conflicts of Interest
    5. Affiliated Index Providers
    C. Exemptive Relief
    1. Issuance of ``Redeemable Securities''
    2. Trading of ETF Shares at Negotiated Prices
    3. In-Kind Transactions Between ETFs and Certain Affiliates
    4. Additional Time for Delivering Redemption Proceeds
    D. Disclosure Amendments
    1. Delivery of Prospectuses to Investors
    2. Amendments to Form N-1A
    E. Amendment of Previously Issued Exemptive Orders
IV. Exemption for Investment Companies Investing in ETFs
    A. Background
    B. Proposed Rule 12d1-4 Conditions
    1. Control
    2. Redemptions
    3. Complex Structures
    4. Layering of Fees
    C. Scope of Proposed Rule 12d1-4
    1. Acquiring Funds and ETFs Eligible for Relief
    2. Investments in Affiliated ETFs Outside the Fund Complex
    3. Use of Affiliated Broker To Effect Sales
V. Exemption for Affiliated Fund of Funds Investments
    A. Affiliated Fund of Funds Investments in ETFs
    B. Affiliated Fund of Funds Investments in Other Assets
VI. Request for Comment
VII. Paperwork Reduction Act
VIII. Cost-Benefit Analysis
IX. Consideration of Promotion of Efficiency, Competition and 
Capital Formation
X. Initial Regulatory Flexibility Analysis
XI. Statutory Authority
    Text of Proposed Rules and Form Amendments

I. Introduction

    Exchange-traded funds are an increasingly popular investment 
vehicle.\4\ Last year, the number of ETFs

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traded in U.S. markets increased by 67 percent, from 357 to 601, and 
the assets held by ETFs increased by about 42 percent, to approximately 
$580 billion.\5\ Although aggregate ETF assets are less than seven 
percent of assets held by traditional mutual funds (i.e., open-end 
investment companies),\6\ they are growing more rapidly.\7\
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    \4\ When we refer to an ETF in this release, we refer to an ETF 
that meets the definition of ``investment company'' and is 
registered under the Investment Company Act generally because it 
issues securities and is primarily engaged or proposes to primarily 
engage in the business of investing in securities. Some other types 
of exchange-traded funds, which we will not discuss in this release, 
invest primarily in commodities or commodity-based instruments, such 
as crude oil and precious metal (``commodity ETFs''). Commodity ETFs 
are typically organized as trusts, and issue shares that trade on a 
securities exchange like other ETFs, but they are not ``investment 
companies'' under the Investment Company Act. See section 3(a)(1) 
(defining the term ``investment company'' as a company that ``(A) is 
or holds itself out as being engaged primarily, or proposes to 
engage primarily, in the business of investing, reinvesting, or 
trading in securities; (B) is engaged or proposes to engage in the 
business of issuing face-amount certificates of the installment 
type, or has been engaged in such business and has any such 
certificate outstanding; or (C) is engaged or proposes to engage in 
the business of investing, reinvesting, owning, holding, or trading 
in securities, and owns or proposes to acquire investment securities 
having a value exceeding 40 per centum of the value of such issuer's 
total assets (exclusive of Government securities and cash items) on 
an unconsolidated basis.''). 15 U.S.C. 80a-3(a)(1).
    \5\ Investment Company Institute (``ICI''), Outline of 
Supplemental Tables for Exchange-Traded Fund Report (http://
members.ici.org/stats/etfdata.xls (``ICI ETF Statistics 2007'')), 
Exchange-Traded Fund Assets December 2007, Jan. 30, 2008 (``ICI ETF 
Assets 2007''). ICI statistics cited in this release may be found 
at: http://www.ici.org/stats/etf/index.html and exclude commodity 
ETFs. By comparison, 153 ETFs were introduced in 2006, 50 were 
introduced in 2005, and 32 ETFs were introduced in 2004. ICI, 2007 
Investment Company Fact Book, May 2007.
    \6\ In 2007, net new investment in ETFs was approximately $142 
billion compared to $212 billion in traditional mutual funds, or 67 
percent of net new investment in traditional mutual funds. ICI ETF 
Statistics 2007, supra note 5; ICI, Trends in Mutual Fund Investing 
December 2007, Jan. 30, 2008 (``ICI Trends December 2007'').
    \7\ ICI ETF Assets 2007, supra note 5. As of December 2007, 
assets held by traditional equity and bond mutual funds were $8.9 
trillion. ICI Trends December 2007, supra note 6. In 2007, ETF 
assets grew 42 percent (from $407.9 billion to $579.5 billion) while 
traditional equity and bond mutual fund assets grew 9.7 percent 
(from $8.06 trillion to $8.9 trillion). See ICI ETF Statistics 2007, 
supra note 5; ICI Trends December 2007, supra note 6.
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    ETFs offer public investors an undivided interest in a pool of 
securities and other assets and thus are similar in many ways to 
traditional mutual funds, except that shares in an ETF can be bought 
and sold throughout the day like stocks on an exchange through a 
broker-dealer.\8\ ETFs therefore possess characteristics of traditional 
mutual funds, which issue redeemable shares, and of closed-end 
investment companies, which generally issue shares that trade at 
negotiated market prices on a national securities exchange and are not 
redeemable.\9\
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    \8\ ETF shares represent an undivided interest in the portfolio 
of assets held by the fund. ETFs are registered with the Commission 
and are organized either as open-end investment companies or unit 
investment trusts (``UITs''). See section 5(a)(1) of the Investment 
Company Act (defining ``open-end company'' as a management company 
that is offering for sale or has outstanding any redeemable security 
of which it is the issuer); section 4(2) of the Act (defining ``unit 
investment trust'' as an investment company that (A) is organized 
under a trust indenture, contract of custodianship or agency, or 
similar instrument, (B) does not have a board of directors, and (C) 
issues only redeemable securities, each of which represents an 
undivided interest in a unit of specified securities, but does not 
include a voting trust). 15 U.S.C. 80a-5(a)(1).
    \9\ ETFs today have certain characteristics that have made them 
attractive to investors. Many have lower expense ratios and certain 
tax efficiencies compared to traditional mutual funds, and they 
allow investors to buy and sell shares at intra-day market prices. 
Moreover, investors can sell ETF shares short, write options on 
them, and set market, limit, and stop-loss orders on them. The 
shares of many ETFs often trade on the secondary market at prices 
close to the net asset value (``NAV'') of the shares, rather than at 
discounts or premiums.
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    Since they were first developed in the early 1990s, ETFs have 
evolved. The first ETFs held a basket of securities that replicated the 
component securities of broad-based stock market indexes, such as the 
S&P 500.\10\ Many of the newer ETFs are based on more specialized 
indexes,\11\ including indexes that are designed specifically for a 
particular ETF,\12\ bond indexes,\13\ and international indexes.\14\ 
Originally marketed as opportunities for investors to participate in 
tradable portfolio or basket products, ETFs are held today in 
increasing amounts by institutional investors (including mutual funds) 
and other investors as part of sophisticated trading and hedging 
strategies.\15\ Shares of ETFs can be bought and held (sometimes as a 
core component of a portfolio),\16\ or they can be traded frequently as 
part of an active trading strategy.\17\
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    \10\ See, e.g., SPDR Trust, Series 1, Investment Company Act 
Release Nos. 18959 (Sept. 17, 1992) [57 FR 43996 (Sept. 23, 1992)] 
(notice) and 19055 (Oct. 26, 1992) (order) (``SPDR Order''); 
Diamonds Trust, Investment Company Act Release Nos. 22927 (Dec. 5, 
1997) [62 FR 65453 (Dec. 12, 1997)] (notice) and 22979 (Dec. 30, 
1997) (order). The S&P 500 stands for the Standard & Poor's 500 
Composite Stock Price Index.
    \11\ ETF providers offer ETFs that track the performance of 
indexes related to particular industries or market sectors. In 2007, 
domestic sector/industry ETFs increased by 62% from 135 to 219. ICI 
ETF Assets 2007, supra note 5.
    \12\ Many of these indexes are essentially portfolios of assets 
that are compiled (and change) on the basis of criteria that the 
index provider has designed for the particular ETF. Some indexes, 
for example, are ``fundamental'' indexes or rules-based indexes, in 
which the securities are chosen on criteria such as dividends and 
core earnings. See, e.g., PowerShares Exchange-Traded Fund Trust, 
Investment Company Act Release Nos. 25961 (Mar. 4, 2003) [68 FR 
11598 (Mar. 11, 2003)] (notice) (``PowerShares 2003 Notice'') and 
25985 (Mar. 28, 2003) (order) (``PowerShares 2003 Order'') 
(PowerShares offers ETFs that mirror custom-built indexes based on 
``Intellidexes,'' which were created by a quantitative unit of the 
American Stock Exchange). A few of the index providers that compile 
and revise the indexes are affiliated with the sponsor of the ETF. 
See, e.g., WisdomTree Investments, Investment Company Act Release 
Nos. 27324 (May 18, 2006) [71 FR 29995 (May 24, 2006)] (notice) 
(``WisdomTree Notice'') and 27391 (June 12, 2006) (order) 
(``WisdomTree Order'') (WisdomTree's ETFs seek to track the price 
and yield performance of domestic and international equity 
securities indexes provided by an affiliate).
    \13\ As of December 2007, 49 ETFs track bond indexes. ICI, 
Exchange-Traded Fund Assets December 2007, Jan. 30, 2008. See, e.g., 
Ameristock ETF Trust, Investment Company Act Release Nos. 27847 (May 
30, 2007) [72 FR 31113 (June 5, 2007)] (notice) (``Ameristock 
Notice'') and 27874 (June 26, 2007) (order); Vanguard Bond Index 
Funds, Investment Company Act Release Nos. 27750 (Mar. 9, 2007) [72 
FR 12227 (Mar. 15, 2007)] (notice) and 27773 (Apr. 2, 2007) (order); 
Barclays Global Fund Advisors, Investment Company Act Release Nos. 
27608 (Dec. 21, 2006) [71 FR 78235 (Dec. 28, 2006)] (notice) 
(``Barclays High Yield Notice'') and 27661 (Jan. 17, 2007) (order).
    \14\ The first international equity ETFs were introduced in 
1996. As of December 2007, there were 159 ETFs that provide exposure 
to international equity markets. ICI, Exchange-Traded Fund Assets 
December 2007, Jan. 30, 2008. International index-based ETFs 
increased by 87% from 85 in 2006 to 159 in 2007. Id.
    \15\ David Hoffman, Funds' grip loosens as ETFs gain, 
InvestmentNews, Apr. 28, 2006 (reporting that in 2004, 44% of 821 
advisory firms polled by Financial Research Corp. of Boston said 
they collectively allocated an average of 12% of total assets under 
management to ETFs as compared with 2003, in which only 34% used 
ETFs and collectively allocated an average of 8% of assets under 
management).
    \16\ See, e.g., iShares Trust, Investment Company Act Release 
No. 25969 (Mar. 21, 2003) [68 FR 15010 (Mar. 27, 2003)].
    \17\ See Gary L. Gastineau, Exchange-Traded Funds Manual, 2 
(2002) (``Gastineau'') (ascribing the popularity of ETFs among 
active traders to high trading volume, competitive market makers, 
and active arbitrage pricing.). Morgan Stanley, Exchange-Traded 
Funds Quarterly Report, Nov. 16, 2006, at 13 (``They can be used by 
market timers wishing to gain or reduce exposure to entire markets 
or sectors throughout the trading day.'').
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    Like money market funds first offered in the 1970s, ETFs represent 
a new type of registered investment company (``fund''). And like money 
market funds, they have required exemptions from certain provisions of 
the Act before they can commence operations.\18\ Since 1992, the 
Commission has issued 61 orders to ETFs and their sponsors.\19\
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    \18\ See rule 2a-7 under the Act, which codified the standards 
for granting the applications filed by money market funds for 
exemptions from the pricing and valuation provisions of the Act. For 
a discussion of the administrative history of rule 2a-7, see 
Valuation of Debt Instruments and Computation of Current Price per 
Share by Certain Open-End Investment Companies (Money Market Funds), 
Investment Company Act Release No. 12206 (Feb. 1, 1982) [47 FR 5428 
(Feb. 5, 1982)].
    \19\ Since 2000, the Commission has provided ETF sponsors relief 
for any ETFs created in the future in connection with their 
exemptive orders so that the sponsors can introduce new ETFs if the 
ETFs meet the terms and conditions contained in the exemptive 
orders. See, e.g., Barclays Global Fund Advisors, Investment Company 
Act Release Nos. 24394 (Apr. 17, 2000) [65 FR 21219 (Apr. 20, 2000)] 
(notice) and 24451 (May 12, 2000) (order).
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    In this release, we propose a new rule that would codify the 
exemptive orders we have issued to ETFs. Proposed rule 6c-11 would 
allow new competitors (i.e., those sponsors who do not already have 
exemptive orders) to enter the market more easily. We also are 
proposing amendments to our registration form for open-end funds, Form 
N-1A, to provide more useful information to individual investors who 
purchase and sell ETF shares on national securities exchanges. Finally, 
we are proposing a new rule to allow funds to invest in ETFs to a 
greater extent than currently permitted under the Act and our rules.

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II. Operation of Exchange-Traded Funds

    All ETFs trading today operate in a similar way.\20\ Unlike 
traditional mutual funds, ETFs do not sell or redeem their individual 
shares (``ETF shares'') at net asset value (``NAV''). Instead, 
financial institutions purchase and redeem ETF shares directly from the 
ETF, but only in large blocks called ``creation units.'' \21\ A 
financial institution that purchases a creation unit of ETF shares 
first deposits with the ETF a ``purchase basket'' of certain securities 
and other assets identified by the ETF that day, and then receives the 
creation unit in return for those assets. The basket generally reflects 
the contents of the ETF's portfolio and is equal in value to the 
aggregate NAV of the ETF shares in the creation unit. After purchasing 
a creation unit, the financial institution may hold the ETF shares, or 
sell some or all in secondary market transactions.\22\
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    \20\ Until recently, all ETFs had an investment objective of 
seeking returns that are correlated to the returns of a securities 
index, and in this respect operated much like traditional index 
funds. Recently, we issued orders approving actively managed ETFs. 
See WisdomTree Trust, et al., Investment Company Act Release Nos. 
28147 (Feb. 6, 2008) [73 FR 7776 (Feb. 11, 2008)] (notice) 
(``WisdomTree Actively Managed ETF Notice'') and 28174 (Feb. 27, 
2008) (order) (``WisdomTree Actively Managed ETF''); Barclays Global 
Fund Advisors, et al., Investment Company Act Release Nos. 28146 
(Feb. 6, 2008) [73 FR 7771 (Feb. 11, 2008)] (notice) and 28173 (Feb. 
27, 2008) (order) (``Barclays Actively Managed ETF''); Bear Sterns 
Asset Management, Inc., et al., Investment Company Act Release Nos. 
28143 (Feb. 5, 2008) [73 FR 7768 (Feb. 11, 2008)] (notice) and 28172 
(Feb. 27, 2008) (order) (``Bear Sterns Actively Managed ETF''); 
PowerShares Capital Management LLC, et al., Investment Company Act 
Release Nos. 28140 (Feb. 1, 2008) [73 FR 7328 (Feb. 7, 2008)] 
(notice) (``PowerShares Actively Managed ETF Notice'') and 28171 
(Feb. 27, 2008) (order) (``PowerShares Actively Managed ETF'' and 
collectively, ``Actively Managed ETF Orders'').
    \21\ As discussed further below, creation units typically 
consist of at least 25,000 ETF shares. See infra note 113.
    \22\ We note that depending on the facts and circumstances, 
broker-dealers that purchase a creation unit and sell the shares may 
be deemed to be participants in a distribution, which could render 
them statutory underwriters and subject them to the prospectus 
delivery and liability provisions of the Securities Act. See 15 
U.S.C. 77b(a)(11).
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    Like operating companies and closed-end funds, ETFs register 
offerings and sales of ETF shares under the Securities Act and list 
their shares for trading under the Securities Exchange Act of 1934 
(``Exchange Act'').\23\ As with any listed security, investors may 
trade ETF shares at market prices. ETF shares purchased in secondary 
market transactions are not redeemable from the ETF except in creation 
units.
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    \23\ 15 U.S.C. 78a.
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    The redemption process is the reverse of the purchase process. The 
financial institution acquires (through purchases on national 
securities exchanges, principal transactions, or private transactions) 
the number of ETF shares that comprise a creation unit, and redeems the 
creation unit from the ETF in exchange for a ``redemption basket'' of 
securities and other assets.\24\ An investor holding fewer ETF shares 
than the amount needed to constitute a creation unit (most retail 
investors) may dispose of those ETF shares by selling them on the 
secondary market. The investor receives market price for the ETF 
shares, which may be higher or lower than the NAV of the shares, and 
pays customary brokerage commissions on the sale.
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    \24\ ETFs sometimes provide cash-in-lieu payments on some (or 
all) purchases or redemptions. See infra notes 120-121 and 
accompanying text.
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    The ability of financial institutions to purchase and redeem 
creation units at each day's NAV creates arbitrage opportunities that 
may help keep the market price of ETF shares near the NAV per share of 
the ETF. For example, if ETF shares begin trading on national 
securities exchanges at a price below the fund's NAV per share, 
financial institutions can purchase ETF shares in secondary market 
transactions and, after accumulating enough shares to comprise a 
creation unit, redeem them from the ETF in exchange for the more 
valuable securities in the ETF's redemption basket. Those purchases 
create greater market demand for the ETF shares, and thus tend to drive 
up the market price of the shares to a level closer to NAV.\25\ 
Conversely, if the market price for ETF shares exceeds the NAV per 
share of the ETF itself, a financial institution can deposit a basket 
of securities in exchange for the more valuable creation unit of ETF 
shares, and then sell the individual shares in the market to realize 
its profit. These sales would increase the supply of ETF shares in the 
secondary market, and thus tend to drive down the price of the ETF 
shares to a level closer to the NAV of the ETF share.\26\
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    \25\ The purchase of the ETF shares on the secondary market 
combined with the sale of the redemption basket securities also may 
create upward pressure on the price of ETF shares and/or downward 
pressure on the price of redemption basket securities, driving the 
market price and ETF NAV closer together.
    \26\ The institution's purchase of the purchase basket 
securities combined with the sale of ETF shares also may create 
downward pressure on the price of ETF shares and/or upward pressure 
on the price of purchase basket securities, driving the market price 
and the ETF's NAV closer together.
    ETF sponsors and market participants report that the average 
deviation between the daily closing price and the daily NAV of ETFs 
that track domestic indexes is generally less than 2%. See, e.g., 
Vanguard U.S. Stock ETFs, Prospectus 56-59 (Apr. 27, 2007). ETFs 
that track foreign indexes may have a more significant deviation. 
See, e.g., iShares FTSE/Xinhua China 25 Index Fund, Prospectus 19 
(Dec. 1, 2006).
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    Arbitrage activity in ETF shares is facilitated by the transparency 
of the ETF's portfolio. Each day, the ETF publishes the identities of 
the securities in the purchase and redemption baskets, which are 
representative of the ETF's portfolio.\27\ Each exchange on which the 
ETF shares are listed typically discloses an approximation of the 
current value of the basket on a per share basis (``Intraday Value'') 
\28\ at 15 second intervals throughout the day and, for index-based 
ETFs, disseminates the current value of the relevant index.\29\ This 
transparency can contribute to the efficiency of the arbitrage 
mechanism because it helps arbitrageurs determine whether to purchase 
or redeem creation units based on the relative values of ETF shares in 
the secondary market and the securities contained in the ETF's 
portfolio.
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    \27\ With respect to index-based ETFs, portfolio transparency is 
enhanced by the transparency of the underlying index. Index 
providers publicly announce the components of their indexes. Because 
an index-based ETF seeks to track the performance of an index, often 
by replicating the component securities of the index, the 
transparency of the underlying index results in a high degree of 
transparency in the ETF's investment operations. Similarly, each of 
the actively managed ETFs operating under the recent exemptive 
orders approved by the Commission is required to make public each 
day the securities and other assets in its portfolio. See Actively 
Managed ETF Orders, supra note 20.
    \28\ The Intraday Value also is referred to as the Intraday 
Indicative Value, Indicative Optimized Portfolio Value, Indicative 
Fund Value, Indicative Trust Value, or Indicative Partnership Value.
    \29\ National securities exchanges are permitted to disseminate 
this information at 60 second intervals for ETFs that track non-U.S. 
indexes. See, e.g., Commentary .01(b)(2) to NYSE Acra Equities Rule 
5.2(j)(3); Commentary 0.2(a)(C)(c) to American Stock Exchange 
Constitution and Rules & Arbitration Awards Rule 1000A.
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    Arbitrage activity in ETF shares also appears to be affected by the 
liquidity of the securities in an ETF's portfolio. Most ETFs represent 
in their applications for exemptive relief that they invest in highly 
liquid securities.\30\

[[Page 14621]]

Effective arbitrage depends in part on the ability of financial 
institutions to readily assemble the basket for purchases of creation 
units and to sell securities received upon redemption of creation 
units, and liquidity appears to be a factor in this process. An ETF's 
investment in less liquid securities may reduce arbitrage efficiency 
and thereby increase both the likelihood that a deviation between ETF 
share market price and NAV per share may occur and the amount of any 
deviation that does occur.
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    \30\ Index-based ETFs track indexes that have specified 
methodologies for selecting their component securities. The 
methodologies generally ensure that an index consists of securities 
that will be highly liquid. See, e.g., Barclays High Yield Notice, 
supra note 13 (``The Underlying Index is a rules-based index 
designed to reflect the 50 most liquid U.S. dollar-denominated high-
yield corporate bonds registered for sale in the U.S. or exempt from 
registration.''). Because index-based ETFs either replicate or 
sample the indexes, their portfolio securities also should possess 
these characteristics. The actively managed ETFs also appear to 
invest in highly liquid securities. See WisdomTree Actively Managed 
ETF, supra note 20 (investing in U.S. and foreign money market 
securities); Barclays Actively Managed ETF, supra note 20 (investing 
in foreign money market securities); Bear Sterns Actively Managed 
ETF, supra note 20 (investing primarily in investment-grade fixed 
income securities); PowerShares Actively Managed ETF, supra note 20 
(investing in large cap companies or U.S. government and corporate 
debt securities).
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III. Exemptions Permitting Funds To Form and Operate as ETFs

    Today we are proposing for public comment a new rule that would 
codify much of the relief and many of the conditions of orders that we 
have issued to index-based ETFs in the past, and more recently to 
certain actively managed ETFs. The proposed rule is designed to enable 
most ETFs to begin operations without the need to obtain individual 
exemptive relief from the Commission.

A. Scope of Proposed Rule 6c-11

1. Index-Based ETFs
    Proposed rule 6c-11, like our orders, would provide exemptions for 
ETFs that have a stated investment objective of maintaining returns 
that correspond to the returns of a securities index whose provider 
discloses on its Internet Web site the identities and weightings \31\ 
of the component securities and other assets of the index.\32\ In this 
respect, the rule would codify our previous exemptive orders. Our 
experience is that the conditions included in the index-based ETF 
orders have effectively preserved the statutory purposes of the Act.
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    \31\ Proposed rule 6c-11(e)(9) defines ``weighting of the 
component security'' as ``the percentage of the index's value 
represented, or accounted for, by such component security.''
    \32\ Proposed rule 6c-11(e)(4)(v)(B) (defining ``exchange-traded 
fund''); see infra Section III.B.1 for a discussion of this index 
transparency requirement. Index-based ETFs obtain returns that 
correspond to those of an underlying index by replicating or 
sampling the component securities of the index. An ETF that uses a 
replicating strategy generally invests in the component securities 
of the underlying index in the same approximate proportions as in 
the underlying index. See, e.g., First Trust Exchange-Traded Fund, 
Investment Company Act Release No. 27051 (Aug. 26, 2005) [70 FR 
52450 (Sept. 2, 2005)] (``First Trust Notice'') at n.1. If, however, 
there are practical difficulties or substantial costs involved in 
holding every security in the underlying index, the ETF may use a 
representative sampling strategy pursuant to which it will invest in 
some but not all of the relevant component securities. An ETF that 
uses a sampling strategy includes in its portfolio securities that 
are designed, in the aggregate, to reflect the underlying index's 
capitalization, industry, and fundamental investment 
characteristics, and to perform like the index. The ETF implements 
the sampling strategy by acquiring a subset of the component 
securities of the underlying index, and possibly some securities 
that are not included in the corresponding index that are designed 
to help the ETF track the performance of the index. See, e.g., id.
---------------------------------------------------------------------------

    The proposed rule would not limit the types of indexes that an ETF 
may track or the types of securities that comprise any index. Thus, the 
rule would not limit the exemption to ETFs investing in liquid 
securities or assets, although existing ETFs generally have represented 
to us that their portfolios are comprised of highly liquid 
securities,\33\ and, as open-end funds, are required to comply with the 
liquidity guidelines applicable to all open-end funds.\34\
---------------------------------------------------------------------------

    \33\ See supra note 30 and accompanying and following text. See 
also WisdomTree Notice, supra note 12 at n.8 and accompanying text.
    \34\ Long-standing Commission guidelines have required open-end 
funds to hold no more than 15% of their net assets in illiquid 
securities and other illiquid assets. See Statement Regarding 
``Restricted Securities,'' Investment Company Act Release No. 5847 
(Oct. 21, 1969) [35 FR 19989 (Dec. 31, 1970)]; Revisions of 
Guidelines to Form N-1A, Investment Company Act Release No. 18612 
(Mar. 12, 1992) [57 FR 9828 (Mar. 20, 1992)]. A fund's portfolio 
security is illiquid if it cannot be disposed of in the ordinary 
course of business within seven days at approximately the value 
ascribed to it by the ETF. See Acquisition and Valuation of Certain 
Portfolio Instruments by Registered Investment Companies, Investment 
Company Act Release No. 14983 (Mar. 12, 1986) [51 FR 9773 (Mar. 21, 
1986)] (adopting amendments to rule 2a-7 under the Act); Resale of 
Restricted Securities; Changes to Method of Determining Holding 
Period of Restricted Securities under Rules 144 and 145, Investment 
Company Act Release No. 17452 (Apr. 23, 1990) [55 FR 17933 (Apr. 30, 
1990)] (adopting Rule 144A under the Securities Act).
---------------------------------------------------------------------------

    We request comment regarding the effect of portfolio liquidity on 
the potential for deviation between ETF share market price and NAV and 
the amount of any deviation. In addition to the liquidity guidelines 
applicable to all open-end funds, should the Commission include 
additional liquidity requirements as a condition of the exemptions? If 
so, what additional requirements and why? Should the chance (or 
likelihood) that substantial discounts or premiums may occur if an ETF 
portfolio contains less liquid securities or assets be a regulatory 
concern for the Commission, or should it be treated as a material risk 
to be disclosed to prospective investors, permitting them to evaluate 
whether the risk makes the ETF an appropriate investment in light of 
the investor's investment objectives? \35\ We note that currently there 
is substantially more market interest in ETFs that track broad-based 
indexes that are comprised of highly liquid securities than ETFs that 
track more specialized indexes.\36\ How would liquidity or illiquidity 
of securities or other assets in an ETF's portfolio affect the ability 
of financial institutions to assemble securities for a purchase basket 
and thus the arbitrage mechanism and operation of the ETF? Would 
liquidity requirements preclude the development of specialty ETFs that 
serve narrow investment purposes but which may satisfy particular 
investment needs of certain investors?
---------------------------------------------------------------------------

    \35\ The Commission is proposing an amendment to Form N-1A that 
would codify the condition in our orders that ETFs disclose the 
extent and frequency with which market prices have tracked their 
NAV. See infra notes 169-170 and accompanying text.
    \36\ See ICI ETF Statistics 2007, supra note 5.
---------------------------------------------------------------------------

2. Actively Managed ETFs
    We recently issued exemptive orders to several actively managed 
ETFs and their sponsors.\37\ Like our orders, proposed rule 6c-11 would 
provide an exemption for an actively managed ETF that discloses on its 
Internet Web site each business day the identities and weightings of 
the component securities and other assets held by the ETF.\38\ Unlike 
index-based ETFs, an actively managed ETF does not seek to track the 
return of a particular index. Instead, an actively managed ETF's 
investment adviser, like an adviser to any traditional actively managed 
mutual fund, generally selects securities consistent with the ETF's 
investment objectives and policies without regard to a corresponding 
index.
---------------------------------------------------------------------------

    \37\ See Actively Managed ETF Orders, supra note 20.
    \38\ Proposed rule 6c-11(e)(4)(v)(A); see infra Section III.B.1 
for a discussion of this requirement.
---------------------------------------------------------------------------

    In 2001, we sought comment on the concept of an actively managed 
ETF (``2001 Concept Release'').\39\ We requested comment on a broad 
number of questions that we felt were important to consider before 
expanding the scope of the exemptive orders we had issued. We wanted to 
know how investors would use an actively managed ETF because it seemed 
that, unlike an investment in an index-based ETF, an investment in an 
actively managed ETF could not be used, for example, to implement a 
hedging strategy. We questioned whether an actively managed ETF would 
provide investors with the same or similar benefits as

[[Page 14622]]

index-based ETFs, including potential tax efficiencies and low expense 
ratios.
---------------------------------------------------------------------------

    \39\ See Actively Managed Exchange-Traded Funds, Investment 
Company Act Release No. 25258 (Nov. 8, 2001) [66 FR 57614 (Nov. 15, 
2001)] (``2001 Concept Release'').
---------------------------------------------------------------------------

    Our 2001 Concept Release also asked more focused questions about 
the structural and operational differences between the two types of 
ETFs and how those differences might affect the market value of ETF 
shares. We inquired whether as a matter of public policy an ETF must be 
designed to enable efficient arbitrage and thereby minimize the 
probability that ETF shares would trade at a material premium or 
discount.\40\ We asked, for example, whether actively managed ETFs must 
have the same degree of portfolio transparency as index-based ETFs, a 
factor that appeared to contribute significantly to arbitrage 
efficiency.\41\ It was unclear to us at that time whether an adviser to 
actively managed ETFs would be willing to provide the same degree of 
transparency as an adviser to index-based ETFs because, for example, 
disclosure could allow market participants to access the fund's 
investment strategy.\42\ We were concerned that reduced transparency 
could expose arbitrageurs to greater investment risk and result in a 
less efficient arbitrage mechanism, which in turn could lead to more 
significant premiums and discounts than experienced by index-based 
ETFs.
---------------------------------------------------------------------------

    \40\ Id. at text following n.35.
    \41\ See supra note 27 and accompanying text.
    \42\ We also noted concerns that full disclosure could permit 
market participants to ``front-run'' portfolio trades. See infra 
text accompanying and preceding note 84. In addition, because 
actively managed portfolios likely would change more frequently and 
in less foreseeable ways than a portfolio of index-based ETFs, we 
were unclear how or whether an actively managed ETF would 
communicate intra-day portfolio changes to investors. See generally, 
Russ Wermers, The Potential Effects of More Frequent Portfolio 
Disclosure on Mutual Fund Performance, Investment Company Institute 
Perspective, June 2001, Vol. 7, No. 3, at http://www.ici.org/
perspective/per07-03.pdf. (examining the potential effects of more 
frequent portfolio disclosure on the performance of mutual funds and 
concluding that, with more frequent disclosure, shareholders would 
likely receive lower total returns on their investments due to, 
among other things, front-running and free-riding).
---------------------------------------------------------------------------

    We received 20 comments from market participants, many of which 
supported the introduction of actively managed ETFs.\43\ Many 
commenters stated that actively managed ETFs would have the potential 
to provide investors with uses and benefits similar to index-based 
ETFs. For example, commenters maintained that, like index-based ETFs, 
actively managed ETFs could potentially serve as short-term or long-
term investment vehicles, allow investors to gain exposure to an asset 
category such as value, growth or income, and play a significant role 
in an investor's hedging strategies.\44\ Commenters also asserted that 
actively managed ETFs have the potential for providing investors 
benefits similar to index-based ETFs, including low expense ratios and 
intra-day exchange trading.\45\ Other commenters, however, questioned 
whether some of the investor benefits traditionally associated with 
index-based ETFs would be present with actively managed ETFs.\46\
---------------------------------------------------------------------------

    \43\ The comment letters to the 2001 Concept Release are 
available for public inspection and copying in the Commission's 
Public Reference Room, 100 F Street, NE., Washington, DC 20549 (File 
No. S7-20-01), and are available on the Commission's Internet Web 
site: (http://www.sec.gov/rules/concept/s72001.shtml.)
    \44\ See, e.g., Comment Letter of the American Stock Exchange 
LLC, File No. S7-20-01 (Mar. 5, 2002) (``For example, an investor 
may find that a particular actively managed ETF more closely tracks 
his securities holdings, and therefore may be a more effective 
hedge.''); Comment Letter of State Street Bank and Trust Company, 
File No. S7-20-01 (Jan. 14, 2002). One commenter asserted, however, 
that actively managed ETFs would be of greater interest to retail 
investors; institutional investors would not use active fund 
products for hedging, cash equitization or other strategies. Comment 
Letter of Barclays Global Investors, File No. S7-20-01 (Jan. 11, 
2002).
    \45\ See, e.g., Comment Letter of the American Stock Exchange 
LLC, File No. S7-20-01 (Mar. 5, 2002); Comment Letter of State 
Street Bank and Trust Company, File No. S7-20-01 (Jan. 14, 2002).
    \46\ One commenter, for example, asserted that an actively 
managed ETF would likely not experience similar tax efficiency 
because that is predominantly a function of the low portfolio 
turnover of index-based ETFs. The commenter also noted that actively 
managed ETFs are unlikely to have the low expenses associated with 
index-based ETFs, which result primarily from lower advisory fees 
associated with the passive management of those funds. Comment 
Letter of the Vanguard Group, File No. S7-20-01 (Feb. 14, 2002).
---------------------------------------------------------------------------

    Commenters agreed that actively managed ETFs should be designed, 
like index-based ETFs, with an arbitrage mechanism intended to minimize 
the potential deviation between market price and NAV of ETF shares.\47\ 
Not all commenters agreed, however, on whether we should be concerned 
with the extent of premiums or discounts and, therefore, whether we 
should require full portfolio transparency. Some asserted that the 
amount of any discount or premium that might develop ought not to be a 
consideration for us in determining whether to grant exemptive 
relief.\48\ One commenter argued that ETFs with share prices that 
significantly deviate from NAV would likely not attract the interest of 
investors and would ultimately fail if they did not provide information 
necessary for market participants to make knowledgeable investment 
decisions.\49\ Other commenters asserted that it is important to 
require that ETFs provide all investors with the same information about 
portfolio holdings \50\ and to require clear fund disclosures regarding 
the risks associated with the level of transparency provided.\51\ These 
commenters stressed the need, however, for sufficient market 
information to

[[Page 14623]]

value the fund's portfolio.\52\ Others argued that portfolio 
transparency is essential to support effective arbitrage.\53\ One 
commenter asserted that any lack of transparency would negatively 
impact an ETF's arbitrage mechanism and would likely result in ETF 
shares trading at secondary market prices that do not reflect the value 
of the ETF's underlying portfolio.\54\ The commenter noted that to the 
extent an ETF operates with less than full transparency during periods 
of market volatility, this would likely result in some individual 
investors buying or selling ETF shares at secondary market prices 
moving in the opposite direction of the ETF's NAV. The commenter urged 
us to consider carefully the consequence of granting an exemption that 
might yield such a result.\55\ The Investment Company Institute 
asserted that to the extent that all or part of an ETF's portfolio is 
not transparent, it could raise significant investor protection 
concerns including the potential for disparate treatment of investors 
and the potential for the ETF to trade at significant premiums and 
discounts.\56\
---------------------------------------------------------------------------

    \47\ See, e.g., Comment Letter of the Vanguard Group, File No. 
S7-20-01 (Feb. 14, 2002); Comment Letter of Barclays Global 
Investors, File No. S7-20-01 (Jan. 11, 2002).
    \48\ See, e.g., Comment Letter of the American Bar Association, 
Committee on Federal Regulation of Securities, File No. S7-20-01 
(Feb. 1, 2002) (``We believe that the Commission should not mandate 
the level of transparency in ETFs' portfolios, but rather should 
allow fully informed demand in the financial markets to determine 
the proper levels. Different segments of the market with different 
needs might demand investment vehicles with different variation. To 
prevent market demand from determining the structure of investment 
vehicles would retard efficiency, competition, and capital 
formation.''); Comment Letter of State Street Bank and Trust 
Company, File No. S7-20-01 (Jan. 14, 2002) (``* * *[A] non-
transparent actively managed ETF will be no worse off than closed-
end funds trading today. In fact, the premium/discount of a non-
transparent ETF should be narrower due to the ETF's open-ended 
qualities.''); Comment Letter of the Vanguard Group, File No. S7-20-
01 (Feb. 14, 2002) (``While [spreads] may be higher for actively 
managed ETFs than for index ETFs, we do not believe that the 
discounts between market price and NAV will approach those seen in 
closed-end funds.'').
    \49\ See Comment Letter of State Street Bank and Trust Company, 
File No. S7-20-01 (Jan. 14, 2002); see also Comment Letter of the 
American Bar Association, Committee on Federal Regulation of 
Securities, File No. S7-20-01 (Feb. 1, 2002) (``Ultimately it is in 
the interest of the sponsor and investment adviser to provide for 
effective arbitrage opportunities. It is unlikely that an actively 
managed ETF sponsor would be able to convince the critical market 
participants such as specialists, market makers, arbitragers and 
other Authorized Participants to support a product that contained 
illiquid securities to a degree that would affect the liquidity of 
the ETF, making it difficult to price, trade and hedge, ultimately 
leading to its failure in the marketplace.'').
    \50\ See, e.g., Comment Letter of the Vanguard Group, File No. 
S7-20-01 (Feb. 14, 2002) (``Sponsors of actively managed ETFs should 
not be permitted to provide more information about portfolio 
holdings to the exchange specialist and market makers than they 
provide to other investors. Vanguard believes, as a matter of 
fundamental fairness, that all investors in a fund must be treated 
equally. Providing information only to a favored few is inconsistent 
with the foundation of our capital markets--full and fair disclosure 
to all investors.'').
    \51\ See, e.g., Comment Letter of Morgan Stanley & Co., File No. 
S7-20-01 (May 3, 2002) (``Even if the Commission were to determine 
that new forms of ETFs do pose a significant risk of trading at a 
discount or premium to NAV, we do not believe that the Commission 
should delay approval of the product for this reason. Instead, we 
would urge the Commission to address any perceived investor risks by 
requiring additional risk disclosure.''); Comment Letter of the 
Vanguard Group, File No. S7-20-01 (Feb. 14, 2002) (``Investors in an 
actively managed ETF must receive adequate disclosure about the 
risks associated with the level of the ETF's transparency (and other 
risks unique to actively managed ETFs) * * * if the ETF has limited 
transparency, the fund's disclosure documents should discuss the 
possibility that the spreads between bid and asked prices and 
between the market price and NAV of the fund's exchange-traded 
shares may be higher than is typically the case of index ETFs.'').
    \52\ See, e.g., Comment Letter of the American Stock Exchange 
LLC, File No. S7-20-01 (Mar. 5, 2002) (asserting that non-
transparent actively managed ETFs need not disclose the full 
contents of their portfolios ``so long as there is sufficient market 
information available to value the portfolio or a creation unit (or 
if different, the Redemption Basket) on an intra-day basis so as to 
facilitate secondary market trading and hedging.''); Comment Letter 
of State Street Bank and Trust Co., File No. S7-20-01 (``While the 
importance of an effective arbitrage mechanism is clear, there are 
potential ways to achieve an effective arbitrage mechanism with less 
than full transparency, and, potentially, with no portfolio 
transparency. This may be accomplished with proper disclosure of an 
actively managed ETF's investment strategy and portfolio 
characteristics.'').
    \53\ See, e.g., Comment Letter of Barclays Global Investors, 
File No. S7-20-01 (Jan. 11, 2002) (``It is generally accepted that 
portfolio transparency is the key to effective arbitrage. Therefore, 
the most significant issue for the Commission * * * is whether 
[actively managed ETFs] would provide the necessary level and 
frequency of portfolio disclosure to support efficient 
arbitrage.'').
    \54\ Id.
    \55\ Id.
    \56\ Comment Letter of the Investment Company Institute, File 
No. S7-20-01 (Jan. 14, 2002).
---------------------------------------------------------------------------

    Today we propose exemptions applicable to both index-based and 
actively managed ETFs that provide portfolio transparency to market 
participants. The comments we received, together with subsequent 
developments, address the principal concerns we raised in the 2001 
Concept Release with respect to actively managed ETFs. We have received 
a number of applications from actively managed ETFs whose sponsors are 
interested in offering fully transparent, actively managed ETFs, and 
recently we have issued orders approving several of these ETFs.\57\ As 
described in these applications, an actively managed ETF would operate 
in the same manner as an index-based ETF.\58\ Each would be registered 
under the Act as an open-end fund and would redeem shares in creation 
units in exchange for basket assets. Each would be listed on a national 
securities exchange, and investors would trade the ETF shares 
throughout the day at market prices in the secondary market.\59\ The 
national securities exchange typically would disseminate the Intraday 
Value of ETF shares at 15-second intervals throughout the trading 
day,\60\ thereby providing institutional investors and other 
arbitrageurs the information necessary to engage in ETF share purchases 
and sales on the secondary market, and purchases and redemptions with 
the fund, which should help keep ETF share prices from trading at a 
significant discount or premium.\61\ Finally, the actively managed ETFs 
represent that they would provide ETF investors with uses and benefits 
similar to index-based ETFs.\62\
    We believe that permitting fully transparent, actively managed ETFs 
would provide additional investment choices for investors and that 
exemptions necessary to permit the operation of these ETFs would be in 
the public interest and consistent with the policies and purposes of 
the Act. By proposing this rule we are not, however, suggesting that we 
will not consider applications for exemptive orders for actively 
managed ETFs that do not satisfy the proposed rule's transparency 
requirements. Rather, we are at this time proposing to permit fully 
transparent, actively managed ETFs to be offered without first seeking 
individual exemptive orders from the Commission.
    We request comment on allowing actively managed ETFs with fully 
transparent portfolios to rely on the exemptions provided by the 
proposed rule. We only recently approved orders to allow certain 
actively managed ETFs and have not had the opportunity to observe how 
they operate in the markets over a significant period of time. Should 
we wait until we have gained greater experience with the operation of 
actively managed ETFs before adopting a final rule applicable to them? 
Is there any concern that a fully transparent actively managed ETF 
would not facilitate an efficient arbitrage mechanism? Would actively 
managed ETFs provide investors with uses and benefits similar to or 
different than their index-based counterparts? Do these or any other 
concerns regarding the operation of a fully transparent actively 
managed ETF warrant limiting the rule to index-based ETFs and 
considering exemptions for actively managed ETFs on a case by case 
basis through the exemptive applications process? Should we consider 
exemptions for other types of actively managed ETFs? If so, how would 
the arbitrage mechanism work in these ETFs? What kinds of conditions 
should we consider in order to facilitate an arbitrage mechanism?
3. Organization as an Open-End Investment Company
    Our proposed rule would be available only to ETFs that are 
organized as open-end funds.\63\ We have provided similar exemptions to 
unit investment trusts (``UITs'') in the past.\64\ However, because we 
have not received an exemptive application for a new ETF to be 
organized as a UIT since 2002, there does not appear to be a need to 
include UIT relief in the proposed rule.\65\ We understand that ETF 
sponsors prefer the open-end fund structure because it allows more 
investment flexibility.\66\ In

[[Page 14624]]

addition, unlike an ETF that is a UIT, an open-end fund ETF may 
participate in securities lending programs and has greater flexibility 
in reinvesting dividends received from portfolio securities. Of the 601 
ETFs in existence as of December 2007, 593 were organized as open-end 
funds.\67\
---------------------------------------------------------------------------

    \57\ See Actively Managed ETF Orders, supra note 20.
    \58\ See id.
    \59\ See infra notes 88-94 and accompanying text for a 
discussion of the proposed rule's condition that ETF shares be 
approved for listing and trading on a national securities exchange.
    \60\ See infra notes 92-94 and accompanying text for a 
discussion of the proposed rule's condition that ETFs be listed on 
an exchange that disseminates the Intraday Value of ETF shares on a 
regular basis.
    \61\ See supra notes 27-29 and accompanying and following text. 
See also Actively Managed ETF Orders supra note 20.
    \62\ See, e.g., In re PowerShares Capital Management LLC, et 
al., Fifth Amendment, File No. 812-13386, filed Jan. 7, 2008 
(``PowerShares Actively Managed ETF Application''), at 12-13 
(available for public inspection and copying in the Commission's 
Public Reference Room, 100 F Street, NE., Washington, DC 20549).
    \63\ Proposed rule 6c-11(e)(4).
    \64\ See, e.g., SPDR Order, supra note 10. See supra note 8 for 
a definition of UITs.
    \65\ Although two exemptive applications for ETFs organized as 
UITs were filed in 2007, the applications were occasioned by the 
transfer of the sponsorship from Nasdaq Financial Products Services, 
Inc. to PowerShares Capital Management, LLC and did not result in 
new ETFs. See BLDRs Index Funds Trust, Investment Company Act 
Release No. 27745 (Feb. 28, 2007) [72 FR 9787 (Mar. 5, 2007)] 
(``BLDRs Notice''); Nasdaq-100 Trust, Series 1, Investment Company 
Act Release No. 27740 (Feb. 27, 2007) [72 FR 9594 (Mar. 2, 2007)].
    \66\ A UIT portfolio is fixed, and substitution of securities 
may take place only under certain circumstances. As a result, an ETF 
organized as a UIT typically replicates the holdings of the index it 
tracks. By contrast, existing ETFs organized as open-end funds may 
employ investment advisers and use a ``sampling'' strategy to track 
the index. Using a sampling strategy, an investment adviser can 
construct a portfolio that is a subset of the component securities 
in the corresponding index, rather than a replication of the index. 
The investment adviser also may invest a specific portion of the 
ETF's portfolio in securities and other financial instruments that 
are not included in the corresponding index if the adviser believes 
the investment will help the ETF track its underlying index. See, 
e.g., First Trust Notice, supra note 32, at. n.1.
    \67\ The number of ETFs organized as UITs is based on 
information in the Commission's database of Form N-SAR filings.
---------------------------------------------------------------------------

    We request comment on whether we should include ETFs organized as 
UITs in the definition of ETF under the proposed rule. If so, should 
they be subject to the same conditions set forth in the proposed rule?

B. Conditions

    ETF sponsors have sought exemptions from certain provisions of the 
Act and our rules so that they may register ETFs as open-end funds. The 
principal distinguishing feature of open-end funds is that they offer 
for sale redeemable securities.\68\ The Act defines ``redeemable 
security'' as any security that allows the holder to receive his or her 
proportionate share of the issuer's current net assets upon 
presentation to the issuer.\69\
---------------------------------------------------------------------------

    \68\ 15 U.S.C. 80a-5(a)(1); see infra notes 109-121 and 
accompanying text.
    \69\ 15 U.S.C. 80a-2(a)(32).
---------------------------------------------------------------------------

    Section 22(d) of the Act prohibits any dealer in redeemable 
securities from selling open-end fund shares at a price other than a 
current offering price described in the fund's prospectus.\70\ Rule 
22c-1 under the Act requires funds, their principal underwriters, and 
dealers to sell and redeem fund shares at a price based on the current 
NAV next computed after receipt of an order to buy or redeem.\71\ 
Together, these provisions are designed to require that fund 
shareholders are treated equitably when buying and selling their fund 
shares.\72\
---------------------------------------------------------------------------

    \70\ 15 U.S.C. 80a-22(d).
    \71\ 17 CFR 270.22c-1(a). The rule requires that funds calculate 
their NAV at least once daily Monday through Friday (with certain 
exceptions, including days on which no securities are tendered for 
redemption and the fund receives no orders to purchase or sell 
securities). See 17 CFR 270.22c-1(b)(1). Today, most funds calculate 
NAV as of the time the major U.S. stock exchanges close (typically 
at 4 p.m. Eastern Time). Thus, a fund's NAV generally reflects the 
closing prices of the securities it holds. Under rule 22c-1, an 
investor who submits an order before the 4:00 p.m. pricing time 
receives that day's price, and an investor who submits an order 
after the pricing time receives the next day's price.
    \72\ See generally, H.R. Rep. No. 2639, 76th Cong., 3d Sess., 8 
(1940). See also Investment Trusts and Investment Companies, Report 
of the Securities and Exchange Commission, H.R. Doc. No. 279, 76th 
Cong., 1st Sess., pt. 3, at 860-874 (1939).
---------------------------------------------------------------------------

    ETFs seeking to register as open-end funds under the Act require 
exemptions from these provisions because certain investors may purchase 
and sell individual ETF shares on the secondary market at current 
market prices, i.e., at prices other than those described in the ETF's 
prospectus or based on NAV. As discussed above, investors (typically 
financial institutions) can purchase and redeem shares from the ETF at 
NAV only in creation units.\73\ Because these financial institutions 
can take advantage of disparities between the market price of ETF 
shares and NAV, they may be in a different position than investors who 
buy and sell individual ETF shares only on the secondary market.\74\ 
The disparities in market price and NAV, however, provide those 
institutional investors with opportunities for arbitrage that would 
tend to drive the market price in the direction of the ETF's NAV to the 
benefit of retail investors.\75\
---------------------------------------------------------------------------

    \73\ See supra Section II for a discussion on the operation of 
ETFs.
    \74\ See, e.g., Comment Letter of Barclays Global Investors, 
File No. S7-20-01 (Jan. 11, 2002) (``[D]uring periods of market 
volatility * * * it is not unreasonable to assume that some retail 
investors would buy or sell ETF shares at secondary market prices 
moving in the opposite direction of a fund's NAV.'').
    \75\ See supra notes 25-26 and accompanying text.
---------------------------------------------------------------------------

    Today, we propose a rule with certain conditions that may permit 
the ETF structure to operate within the scope of the Act without 
sacrificing appropriate investor protection, and is designed to be 
consistent with the purposes fairly intended by the policy and 
provisions of the Act.\76\ Our orders have provided exemptions from the 
definition of ``redeemable security'' and section 22(d) and rule 22c-1 
for ETFs with an arbitrage mechanism that helps maintain the 
equilibrium between market price and NAV. Our proposed rule would 
codify these exemptions subject to three conditions that appear to have 
facilitated the arbitrage mechanism: Transparency of the ETF's 
portfolio, disclosure of the ETF's Intraday Value, and listing on a 
national securities exchange.
---------------------------------------------------------------------------

    \76\ Section 6(c) of the Act permits the Commission, 
conditionally or unconditionally, to exempt by rule any person, 
security, or transaction (or classes of persons, securities, or 
transactions) from any provision of the Act ``if and to the extent 
that such exemption is necessary or appropriate in the public 
interest and consistent with the protection of investors and the 
purposes fairly intended by the policy and provisions'' of the Act. 
15 U.S.C. 80a-6(c).
---------------------------------------------------------------------------

1. Transparency of Index and Portfolio Holdings
    To take advantage of the proposed exemption, an ETF must either (i) 
disclose on its Internet Web site each business day the identities and 
weightings of the component securities and other assets held by the 
fund, or (ii) have a stated investment objective of obtaining returns 
that correspond to the returns of a securities index, whose provider 
discloses on its Internet Web site the identities and weightings of the 
component securities and other assets of the index.\77\ The Web page of 
the ETF or the index provider, as the case may be, must be publicly 
accessible at no charge.\78\ Thus, the proposed rule would allow for an 
actively managed ETF provided that the actively managed ETF discloses 
its portfolio assets each business day.\79\
---------------------------------------------------------------------------

    \77\ Proposed rule 6c-11(e)(4)(v).
    \78\ Id.
    \79\ See supra discussion at Section III.A.2. An index-based ETF 
that has the investment objective of obtaining returns that 
correspond to the returns of multiple securities indexes may rely on 
the proposed rule provided that it discloses its portfolio in the 
same manner as a fully transparent actively managed ETF.
---------------------------------------------------------------------------

    We seek comment on these transparency conditions. In particular, we 
request comment on the proposed provision requiring that an ETF that 
tracks an index and does not disclose its portfolio each business day 
must track an index whose provider discloses on an Internet Web site 
the component securities and other assets of the index it tracks.\80\ 
Is it necessary for the rule to include this option instead of simply 
requiring daily portfolio disclosure by the ETF? What circumstances, if 
any, would prevent an index-based ETF from disclosing its portfolio 
holdings? \81\ Would Internet Web site disclosure of portfolio holdings 
be sufficient? If not, what other means of disclosure should the ETF or 
the index provider use?
---------------------------------------------------------------------------

    \80\ The proposed rule defines an ``index provider'' to mean the 
person that determines the securities and other assets that comprise 
a securities index. See proposed rule 6c-11(e)(7).
    \81\ See supra note 27.
---------------------------------------------------------------------------

    We also seek comment on whether we should require ETFs to disclose 
daily on their Internet Web sites liabilities (as well as portfolio 
holdings) to permit investors, particularly arbitrageurs, to evaluate 
the impact of leverage from borrowings on the fund's portfolio.\82\

[[Page 14625]]

Should we limit such a requirement to certain kinds of ETFs that may 
have significant liabilities? If so, how should we identify the ETFs 
that would be subject to the condition?
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    \82\ For example, if an ETF enters into a written call to hedge 
the fair value exposure of an equity security in its portfolio, it 
would sacrifice any unrealized gains caused by the price of the 
equity security increasing above the price at which the call may be 
exercised (i.e. the strike price). Unless the ETF discloses the 
presence of these and similar liabilities, investors may not be able 
to evaluate the impact of leverage on the NAV of the ETF.
---------------------------------------------------------------------------

    One of the issues we discussed in the 2001 Concept Release was that 
full portfolio transparency could give market participants an ability 
to access the fund's market strategies (i.e., ``free-riding'') and, in 
some cases, the ability to trade ahead of the ETF (i.e., ``front-
running'').\83\ Those commenters who addressed the issue generally 
agreed that intra-day or advance portfolio disclosure may be 
detrimental to an actively managed ETF because it could enable third 
parties to front-run the fund.\84\ Therefore, the proposed rule does 
not require disclosure of intra-day changes in the portfolio of the 
ETF, because currently, intra-day changes do not affect the composition 
of the ETF's basket assets until the next trading day.\85\ The proposed 
rule also does not require advance disclosure of portfolio trades.\86\
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    \83\ Market participants could trade ahead of an ETF if it 
disclosed portfolio assets in advance of the trades, rather than 
after the assets were acquired.
    \84\ See, e.g., Comment Letter of the Vanguard Group, File No. 
S7-20-01 (Feb. 14, 2002); Comment Letter of the Investment Company 
Institute, File No. S7-20-01 (Jan. 14, 2002).
    \85\ Applicants seeking exemptions for actively managed ETFs 
noted that under accounting procedures followed by the funds, 
portfolio trades made on the prior business day (``T'') would be 
booked and reflected in the fund's NAV on the current business day 
(``T+1''). See, e.g., WisdomTree Actively Managed ETF Notice, supra 
note 20, at n.5. As a result, these funds will not have to announce 
trades before they are made. In addition, the funds will be able to 
disclose at the beginning of each trading day the portfolio that 
will form the basis of the NAV calculation at the end of the day. 
Id.
    \86\ See proposed rule 6c-11(e)(4)(v)(A). Under the proposed 
rule, an ETF could disclose its portfolio at the end of the day on 
which relevant portfolio trades occurred (i.e., after the portfolio 
assets are acquired) or the beginning of the following day, which 
would eliminate the potential for front-running.
---------------------------------------------------------------------------

    We request comment on these aspects of the proposal. Should the 
rule require disclosure of portfolio changes more often than once a 
day? How would more frequent disclosure affect the arbitrage mechanism? 
Would more frequent disclosure increase the likelihood of free-riding 
or front-running? The rule does not limit ETFs to tracking specialized 
indexes that change their assets at or below a specified frequency. How 
might this affect the transparency of the portfolios of ETFs that would 
rely on index rather than portfolio disclosure? \87\
---------------------------------------------------------------------------

    \87\ See supra note 77 and accompanying text.
---------------------------------------------------------------------------

    Should the proposed rule prohibit advance portfolio disclosure? 
Would advance portfolio disclosure increase the likelihood of free-
riding or front-running? If so, should the risk that participants may 
engage in these activities be treated as a material risk to be 
disclosed to prospective investors permitting them to evaluate whether 
the risk makes the ETF an appropriate investment in light of the 
particular investor's investment objectives? How would advance 
disclosure affect the arbitrage mechanism? If the portfolio disclosed 
in advance differed from the actual portfolio acquired, would that 
affect the market's ability to price the ETF's shares?
2. Listing on a National Securities Exchange and Dissemination of 
Intraday Value
    An ETF that relies on rule 6c-11 would need to satisfy two 
additional conditions set forth in the paragraph defining ``exchange-
traded fund.'' \88\ First, shares issued by the ETF would have to be 
approved for listing and trading on a national securities exchange.\89\ 
We have premised our previous exemptive orders on the ETF listing its 
shares for trading on a national securities exchange.\90\ Listing on an 
exchange would provide an organized and continuous trading market for 
the ETF shares at negotiated prices. Applicants for exemptive relief 
have noted that this intra-day trading, combined with the arbitrage 
mechanism inherent in the ETF structure, should prevent significant 
premiums and discounts between the market price of ETF shares and the 
Intraday Value.\91\
---------------------------------------------------------------------------

    \88\ Proposed rule 6c-11(e)(4) (defining ``exchange-traded 
fund'').
    \89\ Proposed rule 6c-11(e)(4)(iii).
    \90\ See, e.g., HealthShares, Inc., Investment Company Act 
Release No. 27553 (Nov. 16, 2006) [71 FR 67404, 67408 (Nov. 21, 
2006)] (``HealthShares Notice'').
    \91\ See, e.g., Amended and Restated Application of Ziegler 
Exchange Traded Trust, File No. 812-13224, filed Dec. 19, 2006 
(``Ziegler Application''), at 10; PowerShares Actively Managed ETF 
Notice, supra note 20.
---------------------------------------------------------------------------

    Second, an ETF could rely on the rule only if a national securities 
exchange disseminates the Intraday Value at regular intervals during 
the trading day.\92\ Applications for exemptive relief have noted that 
exchanges typically disseminate the Intraday Value every 15 seconds 
during trading hours.\93\ They have also asserted that this regular 
dissemination of the Intraday Value enables market makers to engage in 
the arbitrage activities that determine the market price for ETF 
shares.\94\
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    \92\ Proposed rule 6c-11(e)(4)(i).
    \93\ See, e.g., Van Eck, Van Eck Associates Corp., Investment 
Company Act Release No. 27283 (Apr. 7, 2006) [71 FR 19214 (Apr. 13, 
2006)], at n.3; PowerShares Actively Managed ETF Notice, supra note 
20, at n.2.
    \94\ See, e.g., Ziegler Application, supra note 91, at 26-27.
---------------------------------------------------------------------------

    We request comment on these two conditions. Should the rule require 
that ETF shares be listed on a national securities exchange? Should the 
rule make allowance for shares that are delisted for a short time, or 
for suspensions in listing? If an ETF's shares were not listed for 
trading on a national securities exchange (even on a temporary basis), 
would the ETF structure permit the arbitrage mechanism to function 
appropriately? Should the rule require an ETF to liquidate or take 
other steps in the event of delisting? Should the proposed rule 
condition relief on listing exchanges disseminating the Intraday Value? 
If not, are there other means for market makers to receive the Intraday 
Value? Are there alternatives to using the basket as the basis for the 
Intraday Value calculation? For example, should the rule require the 
entity calculating the Intraday Value to use the ETF's portfolio (as 
opposed to the basket)? Should the calculation method be prescribed?
    The proposed rule does not require the dissemination of an ETF's 
Intraday Value at specific intervals because the rules of national 
securities exchanges, as approved by the Commission, establish the 
frequency of disclosure.\95\ Should the rule specify a minimal 
frequency? For example, should the rule prohibit an ETF from relying on 
the exemption if it is listed on an exchange that permits dissemination 
at intervals longer than the current 15 or 60-second intervals?
---------------------------------------------------------------------------

    \95\ An ETF's Intraday Value is disseminated every 15 seconds 
(or 60 seconds in the case of ETFs that track foreign indexes). See 
supra note 29 and accompanying text.
---------------------------------------------------------------------------

3. Marketing
    Our exemptive orders included a condition requiring each ETF to 
agree not to market or advertise the ETF as an open-end fund or mutual 
fund and to explain that ETF shares are not individually 
redeemable.\96\ This condition was designed to help prevent retail 
investors from confusing ETFs with traditional mutual funds. Similarly, 
the proposed rule would require each ETF relying on the rule to 
identify itself in any sales literature as an ETF that does not sell or 
redeem individual shares, and explain that investors may purchase or 
sell individual ETF shares in secondary market transactions that do not 
involve

[[Page 14626]]

the ETF.\97\ This condition, like the prior condition in our orders, is 
designed to help prevent retail investors from confusing ETFs with 
traditional mutual funds.
---------------------------------------------------------------------------

    \96\ See, e.g., WisdomTree Order, supra note 12.
    \97\ Proposed rule 6c-11(e)(4)(ii). The term sales literature is 
defined in the proposed rule to mean any advertisement, pamphlet, 
circular, form letter, or other sales material addressed to or 
intended for distribution to prospective investors other than a 
registration statement filed with the Commission under section 8 of 
the Act. Proposed rule 6c-11(e)(8). An ETF would have to make 
similar disclosures in its prospectus under the proposed amendments 
to Form N-1A. See proposed Item 6(h)(3) of Form N-1A, and infra text 
accompanying note 159.
---------------------------------------------------------------------------

    We request comment on whether the proposed condition is likely to 
provide a benefit for investors with respect to ETF marketing and 
advertising materials. Are investors confused about the distinction 
between ETFs and traditional mutual funds? Should any confusion be 
addressed through rule requirements? Should the rule require ETFs to 
identify themselves as either index-based or actively managed ETFs?
4. Conflicts of Interest
    Section 1(b)(2) of the Investment Company Act states that the 
public interest and the interest of investors are adversely affected 
when investment companies are organized, operated, managed, or their 
portfolio securities are selected, in the interest of directors, 
officers, investment advisers, or other affiliated persons, and 
underwriters, brokers, or dealers rather than in the interest of 
shareholders.\98\ The operation of an ETF--specifically, the process in 
which a creation unit is purchased by delivering basket assets to the 
ETF, and redeemed in exchange for basket assets--may lend itself to 
certain conflicts for the ETF's investment adviser, which has 
discretion to specify the securities included in the baskets. For 
example, the adviser could direct creation unit purchasers to purchase 
securities from affiliates of the adviser for subsequent presentation 
to the ETF. As we noted in the 2001 Concept Release, these conflicts 
would appear to be minimized in the case of an index-based ETF because 
the universe of securities that may be included in the ETF's portfolio 
generally is restricted by the composition of its corresponding 
index.\99\ We also noted that the same would not appear to be the case 
for an actively managed ETF. Because the adviser to an actively managed 
ETF would have greater discretion to designate securities to be 
included in the basket assets, a greater potential for conflicts 
appears to exist.
---------------------------------------------------------------------------

    \98\ 15 U.S.C. 80a-1(b)(2).
    \99\ See 2001 Concept Release, supra note 39, at Section IV.E.2.
---------------------------------------------------------------------------

    Commenters generally stated that actively managed ETFs would not be 
faced with conflicts that are different from those that currently exist 
for actively managed mutual funds.\100\ One commenter, however, 
recommended that the Commission impose any prohibitions or conditions 
under the Act that would apply to transactions directly effected by the 
adviser on any transactions effected at the adviser's discretion.\101\ 
The commenter noted that, for example, an ETF that is prohibited from 
acquiring a security in certain underwritings (under section 10(f) of 
the Act) \102\ should be prohibited from circumventing this prohibition 
by including the security in the ETF's basket assets. Similarly, an 
adviser could attempt to circumvent section 17(a) restrictions on 
principal transactions between a registered fund and its affiliates by 
designating a security for the basket assets that a creation unit 
purchaser would have to purchase from an affiliate of the adviser.\103\
---------------------------------------------------------------------------

    \100\ See, e.g., Comment Letter of the American Stock Exchange 
LLC, File No. S7-20-01 (Mar. 5, 2002); Comment Letter of State 
Street Bank and Trust Company, File No. S7-20-01 (Jan. 14, 2002); 
Comment Letter of Nuveen Investments, File No. S7-20-01 (Jan. 14, 
2002).
    \101\ Comment Letter of the Investment Company Institute, File 
No. S7-20-01 (Jan. 14, 2002).
    \102\ Section 10(f) of the Act prohibits a fund from purchasing 
any security during an underwriting or selling syndicate if a 
principal underwriter of the security is an officer, director, 
member of an advisory board, investment adviser, or employee of the 
fund or if any of these persons is an affiliate of the principal 
underwriter. 15 U.S.C. 80a-10(f). This section protects fund 
shareholders by preventing an affiliated underwriter from placing or 
``dumping'' unmarketable securities in the fund.
    \103\ Section 17(a) generally prohibits affiliated persons of a 
registered fund (``first-tier affiliates'') or affiliated persons of 
the fund's affiliated persons (``second-tier affiliates'') from 
selling securities or other property to the fund (or any company the 
fund controls). 15 U.S.C. 80a-17(a).
---------------------------------------------------------------------------

    We have not included a condition in the proposed rule prohibiting 
an actively managed ETF's adviser, directly or indirectly, from causing 
a creation unit purchaser to acquire a security for the ETF through a 
transaction in which the ETF could not engage directly. An adviser to 
an actively managed ETF already is subject to section 48(a) of the Act, 
which prohibits a person from doing indirectly, through another person, 
what that person is prohibited by the Act from doing directly. An 
adviser, therefore, would be prohibited from causing an institution 
that transacts directly with the ETF (or any investor on whose behalf 
the institution may transact with the ETF) to acquire any security for 
the ETF through a transaction in which the ETF could not engage 
directly.\104\
---------------------------------------------------------------------------

    \104\ See Lessler v. Little, 857 F.2d 866, 873-874 (1st Cir. 
1988) (reversing dismissal of a claim that principals of a 
registered investment company and its adviser had violated sections 
17(a)(2) and 48(a) of the Act by purchasing the fund's assets 
indirectly by arranging for sale of the fund to a third party in 
conjunction with an arrangement whereby the adviser obtained 
excessive interest in the transferred assets); SEC v. Commonwealth 
Chemical Securities, 410 F. Supp 1002, 1018 (S.D.N.Y. 1976) (finding 
violations of sections 17(a) and 48(a) of the Act by directors of a 
registered investment company who caused a third party to purchase 
shares in an offering underwritten by an affiliated broker-dealer 
and sold the shares to the registered investment company).
---------------------------------------------------------------------------

    We request comment on whether it would be useful to include a 
condition in the proposed rule reminding ETFs relying on the rule of 
the prohibitions contained in section 48(a) of the Act. We also request 
comment on potential conflicts of interest for an ETF's investment 
adviser. Does an adviser to a fully transparent, actively managed ETF 
face different conflicts of interest from the conflicts of an adviser 
to a traditional mutual fund? If so, what are those conflicts and how 
could the rule address them?
5. Affiliated Index Providers
    Federal securities laws and the rules of national securities 
exchanges require funds and their advisers to adopt measures reasonably 
designed to prevent misuse of non-public information.\105\ Funds are 
likely to be in a position to well understand the potential 
circumstances and relationships that could give rise to the misuse of 
non-public information, and can develop appropriate measures to address 
them. We believe these requirements should be sufficient to protect 
against the abuses addressed by the terms in the exemptive applications

[[Page 14627]]

of ETF sponsors that represented they would use an affiliated index 
provider. The proposed rule, therefore, does not include terms from 
previous applications that are designed to prevent the communication of 
material non-public information between the ETF and the affiliated 
index provider.\106\
---------------------------------------------------------------------------

    \105\ See rule 38a-1 (requiring funds to adopt policies and 
procedures reasonably designed to prevent violation of federal 
securities laws); rule 17j-1 (requiring funds to adopt a code of 
ethics containing provisions designed to prevent certain fund 
personnel (``access persons'') from misusing information regarding 
fund transactions); Section 204A of the Investment Advisers Act of 
1940 (``Advisers Act'') (15 U.S.C. 80b-204A) (requiring an adviser 
to adopt policies and procedures that are reasonably designed, 
taking into account the nature of its business, to prevent the 
misuse of material, non-public information by the adviser or any 
associated person, in violation of the Advisers Act or the Exchange 
Act, or the rules or regulations thereunder); Section 15(f) of the 
Exchange Act (15 U.S.C. 78o(f)) (requiring a registered broker or 
dealer to adopt policies and procedures reasonably designed, taking 
into account the nature of the broker's or dealer's business, to 
prevent the misuse of material, nonpublic information by the broker 
or dealer or any person associated with the broker or dealer, in 
violation of the Exchange Act or the rules or regulations 
thereunder).
    See, e.g. Rule Commentary .02(b)(i) of American Stock Exchange 
Rule 1000A (requiring ``firewalls'' between an ETF and an affiliated 
index provider).
    \106\ The terms are intended to address the potential conflicts 
of interest between the ETF adviser and its affiliated index 
provider, and include: (i) All of the rules that govern inclusion 
and weighting of securities in each index are made publicly 
available; (ii) the ability to change the rules for index 
compilation is limited and public notice is given before any changes 
are made; (iii) ``firewalls'' exist between (A) the staff 
responsible for the creation, development and modification of the 
index compilation rules and (B) the portfolio management staff; (iv) 
the calculation agent, who is responsible for all index maintenance, 
calculation, dissemination, and reconstitution activities, is not 
affiliated with the index provider, the ETF or any of their 
affiliates; and (v) the component securities of the index may not be 
changed more frequently than on a specified periodic basis. See 
HealthShares Notice, supra note 90; WisdomTree Notice, supra note 
12.
---------------------------------------------------------------------------

    We request comment on our proposal to eliminate these terms. Should 
the rule include any of the terms included in previous exemptive 
applications for affiliated index providers? If so, which terms and 
why?

C. Exemptive Relief

    The unique structure of ETFs has required ETF sponsors to seek 
relief from certain provisions of the Act and our rules in order to 
form and operate. Proposed Rule 6c-11 would permit an ETF that meets 
the conditions of the rule to redeem shares in creation unit 
aggregations, to trade at current market prices, to engage in in-kind 
transactions with certain affiliates and, in certain circumstances, to 
pay the proceeds from the redemption of shares in more than seven days. 
The proposed exemptions would be subject to certain conditions that are 
designed to address the concerns underlying the statute and thereby 
satisfy the requirement that exemptions from statutory provisions are 
in the public interest and consistent with the protection of investors 
and the purposes fairly intended by the policy of the Act.\107\
---------------------------------------------------------------------------

    \107\ See 15 U.S.C. 80a-6(c).
---------------------------------------------------------------------------

1. Issuance of ``Redeemable Securities''
    Our exemptive orders have provided ETFs with relief from sections 
2(a)(32) and 5(a)(1) \108\ of the Act so that they may register under 
the Act as open-end funds while issuing shares that are redeemable in 
creation units only.\109\ In support of the relief, ETF sponsors have 
noted that because the market price of ETF shares is disciplined by 
arbitrage opportunities, investors in ETF shares generally should be 
able to sell the shares in secondary market transactions at 
approximately their NAV.\110\
---------------------------------------------------------------------------

    \108\ 15 U.S.C. 80a-2(a)(32) (defining ``redeemable security'' 
as any security the terms of which permit the holder upon 
presentation to receive the holder's proportionate share of the 
issuer's current net assets, or the cash equivalent); 15 U.S.C. 80a-
5(a)(1).
    \109\ These exemptions are granted under section 6(c) of the 
Act. See supra note 76.
    \110\ See, e.g., Ziegler Exchange Traded Trust, Investment 
Company Act Release No. 27610 (Dec. 22, 2006) [72 FR 163 (Jan. 3, 
2007)] (``Ziegler Notice''); PowerShares Actively Managed ETF 
Notice, supra note 20, at text following n.5.
---------------------------------------------------------------------------

    Proposed rule 6c-11 would deem an equity security issued by an ETF 
to be a ``redeemable security'' for purposes of section 2(a)(32) of the 
Act.\111\ This provision would permit an ETF to register with the 
Commission as an open-end fund, which the Act defines as an investment 
company that issues redeemable securities,\112\ even though ETF shares 
are issued and redeemed in creation unit aggregations.\113\ This 
approach would provide ETFs with the same relief contained in our 
exemptive orders without exempting ETFs from other requirements imposed 
under the Act and our rules that apply to funds that issue redeemable 
securities.\114\
---------------------------------------------------------------------------

    \111\ Proposed rule 6c-11(a). Our orders provided an exemption 
from sections 2(a)(32) and 5(a)(1) to allow ETFs to redeem 
securities in creation unit aggregations rather than individually.
    \112\ See 15 U.S.C. 80a-5(a)(1).
    \113\ ETF creation units have ranged from 25,000 to 200,000 ETF 
shares. See, e.g., PowerShares Actively Managed ETF Notice, supra 
note 20 (creation units are blocks of 50,000 to 100,000 ETF shares); 
ProShares Trust, Investment Company Act Release No. 27323 (May 18, 
2006) [71 FR 29991 (May 24, 2006)] (notice) (``ProShares Notice'') 
(creation units are blocks of 25,000 to 50,000 ETF shares); 
WisdomTree Notice, supra note 12 (creation units are blocks of 
25,000 to 200,000 ETF shares).
    \114\ See, e.g., 15 U.S.C. 80a-22; 17 CFR 270.22c-1. In 
addition, the rules under the Exchange Act that apply to redeemable 
securities issued by a mutual fund would apply to ETFs. See, e.g., 
17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    We request comment on this aspect of the proposed rule. Are there 
differences in ETFs and other funds that would justify not applying any 
provision of the Act or our rules that applies to funds that issue 
redeemable securities?
    As discussed above, ETFs today operate with an arbitrage mechanism 
designed to minimize the potential deviation between the market price 
and NAV of ETF shares. The proposed rule would require that an ETF 
establish creation unit sizes the number of shares of which are 
reasonably designed to facilitate arbitrage, which is described in the 
proposed definition of creation unit as the purchase (or redemption) of 
shares from the ETF with an offsetting sale (or purchase) of shares on 
a national securities exchange at as nearly the same time as 
practicable for the purpose of taking advantage of a difference in the 
Intraday Value and the current market price of the shares.\115\ The 
proposed rule also would require an ETF to disclose in its prospectus 
and any sales literature the number of ETF shares for which it will 
issue or redeem a creation unit to alert investors that they cannot 
purchase or redeem individual ETF shares directly from or with the 
ETF.\116\
---------------------------------------------------------------------------

    \115\ Proposed rule 6c-11(e)(3). We note that the Board of 
Governors of the Federal Reserve defines ``arbitrage'' in a similar 
manner in section 220.6(b) of Regulation T (``Arbitrage. A creditor 
may effect and finance for any customer bona fide arbitrage 
transactions. For the purpose of this section, the term ``bona fide 
arbitrage'' means: (1) A purchase or sale of a security in one 
market together with an offsetting sale or purchase of the same 
security in a different market at as nearly the same time as 
practicable for the purpose of taking advantage of a difference in 
prices in the two markets; or (2) A purchase of a security which is, 
without restriction other than the payment of money, exchangeable or 
convertible within 90 calendar days of the purchase into a second 
security together with an offsetting sale of the second security at 
or about the same time, for the purpose of taking advantage of a 
concurrent disparity in the prices of the two securities.''). 12 CFR 
220.6.
    \116\ Proposed rule 6c-11(e)(4)(ii); Proposed Item 6(h)(3) to 
Form N-1A.
---------------------------------------------------------------------------

    The proposed condition regarding creation unit size is intended to 
require ETFs that rely on the proposed rule to choose creation unit 
sizes that promote an arbitrage mechanism and to preclude ETFs from 
setting very low or high thresholds, such as one ETF share per creation 
unit or one million ETF shares per creation unit. A low creation unit 
size could, as a practical matter, make the use of creation unit 
redemption irrelevant. The ETF would, in effect, be issuing and 
redeeming ETF shares like a traditional mutual fund, but the shares 
would trade on an exchange. Conversely, a high creation unit size could 
reduce the willingness or ability of institutional arbitrageurs to 
engage in creation unit purchases or redemptions. Impeding the ability 
of arbitrageurs to purchase and redeem ETF shares could disrupt the 
arbitrage pricing discipline, which could lead to more frequent 
occurrences of pricing premiums or discounts.
    We request comment on the proposed requirement for creation unit 
size, which is included in the proposed rule's definition of ``creation 
unit.'' Does the requirement that an ETF establish creation unit sizes 
the number of which is reasonably designed to facilitate arbitrage 
provide the sponsor or adviser of the ETF with sufficient guidance in 
setting appropriate thresholds? Should we include other elements in our 
description of arbitrage, which is included in the definition of 
creation

[[Page 14628]]

unit? If so, what elements? Should the proposed rule instead require 
the board of directors of the ETF to make a finding that the ETF is 
structured in a manner reasonably intended to facilitate arbitrage? 
This finding could require the board, for example, to look at the 
number of shares in each creation unit and the liquidity of the 
portfolio securities and other assets. What other elements, if any, 
should the board be required to review in making this finding?
    The proposed rule does not include numerical thresholds for the 
number of ETF shares in each creation unit. Should the proposed rule 
include minimum or maximum numerical thresholds? If so, what would be 
appropriate thresholds and why? For example, should the rule set a 
minimum of 100 ETF shares, and/or a maximum of 500,000 ETF shares, per 
creation unit? Are our concerns with respect to smaller-or larger-sized 
creation units addressed by requiring ETFs to establish creation unit 
sizes that facilitate arbitrage? If the rule does not include any 
thresholds, would any of the exemptions provided by the proposed rule 
be inappropriate for an ETF with smaller-or larger-sized creation 
units? If so, which exemptions?
    ETF applicants represent that ETF share prices are disciplined by 
arbitrage opportunities created by the ability to purchase and redeem 
creation units at NAV on a daily basis.\117\ Would this pricing 
mechanism function differently for smaller-or larger-sized creation 
units? Because ETFs charge transaction fees for direct purchases and 
redemptions from the fund, ETF applicants have asserted that the 
interests of long-term shareholders should not be diluted by frequent 
traders, if those transaction fees accurately reflect the costs to the 
fund.\118\ Are smaller-sized creation units likely to cause the 
transaction fees charged by ETFs to be insufficient to protect the 
long-term shareholders in the event of more frequent purchases and 
redemptions? If so, should an ETF relying on the proposed exemption be 
required to take additional measures designed to protect long-term 
shareholder interests from being diluted by frequent traders? If so, 
what measures?
---------------------------------------------------------------------------

    \117\ See, e.g., Zeigler Application, supra note 91, at 52-53; 
see also supra notes 25-26 and accompanying and preceding text.
    \118\ See Zeigler Application, supra note 91, at 23; PowerShares 
Actively Managed ETF Application, supra note 62, at 17-18.
---------------------------------------------------------------------------

    As discussed above, ETFs issue and redeem shares in creation unit 
aggregations in exchange for the deposit or delivery of a basket of 
securities and other assets. The proposed rule defines ``basket 
assets'' to mean the securities or other assets specified each business 
day in name and number by the ETF as the securities or assets in 
exchange for which it will issue, or in return for which it will 
redeem, ETF shares.\119\ The rule does not require that the basket 
mirror the portfolio of the ETF because in some circumstances it may 
not be practicable, convenient or operationally possible for the ETF to 
operate on an in-kind basis.\120\ The rule, like our orders, allows an 
ETF to require or permit a purchasing or redeeming shareholder to 
substitute cash for some or all of the securities in the basket 
assets.\121\
---------------------------------------------------------------------------

    \119\ Proposed rule 6c-11(e)(1). Under the proposed rule, the 
term ``business day'' with respect to an ETF would mean any day that 
the fund is open for business, including any day on which it is 
required to make payment under section 22(e) of the Act. Section 
22(e) of the Act prohibits registered funds from suspending the 
right of redemption or postponing the date of payment upon 
redemption of any redeemable security for more than seven days 
except for certain periods specified in the provision. See 15 U.S.C. 
80a-22(e). Proposed rule 6c-11(e)(2).
    \120\ The ETF and its adviser may decide to permit cash-only 
purchases of creation units to minimize transaction costs or enhance 
the ETF's operational efficiency. For example, on a day when a 
substantial rebalancing of an index-based ETF's portfolio is 
required, the adviser might prefer to receive cash rather than in-
kind securities so that it has the liquid resources at hand to make 
the necessary purchases. If the ETF received in-kind securities on 
that day, it might have to sell some securities and acquire new ones 
to properly track its underlying index, incurring transaction costs 
that could have been avoided if the ETF had received cash instead. 
See, e.g., Ziegler Application, supra note 91, at 21-22. For some 
ETFs that track country-specific equity securities indexes, it is 
operationally necessary to engage in cash-only transactions because 
of local law restrictions on transferability of securities. See 
iShares, Inc., Investment Company Act Release Nos. 25595 (May 29, 
2002) [67 FR 38684 (June 5, 2002)] (notice) and 25623 (June 25, 
2002) (order) (certain iShares ETFs that invest in certain foreign 
markets currently effect purchases and redemptions through cash 
transactions).
    \121\ Proposed rule 6c-11(e)(1). Though the standard operations 
of most existing ETFs involve in-kind purchases and redemptions, the 
Commission has consistently permitted the substitution of cash for 
certain securities in the basket assets. See, e.g., WisdomTree 
Notice, supra note 12 at text preceding n.9. In addition, the 
Commission has permitted ETFs that primarily hold financial 
instruments, cash and cash equivalents in their portfolios to 
operate on a cash-only basis because of the limited transferability 
of financial instruments. See, e.g., ProShares Notice, supra note 
113, at n.2 and accompanying text. See also SPDR Lehman Municipal 
Bond ETF, Prospectus 19-22 (Sept. 10, 2007) (ETF generally sells 
creation units for cash only and redeems creation units in-kind 
only).
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    We request comment on the proposed definition of basket assets. Are 
there any reasons why an ETF should not be permitted to substitute cash 
for some or all of the assets in the basket? Should the proposed rule 
include any conditions for when an ETF may require or permit cash 
substitutions? If so, what conditions should be included? Should the 
rule specify how the ETF would announce the composition of the basket? 
For example, should the rule mandate that the ETF post the information 
on its Internet Web site? Should the rule specify the frequency with 
which the ETF must announce the composition of the basket? If so, how 
often?
2. Trading of ETF Shares at Negotiated Prices
    As noted above, section 22(d), among other things, prohibits a 
dealer from selling a redeemable security that is being offered 
currently to the public by or through an underwriter, except at a 
current public offering price described in the prospectus.\122\ Rule 
22c-1 generally requires that a dealer selling, redeeming, or 
repurchasing a redeemable security do so only at a price based on its 
NAV.\123\ Because secondary market trading in ETF shares takes place at 
current market prices, and not at the current offering price described 
in the prospectus or based on NAV, ETFs have obtained exemptions from 
section 22(d) and rule 22c-1.
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    \122\ 15 U.S.C. 80a-22(d).
    \123\ 17 CFR 270.22c-1.
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    The provisions of section 22(d), as well as rule 22c-1, are 
designed to prevent dilution caused by certain riskless trading schemes 
by principal underwriters and dealers, and to prevent unjust 
discrimination or preferential treatment among investors purchasing and 
redeeming fund shares.\124\ The proposed rule would exempt a dealer in 
ETF shares from section 22(d) of the Act and rule 22c-1(a) with regard 
to purchases, sales and repurchases of ETF shares in secondary market 
transactions at current market prices.\125\ As discussed above, we have 
provided exemptions from section 22(d) and rule 22c-1 in our orders 
because the arbitrage function appears to address the potential 
concerns regarding shareholder dilution and unjust discrimination that 
these provisions

[[Page 14629]]

were designed to address.\126\ In addition, secondary market trading 
should not cause dilution for ETF shareholders because those 
transactions do not directly involve ETF portfolio assets (the 
transactions are with other investors, not the ETF), and thus have no 
direct impact on the NAV of ETF shares held by other investors. 
Moreover, to the extent that different prices for ETF shares exist 
during a given trading day, or from day to day, these variations occur 
as a result of third-party market forces, such as supply and demand, 
and not as a result of discrimination or preferential treatment among 
purchasers.
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    \124\ For a complete legislative history of section 22(d), see 
Exemption from Section 22(d) to Permit the Sale of Redeemable 
Securities at Prices that Reflect Different Sales Loads, Investment 
Company Act Release No. 13183 (Apr. 22, 1983) [44 FR 19887 (May 10, 
1983)]. See also Adoption of Rule 22c-1 under the Investment Company 
Act of 1940 Prescribing the Time of Pricing Redeemable Securities 
for Distribution, Redemption, and Repurchase and Amendment of Rule 
17a-3(a)(7) under the Securities Exchange Act of 1934 Requiring 
Dealers to Time Stamp Orders, Investment Company Act Release No. 
5519 (Oct. 16, 1968) [33 FR 16331 (Nov. 7, 1968)].
    \125\ Proposed rule 6c-11(b).
    \126\ See supra notes 71-7573 and accompanying text.
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    We request comment on this proposed relief. Should the relief also 
apply to parties other than dealers in ETF shares? If so, which other 
parties require similar relief, and why? Do dealers (or others) need 
relief from other provisions to facilitate transactions in ETF shares 
on the secondary market?
3. In-Kind Transactions Between ETFs and Certain Affiliates
    Section 17(a) of the Act generally prohibits an affiliated person 
of a registered investment company, or an affiliated person of such 
person, from selling any security to or purchasing any security from 
the company.\127\ Purchases and redemptions of ETF creation units are 
typically in-kind rather than cash transactions,\128\ and section 17(a) 
prohibits these in-kind purchases and redemptions by persons who are 
affiliated with the ETF, including those affiliated because they own 5 
percent or more, and in some cases more than 25 percent, of the ETF's 
outstanding securities (``first-tier affiliates''), and by persons who 
are affiliated with the first-tier affiliates or who own 5 percent or 
more, and in some cases more than 25 percent, of the outstanding 
securities of one or more funds advised by the ETF's investment adviser 
(``second-tier affiliates'').\129\
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    \127\ 15 U.S.C. 80a-17(a).
    \128\ ETFs must comply with the federal securities laws in 
accepting and satisfying redemptions with basket assets, including 
the registration provisions of the Securities Act. See, e.g., 
Ameristock Notice, supra note 13, at n.3.
    \129\ An affiliated person of a fund includes, among others: (i) 
Any person directly or indirectly owning, controlling, or holding 
with power to vote, five percent or more of the outstanding voting 
securities of the fund; (ii) any person five percent or more of 
whose outstanding voting securities are directly or indirectly 
owned, controlled, or held with power to vote by the fund; and (iii) 
any person directly or indirectly controlling, controlled by, or 
under common control with such other person. 15 U.S.C. 80a-
2(a)(3)(A), (B) and (C). A control relationship will be presumed 
where one person owns more than 25 percent of another person's 
outstanding voting securities. 15 U.S.C. 80a-2(a)(9).
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    We have granted exemptions from sections 17(a)(1) and (a)(2) \130\ 
of the Act to allow these first- and second-tier affiliates of the ETF 
to purchase and redeem creation units through in-kind 
transactions.\131\ In seeking this relief, applicants have submitted 
that because the first- and second-tier affiliates are not treated 
differently from non-affiliates when engaging in purchases and 
redemptions of creation units, there is no opportunity for these 
affiliated persons to effect a transaction detrimental to the other ETF 
shareholders. The securities to be deposited for purchases of creation 
units and to be delivered for redemptions of creation units are 
announced at the beginning of each day. All purchases and redemptions 
of creation units are at an ETF's next-calculated NAV (pursuant to rule 
22c-1), and the securities deposited or delivered upon redemption are 
valued in the same manner, using the same standards, as those 
securities are valued for purposes of calculating the ETF's NAV.
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    \130\ 15 U.S.C. 80a-17(a)(1), 80a-17(a)(2).
    \131\ See, e.g., HealthShares Notice, supra note 90, at text 
following n.10.
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    The proposed rule would permit first- and second-tier affiliates of 
the ETF to purchase and redeem creation units through in-kind 
transactions.\132\ The proposed exemption would not, however, apply to 
a specific category of redemptions that would be addressed in new rule 
12d1-4, which we also are proposing today. Section 12(d)(1) of the Act 
imposes substantial limitations on the ability of investment companies 
to invest in other investment companies.\133\ As discussed in Section 
IV of this release, proposed rule 12d1-4 would permit investment 
companies to acquire shares of ETFs in excess of the limitations on 
those investments under section 12(d)(1) of the Act subject to certain 
conditions intended to address the concerns underlying those 
limitations. One of the proposed conditions would prohibit investment 
companies from redeeming certain ETF shares acquired in reliance on 
proposed rule 12d1-4.\134\ In order to make proposed rule 6c-11 
consistent with the conditions in proposed rule 12d1-4, we propose to 
exclude investment companies that acquire ETF shares in reliance on 
proposed rule 12d1-4 from relying on proposed rule 6c-11(d) to redeem 
those ETF shares in kind.\135\
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    \132\ Proposed rule 6c-11(d).
    \133\ See infra note 194 and accompanying text.
    \134\ As discussed in Section IV.B.2, infra, this condition is 
designed to prevent a fund that relies on the proposed rule to 
acquire ETF shares in excess of the limits of section 12(d)(1)(A)(i) 
from unduly influencing the ETF by the threat of a large-scale 
redemption.
    \135\ The proposed rule would not permit an investment company 
that has acquired ETF shares in excess of the limits in section 
12(d)(1)(A)(i) of the Act in reliance on proposed rule 12d1-4(a) to 
rely on proposed rule 6c-11(d) with regard to the purchase of basket 
assets (i.e., the purchase of securities identified in the basket 
when redeeming ETF shares). Proposed rule 6c-11(d).
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    We request comment on this proposed exemption. Does the proposed 
exemption raise any risks with regard to affiliated transactions with 
the ETF? If so, should the exemption include any conditions to minimize 
those risks? Should the relief extend to parties that are affiliated 
persons of an ETF for other reasons? For example, should a broker-
dealer that is affiliated with the ETF's adviser be allowed to transact 
in-kind with the ETF?
4. Additional Time for Delivering Redemption Proceeds
    Section 22(e) of the Act generally prohibits a registered open-end 
investment company from suspending the right of redemption, or 
postponing the date of satisfaction of redemption requests more than 
seven days after the tender of a security for redemption.\136\ Some 
ETFs that track foreign indexes have stated that local market delivery 
cycles for transferring foreign securities to redeeming investors, 
together with local market holiday schedules, require a delivery 
process in excess of seven days. These ETFs have requested, and we have 
granted, relief from section 22(e) so that they may satisfy redemptions 
up to a specified maximum number of calendar days depending upon 
specific circumstances in the local markets, as disclosed in the ETF's 
prospectus or statement of additional information (``SAI''). Other than 
in the disclosed situations, these ETFs satisfy redemptions within 
seven days.\137\
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    \136\ 15 U.S.C. 80a-22(e).
    \137\ In their applications, ETFs acknowledge that no relief 
obtained from the requirements of section 22(e) will affect any 
obligations that they may otherwise have under rule 15c6-1 under the 
Exchange Act. See, e.g., In re Barclays Global Fund Advisors, Second 
Amended and Restated Application, File No. 812-11598, filed May 11, 
2000 (``Barclays Foreign Application''), at 76 (available for public 
inspection and copying in the Commission's Public Reference Room, 
100 F Street, NE., Washington, DC 20549). Rule 15c6-1 requires that 
most securities transactions be settled within three business days 
of the trade date. 17 CFR 240.15c6-1.
---------------------------------------------------------------------------

    Section 22(e) of the Act is designed to prevent unreasonable delays 
in the satisfaction of redemptions, and ETF sponsors have asserted that 
the requested relief will not lead to the problems that section 22(e) 
was

[[Page 14630]]

designed to prevent.\138\ They have represented that the ETF's SAI 
would disclose those local holidays (over the period of at least one 
year following the date of the SAI) that are expected to prevent the 
satisfaction of redemptions in seven days and the maximum number of 
days needed to satisfy redemption requests with respect to the foreign 
securities at issue.\139\
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    \138\ See Investment Trusts and Investment Companies: Hearings 
on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and 
Currency, 76th Cong., 3d Sess. 291-293 (statements of David 
Schenker).
    \139\ See, e.g., Barclays Foreign Application, supra note 137, 
at 76-84.
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    The delay in satisfying redemption requests seems reasonable under 
the circumstances described by the ETF sponsors because it is for a 
limited period of time and disclosed to investors. The proposed rule, 
therefore, would codify the relief from section 22(e) of the Act 
previously provided to ETFs. If an ETF has a foreign security in its 
basket assets and a foreign holiday prevents timely delivery of the 
foreign security, the ETF would be exempt from the prohibition in 
section 22(e) against postponing the date of satisfaction upon 
redemption for more than seven days. To rely on this exemption, the ETF 
would be required to disclose in its SAI the foreign holidays it 
expects to prevent timely delivery of the foreign securities and the 
maximum number of days it anticipates it would need to deliver the 
foreign securities. Finally, the delivery would have to take place no 
more than 12 calendar days after the tender of ETF shares (in a 
creation unit).\140\
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    \140\ Proposed rule 6c-11(c). Applicants requesting this 
exemptive relief generally have represented that they would be able 
to deliver redemption proceeds within 12 calendar days. See, e.g., 
WisdomTree Notice, supra note 12. An ETF relying on this exemption 
would disclose the information in the SAI. See Item 18 of Form N-1A 
(requiring disclosures regarding purchase, redemption, and pricing 
of shares).
---------------------------------------------------------------------------

    We request comment on this relief in the proposed exemption. Is the 
relief necessary? We specifically request comment from ETFs regarding 
the frequency with which they have relied on this exemption. Could an 
ETF pay cash (as part of the basket assets) in lieu of foreign 
securities in the case of delays in settlement? Should the relief be 
limited to ETFs that satisfy redemptions entirely through in-kind 
transactions? Is the number of days in the proposed rule sufficient or 
is it too long? Should the rule refer to the applicable local market's 
settlement cycle without specifying a number of days? Should the 
disclosure be included in the prospectus of the ETF instead of the SAI, 
which is only delivered upon request? Should the disclosure be included 
in any sales literature of the ETF?
    The rule would provide relief if the ETF's basket assets include a 
foreign security. Should the rule also provide relief if an ETF has 
foreign securities included in its portfolio and, if so, why? Would 
actively managed ETFs present any issues with respect to this exemption 
that do not exist with respect to index-based ETFs? Could the 
investment adviser to an actively managed ETF manage the ETF so as to 
comply with section 22(e)?
    The proposed rule defines ``foreign security'' to mean any security 
issued by a government or any political subdivision of a foreign 
country, a national of any foreign country, or a corporation or other 
organization incorporated or organized under the laws of any foreign 
country, and for which there is no established United States public 
trading market as that term is used in Item 201 of Regulation S-K under 
the Exchange Act. Use of the phrase ``established United States public 
trading market'' is designed to limit this relief to ETFs that invest 
in securities that do not have an active trading market in the United 
States. The rule does not rely on registration status because an 
unregistered large foreign private issuer may have an active U.S. 
market for its securities, in which case the ETF should be able to meet 
redemption requests in a timely manner.\141\
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    \141\ See Termination of a Foreign Private Issuer's Registration 
of a Class of Securities Under Section 12(g) and Duty To File 
Reports Under Section 13(a) or 15(d) of the Securities Exchange Act 
of 1934, Securities Exchange Act Release No. 55540 (Mar. 27, 2007) 
[72 FR 16934 (Apr. 5, 2007)] (adopting rule 12h-6 under the Exchange 
Act, which permits a foreign issuer to terminate its Exchange Act 
registration and reporting obligations regarding a class of equity 
securities if the average daily trading volume (``ADTV'') of the 
securities in the United States has been 5 percent or less of the 
ADTV of that class of securities in the issuer's principal trading 
market during a recent 12-month period, regardless of the size of 
its U.S. public float).
---------------------------------------------------------------------------

    We request comment on the definition of ``foreign security.'' 
Should the definition provide any additional exceptions?

D. Disclosure Amendments

    Congress enacted the federal securities laws to promote fair and 
honest securities markets, and an important purpose of these laws is to 
promote full and fair disclosure of important information by issuers of 
securities to the investing public. The Securities Act and the Exchange 
Act, as implemented by Commission rules and regulations, provide for 
systems of mandatory disclosure of certain material information in 
securities offerings and in periodic reports. Accordingly, the 
Securities Act requires delivery of a prospectus meeting the 
requirements of section 10(a) to each investor in a registered 
offering.\142\ The Securities Act also requires dealers in a security, 
for a specified period of time after the registration statement for the 
security becomes effective, to deliver a final prospectus to 
purchasers, including to most persons purchasing shares in secondary 
market transactions.\143\ The Investment Company Act, however, requires 
dealers to continue prospectus delivery to investors in open-end funds, 
including ETFs, which continuously offer their securities to the 
public.\144\
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    \142\ 15 U.S.C. 77j(a). This is known as a ``final prospectus.'' 
In 2005, the Commission adopted rule 172 under the Securities Act 
which generally deems final prospectus delivery satisfied when the 
prospectus is filed with the Commission (``access equals 
delivery''). 17 CFR 230.172. The Commission, however, specifically 
excluded registered investment companies from rule 172. See 
Securities Offering Reform, Securities Act Release No. 8591 (July 
19, 2005) [70 FR 44722 (Aug. 3, 2005)]. For a detailed discussion on 
the prospectus delivery requirements and related liabilities with 
respect to open-end investment companies, see Enhanced Disclosure 
and New Prospectus Delivery Option for Registered Open-End 
Management Investment Companies, Investment Company Act Release No. 
28064 (Nov. 21, 2007) [72 FR 67790 (Nov. 30, 2007)] (``Enhanced 
Disclosure Proposing Release'') at sections II.B.1 and II.B.4.
    \143\ Under section 4(3) of the Securities Act, dealers must 
deliver a prospectus in connection with original sales by the dealer 
of securities obtained from or through an underwriter, and resales 
by the dealer occurring during the 40 days (90 days for first-time 
issuers) after the effective date of the registration statement (or, 
under certain circumstances, a different date). This aftermarket 
delivery obligation applies to all dealers, whether or not they 
participated in the offering itself. 15 U.S.C. 77d(3). See also rule 
174 under the Securities Act, which provides an exception from the 
requirement in section 4(3) that a prospectus be delivered prior to 
the expiration of the applicable 40-day or 90-day period. 17 CFR 
230.174.
    \144\ Section 24(d) of the Act eliminates the dealer's exception 
with respect to securities issued by funds and UITs on the theory 
that, because those issuers continuously offer their securities to 
the public, all dealers should be compelled to use the statutory 
prospectus. See H.R. Rep. No. 1542, 83d Cong., 2d Sess. 29-30 
(1954).
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1. Delivery of Prospectuses to Investors
    Our orders generally have exempted broker-dealers selling ETF 
shares from the obligation to deliver prospectuses in most secondary 
market transactions.\145\

[[Page 14631]]

Applicants have represented that broker-dealers would instead deliver a 
``product description'' containing basic information about the ETF and 
its shares.\146\ Proposed rule 6c-11 would not include a similar 
exemption, and thus broker-dealers would be required to deliver a 
prospectus meeting the requirements of section 10(a) of the Securities 
Act to investors purchasing ETF shares.\147\
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    \145\ Most of the orders have granted exemptions from section 
24(d) of the Act, which makes inapplicable the dealer exception in 
section 4(3) of the Securities Act to transactions in redeemable 
securities issued by an open-end fund. 15 U.S.C. 80a-24(d); 15 
U.S.C. 77(d)(3); see, e.g., WisdomTree Notice, supra note 12, at 
n.14. ETFs that have this relief continue to be subject to 
prospectus delivery requirements in connection with sales of 
creation units and other non-secondary market transactions. Our most 
recent orders permitting certain actively managed ETFs do not, 
however, provide this exemption. See Actively Managed ETF Orders, 
supra note 20.
    \146\ See, e.g., Ziegler Notice, supra note 110. The product 
description provides a summary of the salient features of the ETF 
and its shares, including the investment objectives of the fund, the 
manner in which ETF shares trade on the secondary market, and the 
manner in which creation units are purchased and redeemed. National 
securities exchanges on which ETFs are listed have adopted rules 
requiring the delivery of product descriptions. See, e.g., American 
Stock Exchange Rules 1000 and 1000A.
    \147\ 15 U.S.C. 77j(a). This prospectus delivery requirement 
would apply to all ETFs, including ETFs operating under current 
exemptive orders. Therefore, we propose to amend orders we issued to 
open-end ETFs to exclude the section 24(d) exemption we have issued 
to existing ETFs. See infra Section III.E for a discussion of this 
proposed amendment to existing orders.
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    We understand that many, if not most, broker-dealers selling ETF 
shares in secondary market transactions do, in fact, transmit a 
prospectus to purchasers, and thus they have not relied on the 
exemptions we have provided in our orders. More important, we believe 
an exemption allowing dealers to deliver product descriptions would be 
unnecessary given our proposal regarding summary prospectus disclosure. 
As discussed below,\148\ we recently proposed amendments to Form N-1A 
and to rule 498 under the Securities Act,\149\ in order to enhance the 
disclosures that are provided to mutual fund investors (``Enhanced 
Disclosure Proposing Release'').\150\ The proposed amendments, if 
adopted, would require key information to appear in plain English in a 
standardized order at the front of the mutual fund prospectus 
(``summary section'').\151\ A person could satisfy its mutual fund 
prospectus delivery obligations under section 5(b)(2) of the Securities 
Act by sending or giving this key information directly to investors in 
the form of a summary prospectus and providing a prospectus that meets 
the requirements of section 10(a) of the Securities Act (``statutory 
prospectus'') on an Internet Web site.\152\ If adopted, broker-dealers 
selling ETF shares could deliver a summary prospectus in secondary 
market transactions. We believe the summary prospectus would contain 
material information that may not be included in a product description, 
but, like the product description, would be in a form that would be 
easy to use and readily accessible.
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    \148\ See infra notes 176-185 and accompanying text.
    \149\ 17 CFR 230.498.
    \150\ See Enhanced Disclosure Proposing Release, supra note 142.
    \151\ See id., at Section II.A.
    \152\ 15 U.S.C. 77j(a). The fund also would be required to 
provide additional information on its Web site. See Proposed rule 
498(c).
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    We request comment on this approach. Are we correct in our 
understanding that many, if not most, broker-dealers deliver a 
prospectus instead of a product description in connection with sales of 
ETF shares in secondary market transactions? If so, why?
    If we were to adopt rule 6c-11 before the amendments proposed in 
the Enhanced Disclosure Proposing Release, we would expect to permit 
delivery of a product description in lieu of a prospectus, pending 
final determination of that proposal by the Commission. We request 
comment on this approach. Should we permit all ETFs, including actively 
managed ETFs and index-based ETFs that rely on the rule instead of an 
exemptive order to deliver product descriptions? Should we prescribe 
the form of the product description? For example, should we propose 
specific requirements for product descriptions that would provide ETF 
investors with information similar to that received by traditional 
mutual fund investors, such as the fee table, name and length of 
service of the portfolio manager, and return information, as noted 
above? Alternatively, should the product description conform to the 
disclosures in the summary section as proposed in Section III.D.2 
below? \153\ If so, are there any additional disclosures to those in 
the proposed summary section that ETFs should be required to include in 
a product description? Are there any disclosures in the proposed 
summary section that ETFs should not be required to include in the 
product description?
---------------------------------------------------------------------------

    \153\ See infra notes 175-189 and accompanying text.
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    If we do not adopt the amendments proposed in the Enhanced 
Disclosure Proposing Release, we would anticipate that dealers in ETF 
shares will nevertheless continue their current practice of delivering 
prospectuses to investors. We request comment on whether the rule 
should require dealers to deliver prospectuses instead of product 
descriptions.\154\ ETFs are becoming more like traditional mutual funds 
in several respects. As discussed above, when we began issuing 
exemptive orders to ETFs, they had basic investment objectives (to 
track a widely-followed index) and simple investment techniques 
(investment in all, or a representative sample of, the securities of a 
widely followed index).\155\ Soon, however, some ETFs will be actively 
managed and have portfolio managers whose role is important to the 
success of the fund.\156\ ETF operations, investment objectives, 
expenses, and other characteristics may become more varied as well. 
Because prospectuses contain information in a standardized form 
prescribed by the Commission, the use of these disclosure forms could 
promote greater uniformity in the content and level of disclosure among 
ETFs.\157\ In addition, as discussed below, we are proposing to amend 
Form N-1A to include additional information relevant to a retail 
investor in an ETF, who does not typically buy or redeem individual 
shares directly from the fund.
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    \154\ For a discussion of the additional burdens associated with 
the requirement that broker-dealers deliver prospectuses in 
secondary market transactions involving ETF shares, see infra 
discussion at Section VIII.
    \155\ See supra note 10 and accompanying text.
    \156\ The investment objectives and techniques of index-based 
ETFs also have become more complex. Some ETFs today follow 
specialized or custom-designed indexes; others are leveraged through 
use of futures contracts and other types of derivative instruments.
    \157\ Certain disclosures required by Form N-1A that generally 
are not included in product descriptions may be important to some 
investors given the evolution of ETFs. Product descriptions do not, 
for example, include a fee table itemizing the ETF's expenses, or 
the name and length of service of the portfolio manager.
---------------------------------------------------------------------------

    If we were to retain the prospectus delivery exemption for broker-
dealers, should the exemption be limited to index-based ETFs or only to 
certain index-based ETFs, such as those that replicate the components 
of a broad-based stock market index? If we were to retain the 
exemption, should we require broker-dealers to deliver prospectuses 
instead of product descriptions to purchasers of actively managed ETF 
shares?
2. Amendments to Form N-1A
    We are proposing several amendments to Form N-1A, the registration 
form used by open-end management investment companies to register under 
the Act and to offer their securities under the Securities Act, to 
accommodate the use of this form by ETFs. The proposed amendments for 
ETF prospectuses are designed to meet the needs of investors (including 
retail investors) who purchase shares in secondary market transactions 
rather than financial institutions purchasing creation units directly 
from the ETF.
    We request comment on our proposal to amend Form N-1A to meet the 
needs of secondary market investors. Is this

[[Page 14632]]

distinction we propose to draw between purchasers of shares in 
secondary market transactions and purchasers of creation units from the 
fund appropriate? Should we instead revise Form N-1A to include the 
additional disclosure (as discussed below) we are proposing today for 
secondary market investors without eliminating (as discussed below) 
certain disclosures relevant to creation unit purchasers? Would 
secondary market investors be confused if Form N-1A included disclosure 
relevant to both types of investors?
    Purchasing and Redeeming Shares. We propose to amend Item 6 of Form 
N-1A to eliminate the requirement that ETF prospectuses disclose 
information on how to buy and redeem shares of the ETF because it is 
not relevant to secondary market purchasers of ETF shares.\158\ Instead 
ETF prospectuses would simply state the number of shares contained in a 
creation unit (i.e. the amount of shares necessary to redeem with the 
ETF) and that individual shares can only be bought and sold on the 
secondary market through a broker-dealer.\159\ Similarly, we also would 
amend Item 3 to exclude from the fee table fees and expenses for 
purchases or sales of creation units.\160\ Instead, the proposed 
amendment would require an ETF to modify the narrative explanation 
preceding the example in the fee table to state that individual ETF 
shares are sold on the secondary market rather than redeemed at the end 
of the periods indicated, and that investors in ETF shares may be 
required to pay brokerage commissions that are not reflected in the fee 
table.\161\
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    \158\ Proposed Item 6(h)(1) of Form N-1A.
    \159\ Proposed Item 6(h)(3) of Form N-1A.
    \160\ Proposed Instruction 1(e)(i) to Item 3 of Form N-1A.
    \161\ Proposed Instruction 1(e)(ii) to Item 3 of Form N-1A. We 
also are proposing a conforming amendment to the fee table in ETF 
annual and semi-annual reports. Proposed Instruction 1(e) to Item 
22(d) of Form N-1A.
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    We request comment on our assumption that investors (including most 
individual investors) purchasing their shares in secondary market 
transactions do not need to know information on how creation units are 
purchased and redeemed, or the payment of transaction fees by investors 
purchasing or redeeming creation units. If they do need this 
information, why?
    ETFs would still be required to include disclosure on how creation 
units are offered to the public in the SAI.\162\ We are not proposing 
to amend this disclosure to include information on creation unit 
redemption, which Item 6 currently requires and which we propose to 
eliminate. Should we amend the SAI to include the disclosure 
requirements we are proposing to eliminate from Item 6? Should we 
require that the information in the SAI regarding the purchase of 
creation units also specify associated fees and expenses? As an 
alternative, should we require purchase and redemption information and 
associated fees and expenses to remain in Item 3 and Item 6 only for 
prospectuses provided to investors purchasing creation units, such as 
in the form of a supplementary prospectus?
---------------------------------------------------------------------------

    \162\ Item 18(a) of Form N-1A.
---------------------------------------------------------------------------

    The proposed alternative disclosures in Items 3 and 6 would not be 
available, however, to ETFs with creation units of less than 25,000 
shares because more retail investors would be able to transact directly 
with an ETF that has smaller-sized creation units.
    We request comment on whether the exemptions we are providing from 
Items 3 and 6 of Form N-1A should be based on the size of the creation 
unit, and whether 25,000 shares per creation unit is an appropriate 
threshold. Should it be higher or lower? Should we instead adopt a 
threshold based on the value of shares rather than the number of 
shares?
    Total Return. We propose to modify instructions to several items 
that require the use of the ETF's NAV to determine its return. In 
addition to returns based on NAV, ETFs also would be required to 
include returns based on the market price of fund shares.\163\ As 
discussed above, returns based on market price may be different than 
returns based on the fund's NAV and better relate to an ETF investor's 
experience in the fund.
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    \163\ We propose to amend the average annual return table to 
include a separate line item for returns based on the market price 
of ETF shares. Proposed Instruction 5(a) to Item 2(c)(2) of Form N-
1A. This would codify, with modifications, a condition in ETF 
exemptive orders. See, e.g., Ziegler Notice, supra note 110. The 
condition in our exemptive orders did not specify the location of 
the disclosure in the prospectus. As a result, ETFs include an 
additional table in the prospectus, rather than including market 
price returns in the average annual returns table required by Item 
2. In addition, ETFs use different time periods for the disclosure, 
with some using calendar years and others fiscal years. The proposed 
amendment would eliminate use of a second table, which may confuse 
investors. It also would standardize the reporting period by 
requiring all ETFs to present the information using calendar years.
    We also propose to amend the financial highlights table to 
require ETFs to calculate total return at market prices in addition 
to returns at NAV. This proposed amendment would provide secondary 
market investors with more pertinent information as to the effect of 
market price movements on their investments. Proposed Instruction 
3(f) to Item 8(a) of Form N-1A. Under the proposed amendment, ETFs 
would be required to include two bar charts under Item 2 of the 
form; one using market price returns and one using NAV returns. See 
Instruction 1(a) to Item 2(c)(2) of Form N-1A.
---------------------------------------------------------------------------

    We request comment on whether use of market prices, in addition to 
NAV, would provide secondary market purchasers of ETF shares with 
meaningful information on their investments. Alternatively, should we 
require returns to be computed solely using market prices? Would 
investors find it confusing to have fund returns presented using both 
market price and NAV? Should we limit this amendment to ETFs with 
creation units of 25,000 shares or more because more retail investors 
may be able to transact directly with the ETF in the event of smaller 
creation units?
    For purposes of determining ETF returns, we would define ``market 
price'' as the last price at which ETF shares trade on their principal 
U.S. trading market during a regular trading session (i.e. closing 
price).\164\ Is this an appropriate definition for market price, or 
should we instead (or in addition) define the market price as the mid-
point price between the highest bid and the lowest offer on the 
principal U.S. market on which the ETF shares are traded, at the time 
the fund's NAV is calculated? \165\
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    \164\ Proposed definition of ``Market Price'' in General 
Instruction A of Form N-1A. We consider the closing price to be the 
strongest indicator of market value. See Codification of Financial 
Reporting Policies, Section 404.03.b.ii, ``Valuation of Securities--
Securities Listed for Trading on a National Securities Exchange,'' 
reprinted in SEC Accounting Rules (CCH) ] 38,221 (``ASR 118''), at 
38, 424-38, 425. See also Fair Value Measurements, Statement of 
Financial Accounting Standards No. 157, Sec.  24 (Fin. Accounting 
Standards Bd. 2006) (``FASB 157'') (``[A] quoted price in an active 
market provides the most reliable evidence of fair value and shall 
be used to measure fair value whenever available.'').
    \165\ In circumstances where closing price may be less accurate 
because the last trade occurred at a much earlier point in the day 
than NAV calculation, some ETFs have used the mid-point price, 
rather than the closing price. See, e.g., Claymore Exchange-Traded 
Fund Trust, Investment Company Act Release No. 27469 (Aug. 28, 2006) 
[71 FR 51869 (Aug. 31, 2006)].
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    Premium/Discount Information. We propose to require that each ETF 
disclose to investors information about the extent and frequency with 
which market prices of fund shares have tracked the fund's NAV.\166\ 
This disclosure, which would be required on the fund's Internet Web 
site and included in its prospectus, is a condition to relief in ETF 
exemptive orders.\167\ Proposed rule 6c-11 also would require each ETF 
to disclose on its Internet Web site the prior business day's last 
determined NAV, the market

[[Page 14633]]

closing price of its shares and the premium/discount of the closing 
price to NAV.\168\ This disclosure is designed to alert investors to 
the current relationship between NAV and the market price of the ETF's 
shares, and that they may sell or purchase ETF shares at prices that do 
not correspond to the NAV of the fund.
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    \166\ Proposed Item 6(h)(4) to Form N-1A.
    \167\ See, e.g., WisdomTree Notice supra note 12; Zeigler Notice 
supra note 110.
    \168\ Proposed rule 6c-11(e)(4)(iv).
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    Proposed Item 6(h)(4) of Form N-1A would require disclosure in the 
ETF prospectus of the number of trading days, during the most recently 
completed calendar year and quarters since that year, on which the 
market price of the ETF shares was greater than the fund's NAV and the 
number of days it was less than the fund's NAV (premium/discount 
information).\169\ In addition to alerting investors that the ETF's NAV 
and share price may differ, this disclosure also would provide 
historical information regarding the frequency of these deviations. In 
light of the historical premium/discount disclosure in the ETF 
prospectus and in order to avoid duplicative disclosures that may 
result in additional regulatory burdens, proposed rule 6c-11, unlike 
the exemptive orders, would not require ETFs to include historical 
premium/discount information on their Internet Web sites.
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    \169\ Consistent with current orders, ETFs would be required to 
present premiums or discounts as a percentage of NAV. They also 
would be required to explain that shareholders may pay more than NAV 
when purchasing shares and receive less than NAV when selling, 
because shares are bought and sold at market prices. Proposed 
Instructions 2, 3 to Item 6(h)(4) of Form N-1A. In addition, the 
amendments also would require each ETF to identify the trading 
symbol(s) and principal U.S. market(s) on which the shares are 
traded. Proposed Item 6(h)(2) of Form N-1A.
---------------------------------------------------------------------------

    We request comment on whether daily and historical premium/discount 
information, which ETFs currently provide, is useful to investors. One 
commenter to the 2001 Concept Release suggested that investors need not 
receive premiums/discounts against NAV disclosure because the more 
useful information is the Intraday Value of the fund's basket as 
disseminated by national securities exchanges at regular 
intervals.\170\ This information, according to the commenter, provides 
investors with contemporaneous pricing of the fund's portfolio and 
enables the investor to see, at the time his order is entered, whether 
the Intraday Value is close to (or between) the bid-asked price.
---------------------------------------------------------------------------

    \170\ See Comment Letter of Nuveen Investments, File No. S7-20-
01 (Jan. 14, 2002). See also Gastineau, supra note 17, at 230-241.
---------------------------------------------------------------------------

    We request comment on whether investors need premium/discount 
disclosure in light of the dissemination of the ETF's Intraday Value at 
regular intervals during trading hours. We request ETF sponsors 
commenting on this condition of the rule to provide us with data 
regarding the frequency with which visitors to their Internet Web sites 
access this information. In addition to current premium/discount 
information, should we also require ETF Web sites to provide historical 
premium/discount information as is currently required by exemptive 
orders? If the Web site includes historical premium/discount 
information, should the rule also require historical information in 
Form N-1A? If so, over what periods?
    Periodic Report Information. We are proposing conforming amendments 
to ETF return information in ETF annual reports. The proposed 
amendments would require each ETF to use the market price of fund 
shares in addition to NAV to determine its return,\171\ and include a 
table with premium/discount information for the five recently completed 
fiscal years.\172\
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    \171\ Proposed Instruction 12(b) to Item 22(b)(7) of Form N-1A. 
This proposed disclosure would be identical to proposed Instruction 
5(a) to Item 2(c)(2) of Form N-1A. See supra note 163. We also are 
proposing to require ETFs to include a new line graph comparing the 
initial and subsequent account values using market price, following 
the line graph using NAV required by Item 22(b)(7)(ii)(A) of Form N-
1A. Proposed Instruction 12(a) to Item 22(b)(7) of Form N-1A. 
Consistent with the amendments proposed above, this proposed 
amendment also is designed to provide individual investors with the 
effect of market price fluctuations on their investment.
    \172\ Proposed Item 22(b)(7)(iv) of Form N-1A. Although similar 
to the proposed disclosure amendment to the shareholder information 
in Item 6 of the form, this proposed disclosure would span a longer, 
and different, reporting period: five fiscal years instead of the 
most recent calendar year and quarter(s). See Proposed Item 6(h)(4) 
of Form N-1A. The proposed amendment would require fiscal year 
disclosure to conform to currently required disclosure in Item 
22(b)(7). We are also proposing to include instructions similar to 
those proposed in Item 6 to assist funds in meeting this proposed 
disclosure obligation. Proposed Instructions to Item 22(b)(7)(iv) of 
Form N-1A.
---------------------------------------------------------------------------

    We request comment on whether it is necessary to include similar 
disclosure in both the prospectus and annual report of an ETF. Should 
ETFs that provide this information on their Internet Web sites be 
exempt from this annual report requirement? Is it necessary for the ETF 
to provide premium/discount data for the most recently completed five 
fiscal years? Should the reporting period conform to that proposed 
under Item 6 of the form (i.e., one calendar year and most recent 
quarters since that year)?
    We also are proposing to amend the prospectus and annual report 
requirements of Form N-1A to require an index-based ETF to compare its 
performance to its underlying index rather than a benchmark index.\173\ 
This amendment would permit use of a narrow-based or affiliated index 
and eliminate the opportunity for an index-based ETF to select an index 
different from its underlying index which should better reflect whether 
the ETF's performance corresponds to the index the performance of which 
it seeks to track.\174\
---------------------------------------------------------------------------

    \173\ Proposed Instruction 5(b) to Item 2(c)(2) of Form N-1A; 
Proposed Instruction 12(c) to Item 22(b)(7) of Form N-1A.
    \174\ Item 2(c)(2)(iii) of Form N-1A; Instruction 12(c) to Item 
22(b)(7) of Form N-1A. The form requires use of a broad-based index 
and prohibits use of affiliated indexes unless widely used and 
recognized. Our amendment would require ETFs that track narrow, 
custom indexes or affiliated indexes, to use the underlying index 
when presenting this return information.
---------------------------------------------------------------------------

    We request comment on whether it is appropriate to require an 
index-based ETF to compare its performance to its underlying index. 
Should an index-based ETF that tracks an index compiled by an 
affiliated index provider use a benchmark index instead of, or in 
addition to, its underlying index? Should an index-based ETF that 
tracks a fundamental or other custom-designed index use a benchmark 
index instead of, or in addition to, its underlying index?
    Summary Prospectus. As noted above, we recently issued the Enhanced 
Disclosure Proposing Release, which would require key information to 
appear in plain English in a summary section of the prospectus.\175\ In 
addition, a person could satisfy its mutual fund delivery obligations 
under section 5(b)(2) of the Securities Act by delivering the summary 
prospectus to investors and providing a statutory prospectus on an 
Internet Web site. Upon request, a fund also would be required to send 
the statutory prospectus to the investor.\176\
---------------------------------------------------------------------------

    \175\ See supra notes 148-152 and accompanying text. References 
to Form N-1A amendments in the Enhanced Disclosure Proposing 
Release, supra note 142, are to the ``proposed summary prospectus.''
    \176\ See Enhanced Disclosure Proposing Release, supra note 142, 
at Section II.B (proposed rule 498 under the Securities Act).
---------------------------------------------------------------------------

    As proposed, the summary section would include certain key 
information, which also would comprise the information in the summary 
prospectus. This key information would include: (i) Investment 
objectives; \177\ (ii) costs; \178\

[[Page 14634]]

(iii) principal investment strategies, risks, and performance; \179\ 
(iv) the fund's top ten portfolio holdings as of the end of its most 
recent calendar quarter; \180\ (v) identity of investment advisers and 
portfolio managers; \181\ (vi) brief purchase and sale and tax 
information; \182\ and (vii) financial intermediary compensation.\183\ 
This information is drawn largely from the current risk/return summary 
and rule 498 fund profile.\184\ In addition, the summary prospectus 
would be required to include on the cover page or at the beginning: (i) 
The fund's name and the share classes to which the summary prospectus 
relates; (ii) a statement identifying the document as a ``summary 
prospectus''; (iii) the approximate date of the summary prospectus's 
first use; and (iv) the following legend:
---------------------------------------------------------------------------

    \177\ See id., at n.43 and accompanying text (proposed summary 
prospectus Item 2 of Form N-1A). This is the same information 
required by current Item 2(a) of Form N-1A.
    \178\ See id., at nn.44-55 and accompanying text (proposed 
summary prospectus Item 3 of Form N-1A). This information would be 
substantially the same as that required by current Item 3 of Form N-
1A (the risk/return summary fee table and example), except for 
proposed amendments that would: (i) Require funds that offer 
discounts on front-end sales charges for volume purchases (i.e. 
breakpoints) to include a brief narrative disclosure alerting 
investors to the availability of those discounts; (ii) revise the 
parenthetical following the heading ``Annual Fund Operating 
Expenses'' to read ``ongoing expenses that you pay each year as a 
percentage of the value of your investment'' in place of ``expenses 
that are deducted from Fund assets''; (iii) require funds to add 
brief disclosure regarding portfolio turnover immediately following 
the fee table example; and (iv) permit funds to include additional 
captions directly below the ``Total Annual Fund Operating Expenses'' 
caption in cases where there were expense reimbursement or fee 
waiver arrangements that reduced fund operating expenses and that 
will continue to reduce them for no less than one year from the 
effective date of the fund's registration statement.
    \179\ See id., at nn.56-57 and accompanying text (proposed 
summary prospectus Item 4 of Form N-1A). This would include the same 
information required by current Items 2(b) and (c) of Form N-1A.
    \180\ See id., at nn.58-66 and accompanying text (proposed 
summary prospectus Item 5 of Form N-1A). This information currently 
is not required in a fund's prospectus. The proposal would allow 
funds to list an amount not exceeding five percent of the total 
value of the portfolio holdings in one amount as ``Miscellaneous 
securities'' provided certain specified conditions are met. Id. at 
n.66 and accompanying text (proposed Instruction 3 to proposed 
summary prospectus Item 5 of Form N-1A).
    \181\ See id., at nn.67-72 and accompanying text (proposed 
summary prospectus Item 6 of Form N-1A) (proposing that a fund 
disclose the name of each investment adviser and sub-adviser of the 
fund, followed by the name, title, and length of service of the 
fund's portfolio managers). This information is similar to 
disclosures required by current Item 5 of Form N-1A. Certain 
additional disclosures regarding investment advisers and portfolio 
managers that are currently required in the statutory prospectus 
would continue to be required in the statutory prospectus, but not 
in the summary section. See id., at n.68.
    \182\ See id., at nn.73-74 and accompanying text (proposed 
summary prospectus Item 7 of Form N-1A) (proposing that a fund 
disclose minimum initial or subsequent investment requirements, the 
fact that the shares are redeemable, and identify the procedures for 
redeeming shares (e.g., on any business day by written request, 
telephone, or wire transfer)), and nn.75-76 and accompanying text 
(proposed summary prospectus Item 8 of Form N-1A) (proposing that a 
fund state, as applicable, that it intends to make distributions 
that may be taxed as ordinary income or capital gains or that the 
fund intends to distribute tax-exempt income, and proposing that a 
fund that holds itself out as investing in securities generating 
tax-exempt income provide, as applicable, a general statement to the 
effect that a portion of the fund's distributions may be subject to 
federal income tax).
    \183\ See id., at nn.77-78 and accompanying text (proposed 
summary prospectus Item 9 of Form N-1A) (proposing that a fund 
provide disclosure that, if an investor purchases the fund through a 
broker-dealer or other financial intermediary (such as a bank), the 
fund and its related companies may pay the intermediary for the sale 
of fund shares and related services, and state that these payments 
may influence the broker-dealer or other intermediary and the 
salesperson to recommend the fund over another investment).
    \184\ Registrants would not be permitted to include any 
additional information in the summary section. See id., at n.37 and 
accompanying text (proposed summary prospectus General Instruction 
C.3.(b) of Form N-1A).

    Before you invest, you may want to review the Fund's prospectus, 
which contains more information about the Fund and its risks. You 
can find the Fund's prospectus and other information about the Fund 
online at [----------]. You can also get this information at no cost 
by calling [----------] or by sending an e-mail request to [--------
-- ].\185\
---------------------------------------------------------------------------

    \185\ See id., at n.98 and accompanying text (proposed rule 
498(b)(1) under the Securities Act).

    If adopted, the amendments to Form N-1A and rule 498 proposed in 
the Enhanced Disclosure Proposing Release would require open-end ETFs 
to include the summary section in their prospectuses and permit persons 
to satisfy their prospectus delivery obligations by sending or giving 
the summary prospectus and providing the statutory prospectus on an 
Internet Web site in the manner set forth in the proposed rules. Today, 
we also propose that, if the Enhanced Disclosure Proposing Release is 
adopted, ETFs include in the summary section of their prospectuses, and 
in their summary prospectuses, the additional proposed disclosures 
discussed above. Specifically, we would modify the amendments proposed 
in the Enhanced Disclosure Proposing Release to include our proposed 
amendments to ETF disclosures as follows: (i) Our proposed amendments 
regarding disclosures about creation units and the purchase and sale of 
individual ETF shares would be included in proposed summary prospectus 
Item 7, which would require brief purchase and sale information; \186\ 
(ii) the additional information on market price returns would be 
included in proposed summary prospectus Item 4, which includes the 
risk/return summary, bar chart and table; \187\ and (iii) premium/
discount information would be included in proposed summary prospectus 
Item 7 (purchase and sale information).\188\ We also would permit ETFs 
to exclude proposed information regarding the purchase and sale of 
creation units consistent with our proposal today.\189\
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    \186\ The disclosures in our proposed Items 6(a)(1), 6(h)(2) and 
6(h)(3) to Form N-1A would be included in proposed summary 
prospectus Item 7 of Form N-1A. As noted, our proposed amendments 
also would require the ETF to modify the narrative explanation 
preceding the example in the fee table, see supra note 160, which 
would remain in current Item 3 of Form N-1A.
    \187\ Our proposed instructions 5(a) and (b) to the risk return 
bar chart and table (current Item 2(c)(2) of Form N-1A), see note 
163 and accompanying and following text, would be added to the end 
of the proposed instructions to proposed summary prospectus Item 4.
    \188\ The disclosure in our proposed Item 6(h)(4) to Form N-1A, 
see notes 167-169 and accompanying and following text, would be 
included at the end of proposed summary prospectus Item 7 of Form N-
1A. Our proposed amendments to the financial highlights (current 
Item 8 of Form N-1A) and the financial statements (current Item 22 
of Form N-1A) would be included in the proposed summary prospectus 
Items 14 and 28 of Form N-1A, respectively.
    \189\ ETFs would be permitted to exclude from the fee table 
(current Item 3 and proposed summary prospectus Item 3 of Form N-1A) 
the fees and expenses associated with creation unit purchases and 
redemptions and would be permitted to exclude the disclosure 
required by proposed summary prospectus Items 7(a) and 7(b) of Form 
N-1A. See supra notes 158-160 and accompanying text.
---------------------------------------------------------------------------

    We request comment on whether ETFs should send or give the proposed 
additional items in the summary prospectus. If so, should any 
information from the statutory prospectus, in addition to the items 
that we are proposing today, be included in the summary section of an 
ETF's prospectus and, therefore, in its summary prospectus? Should ETFs 
not be required to include certain items in the summary section? For 
example, in light of the transparency of portfolio holdings of an ETF, 
should ETFs not have to include the top ten portfolio holdings? Should 
ETFs be permitted or required to locate any of the specific disclosures 
proposed in this release or in the Enhanced Disclosure Proposing 
Release elsewhere in the prospectus outside the summary section?

E. Amendment of Previously Issued Exemptive Orders

    As discussed above, our orders have exempted ETFs from compliance 
with section 24(d) of the Act to relieve dealers from delivering 
prospectuses to investors in secondary market transactions. We are 
proposing today not to include such an exemption in rule 6c-11 to 
ensure that broker-dealers are subject to the same delivery 
requirements with respect to all ETFs.\190\ In addition, we are 
proposing amendments to Form N-1A that would

[[Page 14635]]

revise the prospectus requirements in that form in order to provide 
more useful information to investors in ETF shares. Therefore, pursuant 
to our authority under section 38(a) of the Act, we propose to amend 
the exemptive orders we have issued to ETFs that are open-end funds to 
eliminate the section 24(d) exemptions and require ETFs to satisfy 
their statutory prospectus delivery requirements.\191\
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    \190\ See supra Section III.D.1.
    \191\ Section 38(a) of the Act provides the Commission with the 
authority to amend orders when necessary or appropriate to the 
exercise of its powers conferred elsewhere in the Act. We are not 
proposing to amend the orders of UITs that have sought and obtained 
an exemption from section 24(d) of the Act because those ETFs do not 
prepare their prospectuses in accordance with Form N-1A.
---------------------------------------------------------------------------

    The consequence of the amendment to these orders, if adopted, would 
be to put ETFs that have received exemptive orders on the same footing 
as ETFs that may in the future rely solely on rule 6c-11, and thus 
eliminate any competitive advantage they might otherwise obtain by 
having obtained orders before adoption of the rule.\192\ The amendment 
would be limited to orders issued to ETFs seeking to operate as open-
end management companies.
---------------------------------------------------------------------------

    \192\ For the same purpose, we expect all funds seeking 
exemptive orders to operate an ETF after today to agree as a 
condition of the order that the requested order would expire on the 
effective date of any Commission rule under the Act that provides 
relief permitting the operation of index-based or actively managed 
ETFs.
---------------------------------------------------------------------------

    We are not proposing to rescind the orders we have issued because 
we do not believe rescission would be necessary to eliminate 
competitive advantages for ETFs that have already received exemptive 
orders. With the exception of the section 24(d) exemption (and the 
related prospectus disclosure requirements), the proposed rule contains 
broader exemptive relief than that provided in our orders and therefore 
we expect most, if not all, ETFs would rely on the rule if and when it 
is adopted.
    We request comment on whether we should rescind our previous 
orders. Is our assumption correct that most ETFs that have orders would 
rely on the rule?

IV. Exemption for Investment Companies Investing in ETFs

A. Background

    As we discussed above, institutional investors, including funds, 
have invested in ETFs to achieve asset allocation, diversification, or 
other investment objectives.\193\ Some funds invest primarily in ETFs. 
A fund's ability to invest in ETFs, however, is limited because section 
12(d)(1) of the Act prohibits a fund (and companies or funds it 
controls) (``acquiring fund'') from:
---------------------------------------------------------------------------

    \193\ See supra note 15 and accompanying text (funds also use 
ETFs for hedging purposes). See also, e.g., iShares Trust, 
Investment Company Act Release No. 25969 (Mar. 21, 2003) [68 FR 
15010 (Mar. 27, 2003)].
---------------------------------------------------------------------------

    (i) Acquiring more than three percent of any other investment 
company's outstanding voting securities (``acquired fund'');
    (ii) Investing more than five percent of its total assets in any 
one acquired fund; or
    (iii) Investing more than ten percent of its total assets in all 
acquired funds.\194\
---------------------------------------------------------------------------

    \194\ See 15 U.S.C. 80a-12(d)(1)(A). Both registered and 
unregistered funds are subject to these limits with respect to their 
investments in a registered fund. Registered funds are also subject 
to these same limits with respect to their investments in an 
unregistered fund. Unregistered funds are not subject to limits on 
their investments in another unregistered fund. Id. ETFs are 
registered funds and therefore both registered and unregistered 
funds are subject to section 12(d)(1)(A)'s limits with respect to 
investments in ETFs. Section 12(d)(1)(B) prohibits a registered 
open-end fund from selling any security issued by the fund to any 
other fund (including unregistered funds) if, after the sale, the 
acquiring fund would: (i) Together with companies and funds it 
controls, own more than three percent of the acquired fund's voting 
securities; or (ii) together with other funds (and companies they 
control) own more than ten percent of the acquired fund's voting 
securities. 15 U.S.C. 80a-12(d)(1)(B).
---------------------------------------------------------------------------

    Section 12(d)(1) was enacted to limit so-called ``fund of funds'' 
arrangements. Congress was concerned about ``pyramiding,'' a practice 
under which investors could use a limited investment in an acquiring 
fund to gain control of another (and potentially much larger) fund and 
use the assets of the acquired fund to enrich themselves at the expense 
of acquired fund shareholders.\195\ Control could be exercised either 
directly (such as through holding a controlling interest) or indirectly 
(such as by coercion through the threat of large-scale 
redemptions).\196\ Congress also was concerned about the potential for 
excessive fees when one fund invested in another,\197\ and the 
formation of overly complex structures that could be confusing to 
investors.\198\ Congress imposed these limits, in part, based on our 
conclusion in 1966 that fund of funds structures served little or no 
economic purpose.\199\
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    \195\ The legislative history of these provisions cites examples 
of controlling investors in an acquiring fund using ``pyramiding 
schemes'' to force acquired funds to purchase securities of 
companies in which the investors had an interest and to direct 
underwriting and brokerage business to broker-dealers they 
controlled. In an open-end fund, controlling investors were able to 
exert control and influence over acquired funds through the threat 
of large-scale redemptions. In the 1960s, Fund of Funds, Ltd., an 
unregistered foreign investment company, acquired controlling 
interests in several registered U.S. funds and was able to exert 
undue influence over the management of those acquired funds by 
threatening advisers to those funds with large redemptions. See SEC, 
Public Policy Implications of Investment Company Growth, H.R. Rep. 
No. 2337, 89th Cong., 2d Sess. at 315-16 (1966) (``1966 Study''). 
Congress enacted section 12(d)(1) to prevent these abuses and 
amended the section in 1970 to prevent similar abuses by investors 
in unregistered acquiring funds. Congress later amended section 
12(d)(1) to give the Commission specific authority to provide 
exemptions from these limitations. See infra notes 200 and 214 and 
accompanying text.
    \196\ Large-scale redemptions may disrupt portfolio management 
or increase transaction fees if fund managers must hold cash or sell 
portfolio securities at an inopportune time to meet redemptions. 
Large-scale redemptions also may be threatening to a fund manager 
because they decrease the fund's assets under management, on which 
the manager's fee is based.
    \197\ Pyramiding schemes resulted in fund shareholders paying 
excessive charges due to duplicative fees at the acquiring and 
acquired fund levels. See SEC, Investment Trusts and Investment 
Companies, H.R. Doc. No. 279, 76th Cong., 1st Sess., pt.3, at 2721-
95 (1939) (``Investment Trust Study''). See also Fund of Funds 
Investments, Investment Company Act Release No. 26198 (Oct. 1, 2003) 
[68 FR 58226 (Oct. 8, 2003)] (``Fund of Funds Proposing Release'') 
at nn.2-6 and accompanying text. For example, from 1927 to 1936, it 
was estimated that the duplication of expenses incurred by funds 
investing in other funds exceeded five percent of the total 
operating expenses for all management funds. See Investment Trust 
study, at 2727-2728. Fund of Funds, Ltd. also charged duplicative 
advisory fees at the acquiring and acquired fund levels, provided 
sales loads to an affiliated broker for each investment the 
acquiring fund made in an acquired fund, and directed brokerage to 
an affiliate of the fund of funds. See 1966 Study, supra note 195, 
at 318-320; Arthur Lipper Corp., et al. v. SEC, Securities Exchange 
Act Release No. 11773, 46 S.E.C. 78 (Oct. 24, 1975), sanction 
modified, 547 F.2d 171 (2d Cir. 1976) (a Fund of Funds, Ltd. 
affiliated broker-dealer received commissions under step-out 
arrangements with Arthur Lipper Corp, a registered broker-dealer, 
and other broker-dealers).
    \198\ Pyramiding of funds resulted in complicated corporate 
structures that were confusing to shareholders and made it difficult 
for shareholders to determine the nature and value of the holdings 
ultimately underlying each shareholder's investment. See Investment 
Trust study, supra note 197, at 2778-93.
    \199\ See id., at 2725-41.
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    Our views and those of Congress regarding the economic value of 
fund of funds arrangements have changed over the years as fund of funds 
arrangements have been created that serve new, legitimate purposes. 
Recognizing this, in 1996, Congress granted us specific authority to 
provide exemptions allowing fund of funds arrangements, and directed 
that we use it ``in a progressive way.'' \200\ Pursuant to this

[[Page 14636]]

authority, we have provided exemptions to permit certain fund of funds 
arrangements that would otherwise be prohibited under section 12(d)(1). 
For example, in 2006 we adopted rule 12d1-1, which allows funds to 
invest in money market funds in excess of section 12(d)(1) limits.\201\ 
We also have issued exemptive orders that allow many funds to invest in 
unaffiliated traditional funds (``multigroup fund orders'') and that 
allow the sale of shares issued by several ETFs to unaffiliated funds 
in excess of the statutory limits.\202\ The exemptions provided under 
the rule and these orders facilitate the acquiring funds' ability to 
achieve their investment objectives by expanding their investment 
options to include investments in unaffiliated funds in a manner 
consistent with the protection of investors. These exemptions also 
increase the potential pool of investors and assets available for 
investment in ETFs and traditional funds.
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    \200\ See National Securities Markets Improvement Act of 1996, 
Pub. L. 104-290, Sec.  202(4), 110 Stat. 3416, 3427 (1996) 
(``NSMIA''); H.R. Rep. No. 622, 104th Cong., 2d Sess., at 43-44 
(1996) (``H.R. Rep. No. 622'') (discussing new section 12(d)(1)(J) 
of the Act that gives the Commission authority, by rule or order, to 
provide exemptions from the limits of section 12(d)(1) when it is 
consistent with the public interest and the protection of 
investors). In 1996, Congress also amended the Act to include a 
statutory exemption from section 12(d)(1) limits for funds that 
invest in funds in the same fund group. NSMIA, section 202(5). See 
also infra note 214 and accompanying text.
    \201\ See Fund of Funds Investments, Investment Company Act 
Release No. 27399 (June 20, 2006) [71 FR 36640 (June 27, 2006)] 
(``Fund of Funds Adopting Release''); 17 CFR 270.12d1-1.
    \202\ See, e.g., Schwab Capital Trust, et al., Investment 
Company Act Release Nos. 24067 (Oct. 1, 1999) [64 FR 54939 (Oct. 8, 
1999)] (notice) (``Schwab Notice'') and 24113 (Oct. 27, 1999) 
(order) (``Schwab Order''); First Trust Exchange-Traded Fund, et 
al., Investment Company Act Release Nos. 27812 (Apr. 30, 2007) [72 
FR 25795 (May 7, 2007)] (notice) and 27845 (May 30, 2007) (order); 
iShares Trust, et al., Investment Company Act Release Nos. 25969 
(Mar. 21, 2003) [68 FR 15010 (Mar. 27, 2003)] (notice) and 26006 
(Apr. 15, 2003) (order).
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    ETF applicants have sought exemptive orders similar to those we 
have issued to funds investing in unaffiliated traditional funds.\203\ 
The conditions included in those orders were designed to prevent the 
abuses that historically were associated with fund of funds 
arrangements and that led Congress to enact section 12(d)(1).\204\ The 
conditions include: (i) Limits on the control and influence an 
acquiring fund can exert on the acquired fund; \205\ (ii) limits on 
certain fees charged to the acquiring fund and its shareholders; \206\ 
(iii) limits on the acquired fund's ability to invest in other funds; 
\207\ (iv) the acquired fund and each acquiring fund must enter into an 
agreement stating that both funds understand the terms and conditions 
of the order and agree to fulfill their responsibilities under the 
order (``participation agreement''); \208\ and (v) the acquiring fund 
provides a list of certain of its affiliates to the acquired fund.\209\
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    \203\ Fifteen orders have been issued to ETFs allowing other 
funds to invest in ETFs beyond the limits of section 12(d)(1). See, 
e.g., iShares Trust, et al., Investment Company Act Release No. 
25969 (Mar. 21, 2003) [68 FR 15010 (Mar. 27, 2003)].
    \204\ See, e.g., Schwab Notice and Order, supra note 202.
    \205\ The exemptive orders permitting investments in ETFs 
contain the following conditions relating to influence and control: 
(i) The acquiring fund's investment adviser or sponsor, any person 
in a control relationship with that investment adviser or sponsor, 
any investment company (including a company that would be an 
investment company but for the exceptions provided in sections 
3(c)(1) and 3(c)(7) of the Act) that is advised or sponsored by the 
acquiring fund's investment adviser or sponsor, or any person in a 
control relationship with that investment adviser or sponsor cannot 
control the ETF within the meaning of section 2(a)(9) of the Act; 
(ii) neither the acquiring fund nor certain of its affiliates cause 
any existing or potential investment by the acquiring fund in ETF 
shares to influence the terms of any services or transactions 
between the acquiring fund or its affiliate and the ETF or an ETF 
affiliate; (iii) the board of directors (or trustees) of the 
acquiring fund, including a majority of the independent directors, 
adopts procedures reasonably designed to assure that the acquiring 
fund's investment adviser(s) is conducting the acquiring fund's 
investment program without taking into account any consideration 
received by the acquiring fund or an acquiring fund affiliate from 
the ETF or an ETF affiliate in connection with any services or 
transactions; (iv) the board of directors of an open-end ETF, 
including a majority of its independent directors, determines that 
any consideration paid by the ETF to the acquiring fund or an 
acquiring fund affiliate in connection with any services or 
transactions: (a) Is fair and reasonable in relation to the nature 
and quality of the services and benefits received by the ETF; (b) is 
within the range of consideration that the ETF would be required to 
pay to another unaffiliated entity in connection with the same 
services or transactions; and (c) does not involve overreaching on 
the part of any person concerned; (v) neither the acquiring fund nor 
certain of its affiliates (except to the extent it is acting in its 
capacity as an investment adviser or sponsor to the ETF) causes the 
ETF to purchase a security in any affiliated underwriting (an 
underwriting in which an affiliate of the acquiring fund is a 
principal underwriter); (vi) the board of directors of an open-end 
ETF, including a majority of the independent directors, adopts 
procedures reasonably designed to monitor any purchases of 
securities by the ETF in an affiliated underwriting, including any 
purchases made directly from the affiliate, and the board reviews 
these purchases at least annually to determine whether the purchases 
were influenced by the acquiring fund's investment in the ETF, in 
its review the board must consider: (a) Whether the purchases were 
consistent with the ETF's investment objectives and policies; (b) 
how the performance of the purchased securities compares to the 
performance of comparable securities purchased during a comparable 
period of time in an unaffiliated underwriting or to a benchmark 
such as a comparable market index; and (c) whether the amount of 
securities purchased has changed significantly from prior years; and 
(vii) the ETF maintains and preserves permanently in an easily 
accessible place a written copy of the procedures designed to 
monitor purchases made in an affiliated underwriting and maintains 
and preserves for at least six years, the first two in an easily 
accessible place, a written record of each purchase (and the terms 
thereof) of securities in an affiliated underwriting and the 
information or materials upon which the board's determinations were 
made. See, e.g., Healthshares(tm), Inc. and XShares Advisors LLC, 
Investment Company Act Release No. 27844 (May 29, 2007) [72 FR 30885 
(June 4, 2007)] (``Healthshares(tm), Inc. and XShares Order'').
    \206\ The exemptive orders permitting investments in ETFs 
contain the following conditions relating to fee limits: (i) Before 
approving any advisory contract under section 15 of the Act, the 
board, including a majority of independent directors, finds that the 
advisory fees charged under the contract are based on services 
provided that are in addition to, rather than duplicative of, the 
services provided under the ETF advisory contract(s) and these 
findings and their basis are recorded in the minute books of the 
acquiring fund; (ii) the acquiring fund's adviser(s) (or if the 
acquiring fund is a UIT, its trustee or sponsor) waives fees payable 
to it by the acquiring fund in an amount at least equal to any 
compensation (including fees received pursuant to any 12b-1 plan) 
received from the ETF by the acquiring fund's adviser, trustee, or 
sponsor or an affiliated person of the acquiring fund's adviser, 
trustee, or sponsor (other than any advisory fees paid by the ETF to 
the adviser, trustee, or sponsor or its affiliated person) in 
connection with the acquiring fund's investment in the ETF; and 
(iii) any sales charge and/or service fees charged with respect to 
shares of the acquiring fund do not exceed the limits applicable to 
a fund of funds as set forth in Rule 2830 of the NASD Conduct Rules 
(or with respect to registered separate accounts that invest in a 
fund of funds, no sales load is charged at the acquiring fund level 
or ETF level and other sales charges and services fees, if any, are 
only charged at either the acquiring fund level or ETF level, not 
both). See, e.g., Healthshares(tm), Inc. and XShares Order, supra 
note 205.
    \207\ Under the exemptive orders permitting investments in ETFs, 
the ETF may not invest in shares of other funds (including companies 
relying on sections 3(c)(1) and 3(c)(7) of the Act) in excess of the 
limits in section 12(d)(1)(A) of the Act (some orders allow a few 
exceptions to this condition, see infra note 225). See, e.g., 
Healthshares(tm), Inc. and XShares Order, supra note 205.
    \208\ The exemptive orders require an agreement between the 
acquiring fund and the ETF stating that their boards and investment 
advisers, or their sponsors and trustees, as applicable, understand 
the terms and conditions of the order and agree to fulfill their 
responsibilities under the order (and the acquiring fund transmits 
to the ETF a list of certain of its affiliates and underwriting 
affiliates) and the acquiring fund and ETF maintain and preserve a 
copy of the exemptive order, participation agreement, and the list 
of affiliates with any updated information for the duration of the 
investment and for at least six years thereafter, the first two 
years in an easily accessible place. See, e.g., Healthshares(tm), 
Inc. and XShares Order, supra note 205.
    \209\ See supra note 208.
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    More recently, sponsors of some ETFs as well as managers of funds 
investing in ETFs have expressed concern to our staff that some of the 
conditions in the exemptive orders are burdensome and unnecessary in 
the context of a fund investment in an ETF, which is less likely to be 
subject to at least some of the abuses these conditions were designed 
to prevent.\210\ For example, ETF sponsors have communicated to our 
staff that the participation agreement condition is cumbersome and 
costly because the ETFs must enter into an agreement with each 
acquiring fund and each acquiring fund seeks to negotiate different 
terms in its agreement.\211\ They have suggested that we develop 
conditions that address the

[[Page 14637]]

concerns underlying section 12(d)(1) in a manner that is more suited to 
fund investments in ETFs.\212\
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    \210\ See infra Section IV.B.
    \211\ Acquiring funds also have indicated to the staff that it 
is burdensome for them to enter into participation agreements with 
each ETF in which the funds want to invest.
    \212\ Many funds also appear to consider investments in ETFs to 
be different than investments in other investment companies. In 
2004, our staff conducted examinations of a number of mutual fund 
complexes, which focused on the funds' investments in ETFs and 
whether those investments were made in accordance with section 
12(d)(1) of the Act. Most of the examined mutual fund complexes 
treated ETF investments like investments in traditional equity 
securities and did not identify ETFs as registered funds subject to 
the requirements of section 12(d)(1) of the Act. Thus, those that 
acquired more than three percent of the voting securities of an ETF 
or invested more than five percent of the acquiring fund's assets in 
the voting securities of an ETF were inconsistent with section 
12(d)(1). Most of the mutual funds examined invested in ETFs in 
order to: (i) Hedge the portfolio; (ii) ``equitize'' cash balances 
in order to earn returns in excess of money market rates; and (iii) 
gain exposure to a specific market and/or industry sector in an 
efficient manner.
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B. Proposed Rule 12d1-4 Conditions

    Today, we are proposing a new rule 12d1-4, which would provide an 
exemption to permit acquiring funds to invest in ETFs in excess of the 
limits of section 12(d)(1), subject to four conditions that are 
designed to address the historical abuses that result from pyramiding 
and the threat of large-scale redemptions and may arise in connection 
with investments in ETFs.\213\ The relief we propose is subject to 
fewer conditions than our exemptive orders but, unlike our orders, 
would limit an acquiring fund's ability to redeem ETF shares.\214\
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    \213\ We are also proposing related amendments to rule 12d1-2 
under the Act to include within its exemptive relief investments in 
ETFs made in reliance on proposed rule 12d1-4 and investments in 
non-security assets. See infra Section V.
    \214\ In 1996, Congress added section 12(d)(1)(J) to the Act, 
which gave us specific authority to exempt any person, security or 
transaction, or any class or classes of transactions, from section 
12(d)(1) of the Act if the exemption is consistent with the public 
interest and the protection of investors. NSMIA, section 202(4) 
(codified at 15 U.S.C. 80a-12(d)(1)(J)). The House Report 
accompanying the legislation urged the Commission to use the 
additional exemptive authority under section 12(d)(1)(J) ``in a 
progressive way as the fund of funds concept continues to evolve 
over time.'' H.R. Rep. No. 622, supra note 200, at 43-44 (1996). The 
House Report explained that, in exercising its exemptive authority, 
the Commission should consider factors that relate to the protection 
of investors, including the extent to which a proposed arrangement 
is subject to conditions that are designed to address conflicts of 
interest and overreaching by a participant in the arrangement, so as 
to avoid the abuses that gave rise to the initial adoption of the 
Act's restrictions against funds investing in other funds. Id. at 
44.
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1. Control
    In order to address the concern that a fund could exert control 
over another fund, the proposed rule would limit the exemption to an 
acquiring fund (and any entity in a control relationship with the 
acquiring fund) that does not ``control'' an ETF.\215\ The Act defines 
``control'' to mean ``the power to exercise a controlling influence 
over the management or policies of a company, unless such power is 
solely the result of an official position with such company.'' \216\ 
The Act also creates rebuttable presumptions that any person who 
directly or indirectly beneficially owns more than 25 percent of the 
voting securities of a company controls the company and that one who 
does not own that amount does not control it.\217\ The effect of the 
proposed rule, if adopted, would be that an acquiring fund's beneficial 
ownership of up to 25 percent of the voting securities of an ETF, by 
itself, would not constitute control over the ETF. As a result, a fund 
relying on the rule could make a substantial investment in an ETF 
(i.e., up to 25 percent of the ETF's shares) without seeking further 
exemption from us.
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    \215\ Proposed rule 12d1-4(a)(1). The condition would provide 
that: (i) an acquiring fund and any of its investment advisers or 
depositors, and any company in a control relationship with the 
acquiring fund or any of its investment advisers or depositors, each 
individually or in the aggregate, do not control an ETF; and (ii) 
if, as a result of a decrease in the outstanding voting securities 
of an ETF, the acquiring fund, any of its investment advisers, and 
any company in a control relationship with the acquiring fund or its 
investment adviser, either individually or together in the 
aggregate, become holders of more than 25 percent of the outstanding 
voting securities of an ETF (i.e., are presumed to control the ETF, 
see infra notes 217-218 and accompanying text), each of those 
shareholders must vote its shares of the ETF in the same proportion 
as the vote of all the other ETF shareholders. The same condition is 
in our exemptive orders.
    \216\ 15 U.S.C. 80a-2(a)(9).
    \217\ Id. These presumptions continue until the Commission makes 
a final determination to the contrary by order either on its own 
motion or on application by an interested person. Id.
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    If, however, an acquiring fund uses its ownership interest in the 
ETF (even if that interest is 25 percent or less) to exercise a 
controlling influence over the ETF's management or policies, the fund 
would not be able to rely on the proposed rule.\218\ For example, an 
acquiring fund that used its share position to persuade an ETF manager 
to enter into a transaction with an affiliate of the acquiring fund or 
its adviser would almost certainly exercise a controlling influence on 
the ETF's management and thus lose its exemption under the proposed 
rule.\219\
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    \218\ A determination of control depends on the facts and 
circumstances of the particular situation. ``[N]o person may rely on 
the presumption that less than 25 percent ownership is not control 
when, in fact, a control relationship exists under all the facts and 
circumstances.'' Exemption of Transactions by Investment Companies 
with Certain Affiliated Persons, Investment Company Act Release No. 
10698 (May 16, 1979) [44 FR 29908 (May 23, 1979)] at n.2. (citing 
Fundamental Investors, Inc., 41 SEC 285 (1962)) (``Fundamental 
Investors'') (Commission order noting that rebutting presumption of 
control can have retrospective as well as prospective effect).
    \219\ We have long held that ``controlling influence'' includes, 
in addition to voting power, a dominating persuasiveness of one or 
more persons, the act or process that is effective in checking or 
directing action or exercising restraint or preventing free action, 
and the latent existence of power to exert a controlling influence. 
See, e.g., Investors Mutual, Inc., Investment Company Act Release 
No. 4595 (May 11, 1966) at text accompanying nn.11-14 (citing The 
Chicago Corporation, Investment Company Act Release No. 1203 (Aug. 
24, 1948); Transit Investment Corporation, Investment Company Act 
Release No. 927 (July 31, 1946); In the Matter of the M.A. Hanna 
Company, Investment Company Act Release No. 265 (Nov. 26, 1941)).
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    We request comment on the proposed condition. Do ETF sponsors 
believe that it would sufficiently protect the ETF from the type of 
coercive behavior on the part of acquiring funds that section 12(d)(1) 
was intended to prevent?
2. Redemptions
    The proposed rule includes two provisions that would prevent an 
acquiring fund from redeeming shares it acquired in reliance on the 
proposed rule. First, the rule would prohibit an acquiring fund that 
relies on the proposed rule to acquire shares in excess of section 
12(d)(1)(A)(i) limits (i.e., to acquire more than three percent of an 
ETF's shares) from redeeming those shares.\220\ As a result, acquiring 
funds would not be able to threaten large-scale redemptions as a means 
of coercing an ETF. It is our understanding that most acquiring funds 
purchase and sell ETF shares in secondary market transactions. 
Accordingly, this condition, while precluding one of the historical 
abuses associated with fund of funds arrangements, would not prevent 
acquiring funds from taking passive shareholder positions in ETF shares 
(in excess of section 12(d)(1) limits) in order to, for example, gain 
exposure to a particular market segment.
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    \220\ Proposed rule 12d1-4(a)(2). Under the proposed rule, an 
acquiring fund would be deemed to have redeemed or sold the most 
recently acquired ETF shares first. Id. As a result, an acquiring 
fund could redeem shares from an ETF only when the fund (and 
companies or funds it controls) holds ETF shares in an amount 
consistent with section 12(d)(1)(A)(i) limits. An acquiring fund 
that relies on the proposed rule to invest more than five percent of 
its assets in the acquired ETF (prohibited by section 
12(d)(1)(A)(ii)) and/or to invest more than 10 percent of its assets 
in all funds (including the acquired ETF) (prohibited by section 
12(d)(1)(A)(iii)) but that does not acquire more than three percent 
of the acquired ETF's outstanding securities would not be prohibited 
from redeeming shares of the ETF under the proposed rule.
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    We request comment on whether the condition achieves this purpose. 
If not, are there other conditions that would better address the 
concern?
    Second, the proposed rule would prohibit an ETF, its principal

[[Page 14638]]

underwriter, and a broker or a dealer that relies on the rule to sell 
ETF shares in excess of section 12(d)(1)(B) limits from redeeming (or 
submitting an order to redeem) those shares acquired by another fund 
that exceed the three percent limit in section 12(d)(1)(A)(i).\221\ We 
recognize that it may be difficult in all circumstances for an ETF, its 
principal underwriter, a broker or a dealer to know whether a 
redemption order is submitted by an acquiring fund that acquired more 
than three percent of the ETF's shares in reliance on the proposed 
rule. Accordingly, we are proposing to include a safe harbor for each 
of those entities if it has: (i) Received a representation from the 
acquiring fund that none of the ETF's shares the acquiring fund is 
redeeming includes any shares that it acquired in excess of three 
percent of the ETF's shares in reliance on proposed rule 12d1-4(a); and 
(ii) no reason to believe that the acquiring fund is redeeming ETF 
shares that the acquiring fund acquired in excess of three percent of 
the ETF's shares in reliance on the proposed rule.\222\ If an acquiring 
fund attempts to redeem ETF shares in connection with a threat to 
coerce the ETF, the ETF would know of the attempt. In those 
circumstances, or if the principal underwriter, broker or dealer knows 
or has reason to know of the threat, the entity could not redeem (or 
submit for redemption) the ETF shares held by the acquiring fund. We 
believe that the proposed condition prohibiting acquiring funds from 
redeeming ETF shares acquired in reliance on the proposed rule should 
sufficiently prevent an acquiring fund from threatening redemptions as 
a means of coercing an ETF adviser.
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    \221\ Proposed rule 12d1-4(b)(1). Under the proposed rule, an 
exchange-traded fund, any principal underwriter thereof, and a 
broker or a dealer may sell or otherwise dispose of exchange-traded 
fund shares if the exchange-traded fund does not redeem, or the 
principal underwriter, broker or dealer does not submit for 
redemption any of the exchange-traded fund's shares that were 
acquired by an acquiring fund in excess of the limits of section 
12(d)(1)(A)(i) in reliance on proposed rule 12d1-4(a). Id. An 
acquiring fund would be deemed to have redeemed or sold the most 
recently acquired exchange-traded fund shares first. Id. See also 
supra note 220.
    We note that our adoption of proposed rule 12d1-4 would not 
preclude an acquiring fund from continuing to rely on exemptive 
orders we have previously issued that permit funds to invest in ETFs 
in excess of the limits of section 12(d)(1) but which do not 
restrict their ability to redeem ETF shares, subject to the 
conditions set forth in the orders and described above. Moreover, we 
intend to continue to issue such orders and may consider their 
codification in a rule in the future.
    \222\ Proposed rule 12d1-4(b)(2).
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    We request comment on these conditions. Do most funds that invest 
in ETFs redeem their shares or sell them in secondary market 
transactions? Would the prohibition on redemption impede the ability of 
acquiring funds to dispose of ETF shares? Do acquiring funds realize 
significant benefits from the ability to redeem ETF shares?
    The proposed conditions limiting redemptions of ETF shares are 
designed to eliminate the threat of redemption that an acquiring fund 
could otherwise use to coerce an ETF. Accordingly, the proposed rule 
does not include the conditions in our exemptive orders that require 
the ETF \223\ and the acquiring fund to take measures to prevent the 
acquiring fund from unduly influencing the ETF.\224\
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    \223\ The orders require that: (i) The board of directors of an 
ETF, including a majority of its independent directors, determines 
that any consideration paid by the ETF to the acquiring fund or any 
investment adviser, depositor, or principal underwriter of the 
acquiring fund and any person controlling, controlled by, or under 
common control with an investment adviser, depositor, or principal 
underwriter of the acquiring fund, (but not including any investment 
adviser of the ETF or any person controlling, controlled by, or 
under common control with the investment adviser of the ETF) 
(``acquiring fund affiliate'') in connection with any services or 
transactions: (a) Is fair and reasonable in relation to the nature 
and quality of the services and benefits received by the ETF; (b) is 
within the range of consideration that the ETF would be required to 
pay to another unaffiliated entity in connection with the same 
services or transactions; and (c) does not involve overreaching on 
the part of any person concerned; (ii) the ETF board of directors, 
including a majority of the independent directors, adopts procedures 
reasonably designed to monitor any purchases of securities by the 
ETF in an underwriting in which a principal underwriter is an 
officer, director, member of an advisory board, acquiring fund 
investment adviser, acquiring fund depositor, or an acquiring fund 
employee or an affiliated person of any such person (``affiliated 
underwriting''), and the board reviews these purchases at least 
annually to determine whether the purchases were influenced by the 
acquiring fund's investment in the ETF; and (iii) the ETF maintains 
and preserves a copy of the procedures designed to monitor purchases 
made in an affiliated underwriting and maintains a written record of 
each purchase of securities in an affiliated underwriting and the 
information or materials upon which the board's determinations were 
made. See supra note 205.
    \224\ The orders require that: (i) Neither the acquiring fund 
nor any acquiring fund affiliate cause any existing or potential 
investment by the acquiring fund in an ETF to influence the terms of 
any services or transactions between the acquiring fund or an 
acquiring fund affiliate and the ETF (or certain affiliates of the 
ETF); (ii) neither the acquiring fund nor an acquiring fund 
affiliate causes the ETF to purchase a security in any affiliated 
underwriting; and (iii) the acquiring fund board of directors, 
including a majority of its independent directors, adopts procedures 
reasonably designed to assure that the acquiring fund's investment 
adviser(s) is conducting the acquiring fund's investment program 
without taking into account any consideration received by the 
acquiring fund or an acquiring fund affiliate from the ETF (or 
certain affiliates of the ETF). See supra note 205.
    As discussed above, the proposed rule would however include the 
condition from our exemptive orders that an acquiring fund (and any 
entity in a control relationship with the acquiring fund) could not 
``control'' the ETF. See supra note 215 and accompanying text.
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    We request comment on the exclusion of these conditions from the 
proposed rule. Is there a concern that if the acquiring fund and ETF do 
not take particular measures to prevent the acquiring fund from unduly 
influencing the ETF, acquiring funds may be able more easily to coerce 
the ETF? Notwithstanding the prohibition on control and redemption, 
should we be concerned about particular transactions between an 
acquiring fund (or an acquiring fund affiliate) and an ETF, or an ETF's 
purchase of securities during an underwriting in which a principal 
underwriter is an affiliate of the acquiring fund or its adviser? If 
there is reason for concern about ETF purchases of securities in an 
affiliated underwriting, is that concern limited to purchases from an 
affiliate of the acquiring fund or its adviser? Should any specific 
conditions in the exemptive orders be included in the proposed rule in 
addition to or in place of the proposed conditions to prevent an 
acquiring fund or an acquiring fund affiliate from unduly influencing 
an ETF?
3. Complex Structures
    To prevent the formation of overly complex multi-tiered fund 
structures, the proposed rule would prohibit an acquired ETF from 
itself being a fund of funds (i.e., the rule would prohibit a fund of 
funds of funds, or three-tier fund, structure).\225\ A fund of ETFs has

[[Page 14639]]

the potential to become a complicated corporate structure of the kind 
that concerned Congress when section 12(d)(1) was enacted.\226\ If an 
acquiring fund invests in an ETF that in turn invests in other funds 
(including other ETFs), an acquiring fund shareholder could find it 
difficult to determine the nature and value of the holdings ultimately 
underlying his or her investment. The proposed rule is designed to 
allow an ETF the flexibility to invest in other funds in order to meet 
its investment objectives while preventing shareholder confusion as to 
the nature of their investment in an acquiring fund by limiting the 
extent of those ETF investments.\227\
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    \225\ Proposed rule 12d1-4(a)(4) (``The exchange-traded fund has 
a disclosed policy that prohibits it from investing more than 10 
percent of its assets in: (i) Other investment companies in reliance 
on section 12(d)(1)(F) or section 12(d)(1)(G) of the Act or [rule 
12d1-4]; and (ii) Any other company that would be an investment 
company under section 3(a) of the Act but for the exceptions to that 
definition provided in sections 3(c)(1) and 3(c)(7) of the Act (15 
U.S.C. 80a-3(c)(1) and 80a-3(c)(7)).''). Section 12(d)(1)(A)(iii) of 
the Act limits an acquiring fund's total investment in other funds 
to no more than 10 percent of the acquiring fund's assets. An ETF 
would still be able to make limited investments in other funds, 
including other ETFs. This is similar to a condition in section 
12(d)(1)(G) of the Act that provides an exemption from section 
12(d)(1) limits for funds to invest in other funds in the same group 
provided, among other things, the acquired fund has a policy that it 
will not rely on exemptions allowing it to be a fund of funds. See 
15 U.S.C. 80a-12(d)(1)(G)(i)(IV). The exemptive orders generally 
prohibit an acquired ETF from investing in other funds beyond 
section 12(d)(1)(A) limits. Many of the orders have provided 
exceptions to this general prohibition, which permit the ETF to 
invest in money market funds beyond the limits of section 
12(d)(1)(A) either in reliance on another exemptive order allowing 
the ETF to do so or in reliance on rule 12d1-1. In addition, some of 
the orders permit the ETF to invest in another fund beyond the 
limits of section 12(d)(1)(A) to the extent permitted by section 
12(d)(1)(E) of the Act. An acquiring fund relying on any of these 
exceptions may have difficulty determining whether an acquired ETF 
would itself be considered a fund of funds because the acquiring 
fund might not be able to ascertain easily if the ETF is relying on 
an order, section 12(d)(1)(E) of the Act, or rule 12d1-1 to invest 
in other funds beyond the limits of section 12(d)(1)(A) of the Act. 
The orders also do not anticipate any future exemptive relief the 
Commission might provide to allow acquired ETFs to invest in other 
non-money market funds in excess of section 12(d)(1)(A) limits. 
Limiting exemptive relief to investments in ETFs with disclosed 
policies would allow an acquiring fund to determine easily if it 
could invest in a particular ETF.
    \226\ See supra note 198 and accompanying text.
    \227\ Under the proposed rule, an acquiring fund could invest in 
an ETF that invests up to 10 percent of its assets in other ETFs.
---------------------------------------------------------------------------

    We request comment on the proposed limits on an ETF itself being a 
fund of funds. Are the proposed limits on an underlying ETF's 
investments in other funds sufficient to prevent investor confusion? If 
not, what limits should the proposed rule include to prevent 
shareholder confusion? Should the proposed rule include the same limit 
(and exceptions to the limit) as in our exemptive orders? \228\ Are 
there reasons not to restrict the ability of an acquired ETF itself to 
invest in other funds, including ETFs, beyond the limits of section 
12(d)(1)(A)? \229\ Does the fact that ETF shares trade more like a 
typical equity security make it less likely that investors would be 
confused if we were to allow an acquiring fund to invest in an ETF that 
itself invests more than ten percent of its assets in other ETFs in 
reliance on proposed rule 12d1-4?
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    \228\ As discussed above, the orders generally prohibit an 
acquired ETF from investing in other funds beyond the limits of 
section 12(d)(1)(A). Some of the orders include a few exceptions to 
this general prohibition. See supra note 225.
    \229\ The proposed rule would allow an acquired ETF to invest in 
other funds, including ETFs, beyond the limits of section 
12(d)(1)(A) in reliance on sections 12(d)(1)(F) and 12(d)(1)(G) and 
to invest in other ETFs beyond the limits of section 12(d)(1)(A) in 
reliance on the proposed rule. However, the proposed rule would 
limit an acquired ETF's aggregate investment in these funds to no 
more than 10 percent of the acquired ETF's assets. Proposed rule 
12d1-4(a)(4).
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4. Layering of Fees
    As discussed above, one of Congress' concerns regarding fund of 
funds arrangements was that acquiring fund shareholders might pay 
excessive charges due to duplicative fees at the acquiring and acquired 
fund levels.\230\ To prevent duplicative fees at the acquiring and 
acquired fund levels, the proposed rule would limit sales charges and 
service fees charged by the acquiring fund to those set forth in the 
Financial Industry Regulatory Authority's (``FINRA'') sales charge 
rule, which takes into consideration fees charged at both levels of a 
fund of funds arrangement.\231\ In addition, like all acquiring funds, 
funds that invest in ETFs would be subject to our disclosure rules for 
fund investments in other funds. These rules require all registered 
funds to disclose in their prospectus fee tables expenses paid by both 
the acquiring and acquired funds so that shareholders can evaluate the 
costs of investing in a fund that invests in other funds, including 
ETFs.\232\ These rules and the proposed fee limit may fully address 
congressional concerns with the duplication and layering of fees that 
hide the real cost of investing in an investment company.\233\
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    \230\ See supra note 197 and accompanying text.
    \231\ Proposed rule 12d1-4(a)(3). The proposed rule would limit 
the sales charge (including any 12b-1 fee) or service fee charged in 
connection with the purchase, sale, or redemption of securities 
issued by the acquiring fund to the FINRA fee limits for fund of 
funds set forth in NASD Conduct Rule 2830(d)(3). Some ETFs charge a 
12b-1 fee. See, e.g., Select Sector SPDRs[supreg], Prospectus 20,28 
(Jan. 31, 2008). FINRA does not, however, apply Conduct Rule 2830 to 
variable annuity contracts. See NASD Conduct Rule 2820(a) (rule 2820 
applies exclusively and in lieu of rule 2830 to the activities of 
members in connection with variable contracts to the extent the 
activities are subject to federal securities law regulation). To 
address the potential for excessive layering of fees in a separate 
account that invests in an acquiring fund, proposed rule 12d1-
4(a)(3)(ii) would: (i) Prohibit an acquiring fund in which a 
separate account invests and any ETF in which the acquiring fund 
invests from charging a sales load and would allow only the 
acquiring fund or ETF, but not both, to impose asset-based sales 
charges or service fees; and (ii) require the aggregate fees 
associated with the variable insurance contract and the sales 
charges and service fees charged by the acquiring fund and the ETF 
to be reasonable in relation to the services rendered, the expenses 
expected to be incurred and, with respect to the variable insurance 
contract, the risks assumed by the insurance company.
    \232\ See Item 3(f) to Form N-1A; Fund of Funds Adopting 
Release, supra note 201, at Section II.D.
    \233\ See supra note 197.
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    We request comment on the proposed condition limiting the fees 
charged by an acquiring fund. Would the proposed fee limits adequately 
prevent acquiring fund shareholders from paying excessive distribution 
or service fees? \234\ Are there any special concerns as to how to 
apply the proposed fee limits to an acquiring fund when a separate 
account invests in an acquiring fund? Do our disclosure requirements 
provide sufficient information to investors to allow them to determine 
whether the total fees imposed on a fund of ETFs are consistent with 
their investment objectives?
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    \234\ The proposed rule would not include the condition from our 
orders requiring the acquiring fund adviser (or sponsor or trustee) 
to waive its fee in an amount at least equal to any compensation 
(including fees received pursuant to any 12b-1 plan but excluding 
advisory fees) received from the ETF by the acquiring fund's 
adviser, trustee, or sponsor or an affiliated person of the 
acquiring fund's adviser, trustee, or sponsor in connection with the 
acquiring fund's investment in the ETF. The proposed rule also does 
not include the condition from our orders that requires the board of 
the acquiring fund to find that the advisory fees charged under an 
advisory contract are based on services provided that will be in 
addition to, rather than duplicative of, the services provided by an 
adviser to an acquired ETF. As we noted in the proposing and 
adopting releases for rule 12d1-1 explaining our exclusion of a 
similar condition from rule 12d1-1, an acquiring fund board is 
already obligated to protect the fund from being overcharged for 
services provided to the fund regardless of any special findings we 
might require. See Fund of Funds Adopting Release, supra note 201, 
nn.51-52 and accompanying text; Fund of Funds Proposing Release, 
supra note 197, at nn.65-67 and accompanying text.
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C. Scope of Proposed Rule 12d1-4

1. Acquiring Funds and ETFs Eligible for Relief
    Proposed rule 12d1-4 would permit open-end and closed-end 
management companies (including business development companies) \235\ 
and UITs \236\ that comply with the rule's conditions to invest in ETFs 
beyond the

[[Page 14640]]

limits of section 12(d)(1).\237\ Our orders to date have provided 
exemptions only for investments in ETFs by registered management funds 
and UITs.\238\ We do not anticipate that providing a similar exemption 
for business development companies would raise particular concerns that 
section 12(d)(1) was designed to address.
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    \235\ A business development company is any closed-end company 
that: (i) Is organized under the laws of, and has its principal 
place in, any state or states; (ii) is operated for the purpose of 
investing in securities described in section 55(a)(1)-(3) of the Act 
and makes available ``significant managerial assistance'' to the 
issuers of those securities, subject to certain conditions; and 
(iii) has elected under section 54(a) of the Act to be subject to 
the sections addressing activities of business development companies 
under the Act. See 15 U.S.C. 80a-2(a)(48). Section 60 of the Act 
extends the limits of section 12(d) to a business development 
company to the same extent as if it were a registered closed-end 
fund. Section 6(f) of the Act exempts business development companies 
that have made the election under section 54 of the Act from 
registration and other provisions of the Act. We similarly included 
business development companies within the scope of rule 12d1-1 to 
allow then to invest in money market funds beyond the limits of 
section 12(d)(1). See Fund of Funds Adopting Release, supra note 
201, at nn.44-46 and accompanying text.
    \236\ Because an ETF can be organized either as an open-end 
management company or UIT, see supra note 8, it could rely on the 
proposed rule to invest in other ETFs beyond the limits contained in 
section 12(d)(1).
    \237\ Section 12(d)(1)(B)'s limits on sales of an acquired 
fund's securities apply only to shares of an ETF organized as an 
open-end investment company.
    \238\ We have not had the opportunity to consider a request for 
an individual exemptive order for other types of investment 
companies. Our orders also have permitted funds to invest in ETFs 
organized as UITs (and as open-end funds). Proposed rule 12d1-4 
would include relief for investments in ETFs that are organized as 
UITs as long as the UITs satisfy the criteria enumerated in proposed 
rule 6c-11(e)(4). Proposed rule 12d1-4(d)(2). As noted above, 
proposed rule 6c-11 would not include a UIT within its relief 
because we have not received an exemptive application for a new ETF 
to be organized as a UIT in a number of years. See supra note 65 and 
accompanying text.
---------------------------------------------------------------------------

    We request comment on the inclusion of business development 
companies within the scope of proposed rule 12d1-4. Would these 
entities benefit from this exemption? Are there reasons not to extend 
the exemption to these companies? Do any special concerns arise with 
respect to extending the exemption to these companies?

2. Investments in Affiliated ETFs Outside the Fund Complex

    In addition to providing an exemption from section 12(d)(1) of the 
Act, the proposed rule would provide exemptions from sections 17(a)(1), 
17(a)(2), 57(a)(1) and 57(a)(2) of the Act. These provisions restrict a 
fund's ability to enter into transactions with affiliated persons.\239\ 
They are designed to prevent affiliated persons from managing the 
fund's assets for their own benefit, rather than for the benefit of the 
fund's shareholders.\240\ These provisions would otherwise effectively 
preclude a fund that acquires five percent or more of the securities of 
an ETF in another fund complex from making any additional purchases of 
shares from the ETF.\241\ They also would prohibit an affiliated 
acquiring fund from depositing (i.e., ``selling'') securities 
identified in the creation basket. Permitting an acquiring fund to 
purchase additional ETF shares from the ETF at NAV on the same basis as 
any other purchaser of a creation unit, by itself, seems to provide 
little opportunity for the acquiring fund to manage the ETF for its own 
benefit.\242\ Allowing the ETF to acquire securities identified in a 
creation basket from an affiliated acquiring fund on the same basis as 
any other investor also would not seem to implicate the concerns 
underlying section 17(a). Accordingly, we believe that exemptions from 
sections 17(a)(1), 17(a)(2), 57(a)(1), and 57(a)(2) of the Act for 
these transactions would be appropriate, in the public interest, and 
consistent with the protection of investors and the purposes of the 
Act.\243\
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    \239\ Section 17 of the Act limits transactions between a fund 
and its affiliated persons. Section 17(a) of the Act generally 
prohibits affiliated persons of a registered fund (``first-tier 
affiliates'') or affiliated persons of the fund's affiliated persons 
(``second-tier affiliates'') from selling securities or other 
property to or purchasing securities or other property from the fund 
(or any company the fund controls). Section 57 of the Act restricts 
certain transactions between business development companies and 
certain of their affiliates. An affiliated person of a fund 
includes: (i) Any person directly or indirectly owning, controlling, 
or holding with power to vote, five percent or more of the 
outstanding voting securities of the fund; and (ii) any person five 
percent or more of whose outstanding voting securities are directly 
or indirectly owned, controlled, or held with power to vote by the 
fund. See 15 U.S.C. 80a-2(a)(3)(A), (B). Thus, if an acquiring fund 
holds five percent or more of the outstanding voting shares of the 
ETF, the acquiring fund is an affiliated person of the ETF and the 
ETF is an affiliated person of the acquiring fund.
    \240\ See Investment Trusts and Investment Companies: Hearings 
on S. 3580 Before a Subcomm. of the Senate Comm. On Banking and 
Currency, 76th Cong., 3d Sess. 37 (1940) (Statement of Commissioner 
Healy). Section 17 also would restrict an acquiring fund from 
investing in an ETF that is affiliated with the acquiring fund 
because both funds have a common investment adviser or other person 
exercising a controlling influence over the management or policies 
of the funds. See 15 U.S.C. 80a-2(a)(3)(C). The determination of 
whether a fund is under the control of its adviser, officers, or 
directors depends on all the relevant facts and circumstances. See 
Investment Company Mergers, Investment Company Act Release No. 25259 
(Nov. 8, 2001) [66 FR 57602 (Nov. 15, 2001)], at n.11. For purposes 
of this release, we presume that funds with a common investment 
adviser are under common control because funds that are not 
affiliated persons would not require, and thus not rely on, the 
exemptions from section 17(a). Although funds in the same group of 
investment companies generally are under common control of an 
investment adviser or other person exercising a controlling 
interest, these funds may rely on section 12d(1)(G) of the Act to 
invest in an ETF in the same group. See infra note 249 and 
accompanying text.
    \241\ An ETF would be prohibited under section 17(a)(1) from 
selling its shares to an affiliated acquiring fund and under section 
17(a)(2) from purchasing securities (i.e., securities designated in 
the creation basket) from the affiliated acquiring fund in exchange 
for ETF shares. An acquiring fund would be prohibited under section 
17(a)(1) from selling any securities (i.e., securities identified in 
the creation basket) to an affiliated ETF in exchange for the ETF's 
shares. An acquiring fund also would be prohibited under section 
17(a)(2) from purchasing (creation basket) securities from an 
affiliated ETF for the redemption of ETF shares. The ETF would be 
prohibited under section 17(a)(1) from selling the affiliated 
acquiring fund (creation basket) securities in exchange for ETF 
shares redeemed and under section 17(a)(2) from acquiring the ETF 
shares submitted for redemption by the affiliated acquiring fund.
    \242\ The exemptive orders provide similar relief from sections 
17(a)(1) and 17(a)(2) of the Act, including relief to allow the 
acquiring fund to redeem shares of an affiliated ETF. The proposed 
rule would not, however, provide an acquiring fund relief from 
sections 17(a)(2) and 57(a)(2) of the Act in order to redeem shares 
in excess of the three percent limit in section 12(d)(1)(A)(i) from 
an affiliated ETF. In addition, proposed rule 6c-11, which would 
permit persons affiliated with an ETF solely because they own five 
percent or more of the ETF's shares, to purchase and sell ETF shares 
in-kind (i.e., in exchange for securities designated in the creation 
basket) would not extend relief to certain redemptions by acquiring 
funds consistent with proposed rule 12d1-4(a). See supra Section 
III.C.3 and proposed rule 6c-11(d). As noted above, no orders have 
been issued to business development companies therefore no order 
includes relief from sections 57(a)(1) and 57(a)(2) of the Act. See 
supra note 238 and accompanying text.
    \243\ Our proposal would not provide an exemption for any 
transactions other than the sale of securities by an acquiring fund 
to an affiliated ETF for a creation unit of ETF shares. The proposed 
rule also would not provide an exemption for any other transactions 
between a business development company and an affiliated ETF that 
would be subject to section 57 limitations.
---------------------------------------------------------------------------

    We seek comment on these exemptions. Are there risks other than the 
concerns we addressed with respect to section 12(d)(1) limitations, 
regarding the potential that the acquiring fund could manage the ETF, 
that would arise from the proposed exception allowing a fund to acquire 
more than five percent of the shares of an affiliated ETF in another 
complex?
3. Use of Affiliated Broker to Effect Sales
    In order to allow acquiring funds to take full advantage of the 
exemptive relief, proposed rule 12d1-4 also would provide limited 
relief from section 17(e)(2) of the Act. If an investment company in 
one complex acquired more than five percent of the assets of an ETF in 
another complex, any broker-dealer affiliated with that ETF would 
become a (second-tier) affiliated person of the acquiring fund.\244\ As 
a result of the affiliation, the broker-dealer's fee for effecting the 
sale of securities to (or by) the acquiring fund would be subject to 
the conditions set forth in rule 17e-1, including the quarterly board 
review and recordkeeping requirements with respect to certain 
securities transactions involving the affiliated broker-dealer.\245\

[[Page 14641]]

We believe that it is unlikely that a broker-dealer would be in a 
position to take advantage of the acquiring fund merely because that 
fund owned a position in an ETF affiliated with the broker-dealer.\246\ 
Accordingly, the proposed rule would permit an acquiring fund to pay 
commissions, fees, or other remuneration to a (second-tier) affiliated 
broker-dealer without complying with the quarterly board review and 
recordkeeping requirements set forth in rules 17e-1(b)(3) and 17e-
1(d)(2).\247\ This relief would be available only if the broker-dealer 
and the acquiring fund are affiliated solely because of the acquiring 
fund's investment in the ETF.
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    \244\ See supra notes 239-240.
    \245\ Section 17(e)(2) of the Act prohibits an affiliated person 
(or second-tier affiliate) of a fund from receiving compensation for 
acting as a broker, in connection with the sale of securities to or 
by the fund if the compensation exceeds limits prescribed by the 
section. Rule 17e-1 sets forth a conditional exemption under which a 
commission, fee or other remuneration shall be deemed as not 
exceeding the ``usual and customary broker's commission'' for 
purposes of section 17(e)(2)(A) of the Act. Rule 17e-1(b)(3) 
requires the fund's board of directors, including a majority of the 
directors who are not interested persons under section 2(a)(19) of 
the Act, to determine at least quarterly that all transactions 
effected in reliance on the rule have complied with procedures which 
are reasonably designed to provide that the brokerage compensation 
is consistent with the rule's standards. Rule 17e-1(d)(2) specifies 
the records that must be maintained by each fund with respect to any 
transaction effected pursuant to rule 17e-1.
    \246\ We expect that the ETF's adviser would have no influence 
over the decisions made by the acquiring fund's adviser. In 
addition, because the interests of the adviser to the ETF and the 
adviser to the acquiring fund are directly aligned with their 
respective funds, transactions between the acquiring fund and a 
broker-dealer affiliate of the ETF are likely to be at arm's length.
    \247\ Proposed rule 12d1-4(c). The proposed relief is similar to 
relief we have provided in rule 12d1-1, which permits funds to 
invest in money market funds in excess of section 12(d)(1) limits. 
See Fund of Funds Adopting Release, supra note 201, at nn.32-36 and 
accompanying text. An acquiring fund relying on this exemption would 
be required to comply with all of the provisions of rule 17e-1, 
except for those in paragraphs (b)(3) and (d)(2). It does not appear 
that having to comply with the other provisions contained in rule 
17e-1 would deter acquiring funds from taking full advantage of the 
exemption provided by proposed rule 12d1-4.
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    We request comment on the proposed exemptions. Is the scope of the 
proposed exemptions from section 17 limitations sufficiently broad to 
allow funds to take full advantage of the proposed relief? Are the 
proposed exemptions from board review and recordkeeping requirements 
with respect to transactions with an affiliated broker-dealer 
necessary? Do funds engage in these transactions with broker-dealer 
affiliates of acquired ETFs? Is there additional section 17 relief that 
would be helpful in order for acquiring funds to take full advantage of 
the proposed exemption for investments in ETFs? If so, please be 
specific regarding the transactions that would prevent funds from 
relying on the proposed rule.

V. Exemption for Affiliated Fund of Funds Investments

A. Affiliated Fund of Funds Investments in ETFs

    As noted above, Congress recognized that the investment limits in 
section 12(d)(1) might restrict certain legitimate fund of funds 
arrangements, and included three exceptions to those limits.\248\ One 
of these exceptions--section 12(d)(1)(G)--permits a registered open-end 
investment company or UIT to invest in other registered open-end 
investment companies or UITs (including ETFs) that are in the ``same 
group of investment companies'' (``affiliated funds'') beyond the 
section 12(d)(1) limits.\249\ A fund that invests in unaffiliated ETFs 
(i.e., ETFs in other fund groups) in many cases, however, is still 
subject to the section 12(d)(1) limits.\250\ Section 12(d)(1)(G) 
restricts the other investments an acquiring fund investing in 
affiliated funds can make to government securities and short-term 
paper.\251\
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    \248\ For a full discussion of section 12(d)(1) limitations and 
the exceptions under sections 12(d)(1)(E), 12(d)(1)(F), and 
12(d)(1)(G) of the Act, see Fund of Funds Proposing Release, supra 
note 197, at Section I.
    \249\ See 15 U.S.C. 80a-12(d)(1)(G). Section 12(d)(1)(G)(ii) of 
the Act defines ``same group of investment companies'' to mean ``any 
2 or more registered investment companies that hold themselves out 
to investors as related companies for purposes of investment and 
investor services.'' Section 12(d)(1)(G) imposes the following 
conditions on funds relying on this exception: (i) other investments 
are limited to short-term paper and government securities; (ii) 
acquired funds must have a policy against investing in shares of 
other funds in reliance on sections 12(d)(1)(F) or 12(d)(1)(G) (to 
prevent multi-tiered structures); and (iii) overall distribution 
expenses are limited.
    \250\ A fund could invest in unaffiliated funds in reliance on 
two other statutory exemptions. Under section 12(d)(1)(E) an 
investment company may acquire securities issued by another 
investment company provided that (i) the acquiring fund's depositor 
or principal underwriter is a broker or dealer registered under the 
Securities Exchange Act of 1934, (or a person the broker-dealer 
controls), (ii) the security is the only investment security the 
acquiring fund holds (or the securities are the only investment 
securities the acquiring investment company holds if it is a 
registered UIT that issues two or more classes or series of 
securities, each of which provides for the accumulation of shares of 
a different investment company), and (iii) the acquiring investment 
company is obligated (a) to seek instructions from its shareholders 
with regard to voting the acquired investment company's securities 
or to vote the acquired investment company's shares in the same 
proportion as the vote of all other acquired investment company 
shareholders, and (b) if unregistered, to obtain Commission approval 
before substituting the investment security. A fund relying on 
section 12(d)(1)(F) of the Act (and its affiliated persons) may 
acquire no more than three percent of another investment company's 
outstanding stock, cannot charge a sales load greater than 1\1/2\ 
percent; is restricted in its ability to redeem shares of the 
acquired investment company; and must vote shares of an acquired 
investment company either by seeking instructions from the acquiring 
fund's shareholders, or voting the shares in the same proportion as 
the vote of all other shareholders of the acquired investment 
company.
    \251\ Congress imposed this limitation to restrict the use of 
the exemption provided by section 12(d)(1)(G) to a ``bona fide'' 
fund of funds. Congress permitted other investments to include only 
government securities and short-term paper, which provide the fund 
with a source of liquidity to redeem shares. See H.R. Rep. No. 622, 
supra note 200, at 42.
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    When it added section 12(d)(1)(G) to the Act, Congress also gave us 
specific authority to provide certain exemptions from the limitations 
of section 12(d)(1) if the exemption is consistent with the public 
interest and the protection of investors.\252\ In conjunction with the 
adoption of rule 12d1-1 in 2006 (allowing funds to invest in money 
market funds beyond the limits of section 12(d)(1)), we adopted rule 
12d1-2, which allows funds relying on section 12(d)(1)(G) also to 
invest in: (i) Unaffiliated money market funds when the acquisition is 
in reliance on rule 12d1-1; (ii) securities issued by unaffiliated 
funds (including ETFs), subject to the investment limits in sections 
12(d)(1)(A) and 12(d)(1)(F) of the Act; \253\ and (iii) securities not 
issued by an investment company. Under rule 12d1-2, therefore, a fund 
that invests in affiliated funds in reliance on section 12(d)(1)(G) and 
desires to invest in unaffiliated ETFs is subject to these statutory 
limitations (e.g., to acquiring no more than three percent of the 
acquired ETF's shares). There seems no reason, however, to maintain the 
statutory limitations on investments in ETFs in these circumstances 
when we are proposing to permit other types of funds to invest in ETFs 
in excess of section 12(d)(1) limits. No special issues appear to arise 
in connection with an acquiring fund's investments in an unaffiliated 
ETF simply because the acquiring fund also invests in affiliated funds. 
Accordingly, we propose to amend rule 12d1-2 to allow acquiring funds 
that invest in affiliated funds in reliance on section 12(d)(1)(G) to 
invest in unaffiliated ETFs beyond the statutory limitations as long as 
the funds comply with the conditions of proposed rule 12d1-4.\254\ This 
is similar to the relief we provided to affiliated funds of funds to 
allow them to acquire shares in money market funds, if the acquisition 
is in reliance on rule 12d1-1.\255\
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    \252\ Section 12(d)(1)(J) of the Act authorizes the Commission 
to exempt any person, security or transaction, or any class or 
classes of transactions, from section 12(d)(1) of the Act if the 
exemption is consistent with the public interest and the protection 
of investors. See supra note 214.
    \253\ See supra note 250.
    \254\ Proposed rule 12d1-2(a)(4).
    \255\ See 17 CFR 270.12d1-2(a)(3).
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    We request comment on the proposed amendment. Are there reasons not 
to extend the proposed relief to affiliated funds of funds? Do 
investments by an acquiring fund that invests in affiliated funds raise 
any special concerns if the acquiring fund also invests in unaffiliated 
ETFs? Are these concerns different than any other fund's investment in 
unaffiliated ETFs?

[[Page 14642]]

B. Affiliated Fund of Funds Investments in Other Assets

    We also are proposing an amendment to rule 12d1-2 that would allow 
funds relying on section 12(d)(1)(G) to invest in assets other than 
securities. As discussed above, in 2006 we adopted rule 12d1-2 to 
permit affiliated funds of funds to acquire securities issued by other 
unaffiliated investment companies, as well as ``securities (other than 
securities issued by an investment company).'' \256\ The rule was 
intended to allow an acquiring fund greater flexibility to meet 
investment objectives that may not be met as well by investments in 
affiliated funds. We noted that these investments would not seem to 
present any additional concerns that section 12(d)(1)(G) was intended 
to address.\257\
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    \256\ See 17 CFR 270.12d1-2(a)(1), 17 CFR 270.12d1-2(a)(2).
    \257\ See Fund of Funds Proposing Release, supra note 197, at 
n.80 and accompanying text.
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    Since we adopted the rule, it has been brought to our attention 
that funds relying on section 12(d)(1)(G) wish to invest in other types 
of financial assets, including futures and other financial instruments 
that might not be securities under the Act and thus may not be within 
the scope of rule 12d1-2.\258\ Investments in these types of assets may 
allow an acquiring fund greater flexibility to meet investment 
objectives that may not be met as well by investments in securities. In 
addition, like investments in securities, investments in these assets 
do not appear to raise concerns that the investment limits on fund of 
funds arrangements contained in section 12(d)(1) were intended to 
address. Accordingly, we propose to amend rule 12d1-2 to allow funds 
relying on section 12(d)(1)(G) to invest in assets or instruments other 
than securities.\259\ Under the proposed rule, funds relying on the 
exemptive relief in section 12(d)(1)(G) would be able to invest in, 
among other things, real estate, futures contracts, and other financial 
instruments that do not qualify as a security under the Act.\260\ Those 
investments would, of course, have to be consistent with the fund's 
investment policies.\261\
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    \258\ See 15 U.S.C. 80a-2(a)(36) (defining ``security''). If a 
future or other financial instrument in which a fund relying on 
section 12(d)(1)(G) proposes to invest is included within the Act's 
definition of ``security,'' investments in such an instrument would 
be permitted under current rule 12d1-2(a)(2).
    \259\ Proposed rule 12d1-2(a)(5).
    \260\ We have issued exemptive orders to funds that rely on 
section 12(d)(1)(G) to allow those funds to invest in futures 
contracts and other financial instruments. See, e.g., Schroder 
Series Trust, et al., Investment Company Act Release Nos. 28133 
(Jan. 24, 2008) [73 FR 5603 (Jan. 30, 2008)] (notice) and 28167 
(Feb. 25, 2008) (order); The UBS Funds, et al., Investment Company 
Act Release Nos. 28080 (Dec. 19, 2007) [72 FR 74372 (Dec. 31, 2007)] 
(notice) and 28122 (Jan. 16, 2008) (order); Vanguard Star Funds, et 
al., Investment Company Act Release Nos. 28009 (Sept. 28, 2007) [72 
FR 56813 (Oct. 4, 2007)] (notice) and 28024 (Oct. 24, 2007) (order) 
(permitting funds relying on section 12(d)(1)(G) and rule 12d1-2 
under the Act to invest in financial instruments that may not be 
securities within the meaning of section 2(a)(36) of the Act).
    \261\ See Item 4 of Form N-1A (requiring disclosure of funds' 
investment objectives and principal investment strategies).
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    We seek comment on this proposal. Would any concerns arise if a 
fund relying on section 12(d)(1)(G) could invest directly in non-
securities? Do these concerns differ from a traditional fund that can 
invest in such assets and invests in other funds subject to the limits 
of section 12(d)(1)?

VI. Request for Comment

    The Commission requests comment on the rules, rule amendments, and 
Form N-1A amendments proposed in this release. The Commission also 
requests suggestions for additional changes to existing rules or forms, 
and comments on other matters that might have an effect on the 
proposals contained in this release. Commenters are requested to 
provide empirical data to support their views.

VII. Paperwork Reduction Act

    Certain provisions of proposed rule 6c-11 would result in new 
``collection of information'' requirements within the meaning of the 
Paperwork Reduction Act of 1995 (``PRA'').\262\ The Commission is 
therefore submitting this proposal to the Office of Management and 
Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 
CFR 1320.11. The title for the collection of information requirements 
is ``Rule 6c-11 under the Investment Company Act of 1940, `Exchange-
traded funds.' '' If adopted, this collection would not be mandatory, 
but would be necessary for ETFs that seek to form and operate as open-
end management companies without seeking individual exemptive orders. 
Responses to the collection of information requirements of proposed 
rule 6c-11 would not be kept confidential.
---------------------------------------------------------------------------

    \262\ 44 U.S.C. 3501-3520.
---------------------------------------------------------------------------

    In addition, the Commission is proposing amendments to an existing 
collection of information requirement titled ``Form N-1A under the 
Investment Company Act of 1940 and Securities Act of 1933, Registration 
Statement for Open-End Management Companies.'' Compliance with the 
disclosure requirements of Form N-1A is mandatory. Responses to the 
disclosure requirements are not kept confidential.
    Finally, proposed rule 12d1-4 would result in a new ``collection of 
information'' requirement within the meaning of the PRA. The Commission 
is therefore submitting the proposal for rule 12d1-4 to OMB for review. 
The title for the collection of information requirements is ``Rule 
12d1-4 under the Investment Company Act of 1940, `Exemption for 
investments in exchange-traded funds.' '' If adopted, this collection 
would not be mandatory, but would be a condition that an acquiring fund 
would have to satisfy in order for an ETF, its principal underwriter, a 
broker, or a dealer to rely on the safe harbor if an acquiring fund 
redeems ETF shares. Responses to the collection of information 
requirements of proposed rule 12d1-4 would not be kept confidential.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a 
currently valid control number. OMB has not yet assigned control 
numbers to the new collections for proposed rules 6c-11 and 12d1-4. The 
approved collection of information associated with Form N-1A, which 
would be revised by the proposed amendments, displays control number 
3235-0307.

A. Proposed Rule 6c-11

    Proposed rule 6c7-11 would exempt ETFs from certain provisions of 
the Act, permitting them to begin operating without obtaining an 
exemptive order from the Commission. The proposed rule also would 
expand the relief we have issued in the past to index-based ETFs, and 
to transparent, actively managed ETFs. Each ETF seeking to rely on the 
proposed rule would have to disclose on a daily basis specific 
information to market participants: (i) The contents of its basket 
assets; (ii) the identities and weightings of the component securities 
and other assets in its portfolio if it does not track an index whose 
provider discloses its composition daily; and (iii) the prior business 
day's NAV, market closing price for its ETF shares and premium/discount 
information.\263\ In addition, each ETF would have to disclose in its 
registration statement: (i) the number of shares that comprise a 
creation unit; and (ii) the foreign holidays that would prevent timely 
satisfaction of redemption with respect to foreign securities in its 
basket assets.\264\ An ETF

[[Page 14643]]

that chooses not to disclose its portfolio would have to track an index 
whose provider discloses the identities and weightings of the 
securities and other assets that constitute the index in order to rely 
on the proposed rule. In addition, each ETF seeking to rely on the 
proposed rule also would have to, in any sales literature (as defined 
in the rule), identify itself as an ETF, which does not sell or redeem 
individual shares, and explain that investors may purchase or sell 
individual shares on national securities exchanges.
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    \263\ 263 Proposed rule 6c-11.
    \264\ 264 Id.
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    Two of the disclosure conditions in proposed rule 6c-11 would not 
result in a burden for purposes of the PRA. Disclosure of the contents 
of the basket assets that comprise a creation unit and the number of 
shares in each creation unit does not result in a burden because ETFs 
must disclose this information in the normal course of business.\265\ 
Similarly, disclosure by an index provider of the identities and 
weightings of the component securities and other assets that comprise 
the index would not result in a burden because index providers disclose 
this information in the normal course of business.
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    \265\ See Section II of this release for a discussion on the 
operation of ETFs. Disclosure of the contents of the basket assets 
and the number of shares that comprise a creation unit are critical 
to investors who seek to purchase or redeem creation units from the 
ETF and, therefore, to the operation of an ETF. To purchase a 
creation unit, an investor would need to know the securities and 
other assets that must be deposited with the ETF in exchange for a 
creation unit. To redeem a creation unit, an investor would need to 
know the number of ETF shares that comprise a creation unit in order 
to compile enough shares to redeem from the ETF. Disclosure of the 
contents of the basket assets also is important to the arbitrage 
mechanism of the ETF. Arbitrageurs compare the NAV of the basket to 
the NAV of ETF shares to determine whether to purchase or redeem 
creation units based on the relative values of ETF shares in the 
secondary market and the securities contained in the basket.
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    The remaining four disclosure requirements are collections of 
information. First, the proposed rule would require an ETF that does 
not track an index whose provider discloses its composition daily to 
provide daily disclosure of the identities and weightings of the 
component securities and other assets in the ETF's portfolio. 
Currently, two ETF registrants are required to disclose their 
portfolios daily under the terms of their exemptive orders.\266\ The 
Commission staff estimates that an ETF each year would spend 
approximately 200 hours of professional time to update the relevant 
Internet Web page daily with this information, at a cost of 
$42,000.\267\ The staff also estimates that each new ETF initially 
would spend 100 hours to develop the Web page for this disclosure. 
Staff estimates the initial cost would be $22,520 for internal ETF 
staff time to develop the Web page and $12,600 for an external Web site 
developer, for a total of $35,120.\268\
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    \266\ ProShares Notice, supra note 113; Rydex ETF Trust, 
Investment Company Act Release No. 27703 (Feb. 20, 2007) [72 FR 8810 
(Feb. 27, 2007)]. Together, these registrants offer 64 ETFs that are 
required to disclose their portfolios daily.
    \267\ Estimates on the number of burden hours and external costs 
associated with the collections of information are based on informal 
conversations between Commission staff and representatives of ETFs. 
The staff estimates the cost would be 200 hours for an internal Web 
site developer (at $211 per hour) (200 x $211 = $42,200). Hourly 
wages used for purposes of this PRA analysis are from the Securities 
Industry Association (now named Securities Industry and Financial 
Markets Association), SIA Report on Management & Professional 
Earnings in the Securities Industry 2006, modified to account for an 
1800-hour work-year and multiplied by 5.35 to account for bonuses, 
firm size, employee benefits and overhead.
    \268\ Commission staff estimates the cost would equal 80 hours 
for Web site developers at the ETF (at $211 per hour) to develop the 
Web page and 20 hours for internal Web site managers (at $282 per 
hour) to review the Web page ((80 hours x $211) + (20 hours time x 
$282) = $22,520). In addition, based on discussions with industry 
representatives, the staff estimates that each ETF initially would 
spend an additional $12,600 to external Web site developers ($22,520 
+ 12,600 = $35,120).
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    We seek comments on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide data that would 
allow us to make more accurate estimates.
    Second, the proposed rule also would require each ETF to disclose 
its prior business day's NAV, market price for its shares, and premium/
discount information, which would provide investors with information on 
the deviation, if any, between the price of ETF shares and the NAV of 
the underlying portfolio. Commission staff estimates that an ETF each 
year spends approximately 206 hours of professional time to update the 
relevant Internet Web page daily with this information. Based on staff 
estimates, we estimate the annual cost would be $43,466 for internal 
ETF staff time to update the Web page and $6,000 to acquire the data 
from external data providers.\269\ The staff also estimates that each 
new ETF initially would spend 75 hours to develop the Web page for 
these disclosures. Based on staff estimates, we estimate the initial 
cost would be $16,890 for internal ETF staff time to develop the Web 
page and $9,540 for an external Web site developer, for a total of 
$26,430.\270\
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    \269\ Commission staff estimates the cost would equal 206 hours 
for internal Web site developers at ($211 per hour) (206 x $211 = 
$43,466).
    \270\ Commission staff estimates the cost would equal 60 hours 
for internal Web site developers (at $211 per hour) to develop the 
Web page and 15 hours for Web site managers (at $282 per hour) to 
review the Web page ((60 hours x $211) + (15 hours x $282) = 
$16,890). In addition, based on discussions with industry 
representatives, the staff estimates that each fund would spend an 
additional $9540 to external Web site developers ($16,890 + $9540 = 
$26,430).
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    We seek comments on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide data that would 
allow us to make more accurate estimates.
    Third, in any sales literature each ETF must identify itself as an 
ETF that does not sell or redeem individual shares, and explain that 
investors may purchase or sell individual shares only on national 
securities exchanges. This condition is similar to the condition in our 
exemptive orders, which requires each ETF to agree not to market or 
advertise the ETF as an open-end fund or mutual fund and to explain 
that the ETF shares are not individually redeemable. Based on 
conversations with ETF representatives, Commission staff estimates that 
an ETF each year spends approximately 30 hours at a cost of $1704 to 
comply with the condition in our exemptive orders.\271\ Because the 
condition in the proposed rule is similar, the staff estimates that 
each new ETF also would spend 30 hours at a cost of $1704 to comply 
with the condition in the proposed rule.
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    \271\ Commission staff estimates the cost would equal 2 hours 
for the ETF's internal counsel (at $292 per hour) to draft the 
disclosure and 28 hours for clerical staff (at $40 per hour) to 
input and copy check the marketing materials ((2 x $292) + (28 x 
$40) = $1704).
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    We seek comment on this estimate. If commenters believe this 
estimate is not reasonable, we request they provide data that would 
allow us to make a more accurate estimate.
    Finally, some ETFs that track foreign indexes have stated that 
local market delivery cycles for transferring foreign securities to 
redeeming investors, together with local market holiday schedules, 
require a delivery process in excess of the statutory seven days 
required by section 22(e) of the Act. The proposed rule would codify 
the disclosure requirement in existing exemptive orders that requires 
ETFs to disclose in their registration statements the foreign holidays 
that would prevent timely satisfaction of redemption.\272\ The 
collection of information burden for this disclosure is discussed in 
the PRA analysis of proposed Form N-1A amendments in section VI.B 
below.
---------------------------------------------------------------------------

    \272\ See supra notes 136-141 and accompanying text for a 
discussion of the proposed exemption from section 22(e) of the Act.
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    As of December 2007, there were 601 ETFs.\273\ The Commission staff

[[Page 14644]]

estimates that each year 150 new ETFs will form and operate.\274\ The 
staff estimates that each ETF each year would spend approximately 236 
hours to comply with the conditions of proposed rule 6c-11. Each new 
ETF would spend an additional 75 hours to develop the Web sites for 
daily disclosure of its prior business day's NAV, market closing price 
for its shares, and premium/discount information. In addition, ETFs 
that provide the identities and weightings of the securities and other 
assets in their portfolios if they do not track an index whose provider 
discloses its composition daily would spend an additional 100 hours to 
develop the Web sites for this disclosure. Each of those ETFs also 
would spend an estimated 200 hours each year to update the disclosures 
of portfolio assets on its Web site. For purposes of this PRA, the 
staff estimates that one-half of all new ETFs (75 ETFs) would provide 
this disclosure. Based on staff estimates, we estimate that ETFs would, 
in the aggregate, spend 205,036 hours each year to comply with the 
requirements of proposed rule 6c-11.\275\ We estimate further that ETFs 
would spend 18,750 hours initially to develop the Web page for these 
disclosures, amortized over three years for an annual burden of 6250 
hours.\276\ Thus, the estimated total annual burden is 211,286 
hours.\277\ We estimate the annual internal costs of ongoing compliance 
with these disclosure requirements would be $40 million and external 
costs would be $4.5 million.\278\ We further estimate that initial 
internal costs to develop the Web page for these disclosures would be 
$4.2 million and external costs would be $2.3 million, or $1.4 million 
and $0.8 million, respectively, amortized over three years.\279\
---------------------------------------------------------------------------

    \273\ ICI ETF Statistics 2007, supra note 5.
    \274\ To estimate the number of new ETFs each year for purposes 
of this PRA, the staff has used the approximate average of the 
number of new ETFs for the past three years ((50 + 153 + 244)/3 
=149). ICI, Exchange-Traded Fund Assets December 2006, Jan. 31, 
2007; ICI ETF Statistics 2007, supra note 5.
    \275\ Assuming all existing ETFs would rely on the proposed 
rule, these estimates are based on the following calculations: ((206 
hours + 30) x 612 (existing plus estimated new index-based ETFs)) + 
(436 hours x 139 (existing plus estimated new actively managed ETFs) 
= 205,036).
    \276\ This estimate is based on the following calculation: (75 
hours x 75 (estimated new index-based ETFs)) + (175 hours x 75 
(estimated new actively managed ETFs)) = 18,750.
    \277\ This estimate is based on the following calculation: 
205,036 + 6250 = 211,286.
    \278\ These estimates are based on the following calculations: 
(($43,466 + $1704) x 612) + ($42,000 x 139) = $39,760,670; ($6000 x 
612) + ($6000 x 139) = $4,506,000.
    \279\ These estimates are based on the following calculations: 
($16,890 x 75) + (($16,890 + $22,520) x 75) = $4,222,500; ($9540 x 
75) + (($9540 + $12,600) x 75) = $2,376,000.
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B. Form N-1A

    We are proposing amendments to Form N-1A to provide more useful 
information to investors who purchase and sell ETF shares on national 
securities exchanges.
    Creation Units. The proposed amendments would permit an ETF to 
exclude certain information from its prospectus that is not pertinent 
to investors purchasing individual ETF shares. Specifically, an ETF 
that has creation units of 25,000 shares or more may exclude from its 
prospectus: (i) Information on how to purchase and redeem shares of the 
ETF; \280\ and (ii) fee table fees and expenses for purchases and 
redemptions of creation units.\281\ Based on conversations with 
industry representatives, Commission staff estimates that this proposed 
amendment would decrease the information collection burdens of an ETF 
that has creation units of 25,000 shares or more by an average of 1.4 
hours per fund per filing of an initial registration statement or post-
effective amendment to a registration statement.
---------------------------------------------------------------------------

    \280\ Proposed Item 6(h)(1) of Form N-1A.
    \281\ Proposed Instruction 1(e)(i) to Item 3 of Form N-1A.
---------------------------------------------------------------------------

    The proposed amendment also would require disclosures designed to 
include important information for purchasers of individual ETF shares, 
as described below. An ETF would have to modify the narrative 
explanation preceding the example in the fee table in its prospectus 
and periodic reports to state that fund shares are sold on the 
secondary market rather than redeemed at the end of the periods 
indicated, and that investors in ETF shares may be required to pay 
brokerage commissions that are not reflected in the fee table.\282\ We 
believe that the added information collection burdens associated with 
this statement, if any, would be negligible.
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    \282\ Proposed Instruction 1(e)(ii) to Item 3 of Form N-1A; 
Proposed Instruction 1(e)(ii) to Item 22(d) of Form N-1A. The 
proposal also would require each ETF to identify the principal U.S. 
market on which its shares are traded and include a statement to the 
effect that ETF shares are bought and sold on national securities 
exchanges. We believe that the added information collection burdens 
associated with these very brief and specific statements, if any, 
would be negligible.
---------------------------------------------------------------------------

    We request comment on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide data that would 
allow us to make more accurate estimates.
    Total Returns. The proposed amendments would require each ETF to 
include a separate line item for returns based on the market price of 
ETF shares in the average annual total returns table in Item 2 of the 
Form.\283\ This would codify, with modifications, a condition in ETF 
exemptive orders. The amendments also would require ETFs to calculate 
total return at market prices in addition to returns at NAV for their 
financial highlights tables.\284\ One consequence of this proposed 
amendment is that ETFs would be required to include two bar charts 
under Item 2 of Form N-1A; one using market price returns and one using 
NAV returns.\285\ We do not believe these added disclosures would 
increase the hourly burdens of ETFs. ETFs are currently required by our 
orders to calculate and present market price returns in the prospectus 
and, therefore, this disclosure would not present a new substantive 
requirement. The proposal would eliminate industry practice of 
including this disclosure in a supplemental section rather than the 
main body of the prospectus and, therefore, would integrate the 
disclosure within current Form N-1A requirements.\286\ Staff estimates 
that the time it takes to prepare the new line items and the additional 
bar chart would be the same as the amount of time ETFs currently spend 
preparing the market price return disclosure that is included in the 
supplemental section. Based on discussions with industry 
representatives, the staff estimates that each ETF currently spends 
approximately 0.6 hours of professional time to prepare the market 
price returns disclosure required by our exemptive orders.
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    \283\ Proposed Instruction 5(a) to Item 2(c)(2) of Form N 1A.
    \284\ Proposed Instruction 3(f) to Item 8(a) of Form N-1A.
    \285\ See Item 2(c)(2)(i) of Form N 1A.
    \286\ See supra note 163.
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    We request comment on this estimate. If commenters believe the 
estimate is not reasonable, we request they provide specific data that 
would allow us to make a more accurate estimate.
    Premium/Discount Information. The amendments also would require 
ETFs to include premium/discount information in both the prospectus and 
annual report of each ETF. This proposed amendment codifies an existing 
exemptive order requirement. Based on discussions with industry 
representatives, the staff estimates that each ETF currently spends an 
average of 0.5 hours per filing of an initial registration statement or 
a post-effective amendment to a registration statement to include this 
disclosure.\287\ The staff

[[Page 14645]]

further estimates that each ETF also would spend 0.5 hours per annual 
report to include this disclosure.
---------------------------------------------------------------------------

    \287\ This estimate is based on discussions with representatives 
of ETFs, which include premium/discount information as required by 
their exemptive orders.
---------------------------------------------------------------------------

    We request comment on this estimate. If commenters believe the 
estimate is not reasonable, we request they provide specific data that 
would allow us to make a more accurate estimate.
    Foreign Holidays. As noted above, proposed rule 6c-11 would require 
certain ETFs to disclose in their registration statements the foreign 
holidays that would prevent timely satisfaction of redemption. As of 
July 2007, there were 125 ETFs that provide exposure to international 
equity markets. Based on discussions with ETF representatives, the 
staff estimates that approximately 10% of these ETFs may need to delay 
satisfaction of redemption requests, and that each of those ETFs would 
spend approximately 0.3 hours to include the required information in 
its registration statement.
    We request comment on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide specific data 
that would allow us to make more accurate estimates.
    The current burden for preparing an initial Form N-1A filing is 
830.47 hours per portfolio. The current burden for preparing a post-
effective amendment on Form N-1A is 111 hours per portfolio. The total 
annual hour burden approved for Form N-1A is 1,575,184. Based on 
Commission filings, Commission staff estimates that on an annual basis, 
ETFs file initial registration statements covering 98 ETF portfolios, 
and post-effective amendments covering 1441 ETF portfolios on Form N-
1A. Based on staff estimates, we estimate that the proposed amendments 
would not increase the hour burden per ETF per filing on an initial 
registration or post-effective amendment to a registration 
statement.\288\ Therefore, if the proposed amendments to Form N-1A were 
adopted, we estimate that the total annual hour burden for all ETFs for 
preparation and filing of initial registration statements would remain 
the same.
---------------------------------------------------------------------------

    \288\ The proposed amendments would add approximately 1.4 hours 
(0.6 hours (total returns), 0.5 hours (premium/discount 
information), and 0.3 hours (foreign holidays)), which staff 
estimates would be offset by approximately 1.4 hours (elimination of 
description of creation units and associated fees).
---------------------------------------------------------------------------

    We request comment on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide specific data 
that would allow us to make more accurate estimates.

C. Proposed Rule 12d1-4

    Proposed rule 12d1-4 would permit an acquiring fund to acquire ETF 
shares in excess of the limits of section 12(d)(1) of the Act, subject 
to certain conditions.\289\ In order to rely on the proposed rule for 
an exemption from section 12(d)(1)(B) limits, an ETF may not redeem and 
its principal underwriter, a broker, or dealer may not submit for 
redemption any of the ETF's shares that were acquired by an acquiring 
fund in excess of the limits of section 12(d)(1)(A)(i) of the Act in 
reliance on proposed rule 12d1-4.\290\ The proposed rule provides a 
safe harbor for these entities if the entity has (i) received a 
representation from the acquiring fund that none of the ETF shares it 
is redeeming was acquired in excess of the limits of section 
12(d)(1)(A)(i) in reliance on the rule, and (ii) no reason to believe 
that the acquiring fund is redeeming any ETF shares that the acquiring 
fund acquired in excess of the limits of section 12(d)(1)(A)(i) in 
reliance on the rule.\291\ The representation required for the safe 
harbor would be a collection of information for purposes of the PRA.
---------------------------------------------------------------------------

    \289\ See discussion in Section IV.A-B supra.
    \290\ See proposed rule 12d1-4(b)(1).
    \289\ See proposed rule 12d1-4(b)(2).
---------------------------------------------------------------------------

    Our understanding is that acquiring funds that invest in ETFs 
generally do not redeem their shares from the ETF, but rather sell them 
in secondary market transactions. We also believe that an acquiring 
fund that would not rely on proposed rule 12d1-4 to acquire ETF shares 
(i.e., an acquiring fund that acquires 3 percent or less of an ETF's 
outstanding voting securities) would be less likely to redeem shares 
because it would be less likely to have a sufficient number of shares 
to permit the acquiring fund to redeem its shares.\292\ We estimate 
that ETFs, their principal underwriters, and brokers and dealers in the 
aggregate would choose to rely on the safe harbor to redeem or submit a 
redemption order with respect to ETF shares that were not acquired in 
reliance on proposed rule 12d1-4 on average two times each year with 
respect to each ETF.\293\
---------------------------------------------------------------------------

    \292\ ETF shares are redeemed only in creation unit 
aggregations. A creation unit typically consists of at least 25,000 
shares. See supra note 113.
    \293\ We recognize that some ETFs may receive more redemption 
requests from acquiring funds and may rely on the safe harbor more 
often, while other ETFs may receive no redemption requests or may 
not choose to rely on the safe harbor when they receive a redemption 
request from an acquiring fund.
---------------------------------------------------------------------------

    We request comment on this estimate. If commenters believe this 
estimate is not reasonable, we request they provide specific data that 
would allow us to make a more accurate estimate.
    There were 601 ETFs as of the end of December 2007.\294\ Based on 
our estimate, two acquiring funds each year would provide a 
representation to an ETF, its principal underwriter, a broker, or a 
dealer with respect to each ETF, for a total of 1202 representations. 
We estimate that each representation would take, on average no more 
than 0.2 hours to prepare and submit to the ETF, principal underwriter, 
broker, or dealer.\295\ Accordingly, we believe that the total annual 
collection of information burden for proposed rule 12d1-4 would be 240 
hours at a cost of $70,080.\296\
---------------------------------------------------------------------------

    \294\ ICI ETF Assets 2007, supra note 5.
    \295\ The proposed rule does not specify language that must 
appear in the representation. It simply requires the acquiring fund 
to represent that the shares submitted for redemption are not shares 
acquired in excess of the limits of section 12(d)(1)(A)(i) of the 
Act in reliance on proposed rule 12d1-4. Accordingly, we expect that 
while initial representations might take half an hour to draft, 
these representations would soon conform to an industry standard 
that would take no more than a few minutes to produce.
    \296\ These estimates are based on the following calculations: 
1202 representations x 0.2 hours = 240.4 hours; 240 hours x $292 
(hourly rate for a fund attorney) = $70,080.
---------------------------------------------------------------------------

    We request comment on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide specific data 
that would allow us to make more accurate estimates.

D. Request for Comments

    We request comment on whether these estimates are reasonable. 
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments 
in order to: (i) Evaluate whether the proposed collections of 
information are necessary for the proper performance of the functions 
of the Commission, including whether the information will have 
practical utility; (ii) evaluate the accuracy of the Commission's 
estimate of the burden of the proposed collections of information; 
(iii) determine whether there are ways to enhance the quality, utility, 
and clarity of the information to be collected; and (iv) minimize the 
burden of the collections of information on those who are to respond, 
including through the use of automated collection techniques or other 
forms of information technology.
    Persons wishing to submit comments on the collection of information 
requirements of the proposed amendments should direct them to the 
Office of Management and Budget, Attention Desk Officer for the 
Securities and Exchange Commission, Office of

[[Page 14646]]

Information and Regulatory Affairs, Room 10102, New Executive Office 
Building, Washington, DC 20503, and should send a copy to Nancy M. 
Morris, Secretary, Securities and Exchange Commission, 100 F Street, 
NE., Washington, DC 20549-1090, with reference to File No. S7-07-08. 
OMB is required to make a decision concerning the collections of 
information between 30 and 60 days after publication of this Release; 
therefore a comment to OMB is best assured of having its full effect if 
OMB receives it within 30 days after publication of this Release. 
Requests for materials submitted to OMB by the Commission with regard 
to these collections of information should be in writing, refer to File 
No. S7-07-08, and be submitted to the Securities and Exchange 
Commission, Public Reference Room, 100 F Street, NE., Washington, DC 
20549-1520.

VIII. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits imposed by 
its rules. As discussed above, the proposed rules and rule amendments 
would permit funds to engage in activities and transactions that are 
otherwise prohibited under the Act without the expense and delay of 
obtaining an individual exemptive order. Specifically, proposed rule 
6c-11 would permit ETFs to form and operate. Proposed rule 12d1-4 would 
permit a fund to invest in ETFs beyond the limits of section 12(d)(1) 
of the Act, and proposed amendments to rule 12d1-2 would expand the 
investment options available to funds that rely on the exemptive relief 
in section 12(d)(1)(G) of the Act. The proposed amendments to Form N-1A 
are designed to provide more useful information to investors who 
purchase and sell ETF shares on national securities exchanges, while 
simplifying the form by permitting most, if not all, ETFs to exclude 
information related to the purchase and redemption of creation 
units.\297\ This cost-benefit analysis examines the costs and benefits 
to ETFs, acquiring funds, and investors that would result from reliance 
on the proposed exemptive rules and rule and form amendments, in 
comparison to the costs and benefits associated with obtaining an 
exemptive order from the Commission.
---------------------------------------------------------------------------

    \297\ As noted above, information on how creation units are 
offered to the public is required to be disclosed in the SAI. Item 
18(a) of Form N-1A.
---------------------------------------------------------------------------

A. Rule 6c-11

1. Benefits
    Proposed rule 6c-11 would codify much of the relief and conditions 
of exemptive orders that we have issued to ETFs in the past.\298\ 
Proposed rule 6c-11 would require an ETF that relies on the proposed 
rule either to (i) disclose on its Internet Web site each business day 
the identities and weightings of the component securities and other 
assets held by the fund, or (ii) have a stated objective of obtaining 
results that correspond to the returns of a securities index whose 
index provider discloses on its Internet Web site the identities and 
weightings of the component securities and other assets of the 
index.\299\ An ETF that meets one of these requirements could redeem 
shares in creation unit aggregations, have its shares traded at current 
market prices, engage in in-kind transactions with certain affiliates, 
and in certain circumstances, redeem shares in more than seven 
days.\300\
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    \298\ The proposed rule does not codify exemptions previously 
provided to ETFs organized as UITs because the Commission has not 
received an exemptive application for a new ETF to be organized as a 
UIT since 2002. See discussion in Section III.A.3 of this release.
    \299\ Proposed rule 6c-11(e)(4)(v); see also discussion in 
Section III.B.1 of this release for a discussion of these 
conditions.
    \300\ Proposed rule 6c-11(a)-(d); see also discussion in Section 
III.C. of this release.
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    Elimination of Exemptive Order Costs. We anticipate that ETFs, 
their sponsors, and ETF investors would benefit from the proposed rule. 
ETFs and their sponsors increasingly have sought exemptive orders 
(which the Commission has granted) to form and operate as open-end 
management companies under the Act. The application process involved in 
obtaining exemptive orders imposes direct costs on ETFs and their 
sponsors, including preparation and revision of an application, as well 
as consultations with Commission staff. The proposed rule would benefit 
ETFs and their sponsors by eliminating the direct costs of applying to 
the Commission for an exemptive order to form and operate as permitted 
under the rule.\301\ The rule would further benefit ETFs and their 
sponsors by eliminating the uncertainty that a particular applicant 
might not obtain relief to form and operate as permitted under the 
rule. We anticipate that the elimination of the direct costs of 
exemptive applications also may benefit ETF investors by enabling ETFs 
to lower their costs as a result of lower start-up costs.
---------------------------------------------------------------------------

    \301\ The cost to an ETF for submitting an application ranges 
from approximately $75,000 to $350,000. These figures are based on 
conversations with attorneys and ETF employees who have been 
involved in submitting applications to the Commission.
---------------------------------------------------------------------------

    We seek comment on whether the elimination of these direct costs 
would result in additional benefits to ETFs or their investors. Are 
there other costs of the proposed rule that would offset any cost 
savings resulting from not having to file an exemptive application?
    The exemptive application process also involves other indirect 
costs. ETFs and their sponsors that apply for an order forgo potential 
market opportunities until they receive the order, while others forgo 
the market opportunity entirely rather than seek an exemptive order 
because they have concluded that the cost of seeking an exemptive order 
would exceed the anticipated benefit of the market opportunity.\302\ 
These direct and indirect costs currently may prevent smaller ETFs and 
their sponsors from coming to market because they have determined that 
the cost of an exemptive application may exceed the potential benefit. 
Eliminating these costs may allow more ETFs, particularly smaller ETFs, 
to come to market.
---------------------------------------------------------------------------

    \302\ The time involved in obtaining an order from the 
Commission ranges from several months to several years depending on 
the nature, complexity, and de novo consideration of the exemptions 
sought.
---------------------------------------------------------------------------

    We seek comment this analysis. Would removing the regulatory 
burdens facilitate greater innovation in the ETF market place, 
particularly with respect to smaller ETFs?
    Increased Investment Options. We expect that the proposed rule also 
would benefit ETF investors to the extent it would remove a possible 
disincentive for some ETFs and their sponsors to form and operate as 
open-end funds and provide investors with additional investment 
choices. As noted above, the direct and indirect costs of the exemptive 
application process may discourage potential sponsors, particularly 
smaller sponsors interested in offering smaller, more narrowly focused 
ETFs which may serve the particular investment needs of certain 
investors. By eliminating the need for individual exemptive relief, we 
anticipate that the proposed rule would, over time, lead to an increase 
in ETFs. In those circumstances, the proposed rule would provide ETF 
investors with greater investment choices, while also providing them 
with the protections afforded by the Investment Company Act.
    We seek comment on this analysis. Would the proposed rule result in 
increased investment options?
    Elimination of Certain Exemptive Order Terms. Proposed rule 6c-11 
also may benefit ETFs and their sponsors by eliminating certain terms 
contained in exemptive orders that we believe may be addressed by other 
provisions of the

[[Page 14647]]

federal securities laws. We propose to eliminate the terms designed to 
prevent the communication of material non-public information between 
the ETF and its affiliated index provider because we believe that there 
are sufficient requirements under federal securities laws and the rules 
of national securities exchanges to protect against the abuses the 
terms were intended to address.\303\ We anticipate that eliminating 
these regulatory burdens may reduce costs of operating an ETF and 
thereby facilitate greater competition and innovation among ETFs.
---------------------------------------------------------------------------

    \303\ See Section III.B.4 of this release for a discussion of 
this condition.
---------------------------------------------------------------------------

    We request comment on this analysis. Are there any costs associated 
with eliminating these terms?
2. Costs
    We do not expect the proposed rule would impose mandatory costs on 
any ETF. As discussed above, the proposed rule is exemptive, and we 
expect that a fund would not operate as an ETF in reliance on the rule 
if the anticipated benefits did not justify the costs. We expect the 
costs of relying on the proposed rule are likely to be the same as or 
less than the costs to an ETF that relies on an existing exemptive 
order because the proposed rule includes the same or fewer conditions 
than existing orders that provide equivalent exemptive relief.
    The proposed rule would affect different types of ETFs and their 
sponsors in different ways. A sponsor or adviser that has not sought 
and would not seek exemptive relief to form and operate an ETF 
registered under the Act would not be affected by the rule. For an ETF 
and its sponsor that currently rely on an exemptive order, there may be 
one-time ``learning costs'' in determining the differences between the 
order and rule. After making this determination, we expect that the 
costs for this ETF would be the same as or less than the costs of 
relying on its exemptive order because the rule contains the same or 
fewer conditions than existing orders. In addition, an ETF and its 
sponsor that currently rely on an exemptive order could generally 
satisfy all the conditions of the rule that provide similar exemptive 
relief without changing its operation. Finally, a sponsor that has not 
relied on an exemptive order and that intends to rely on the proposed 
rule would bear the same or lower continuing costs of complying with 
conditions that it would have borne had it obtained an exemptive order. 
In that case, its total costs are likely to have been the same as or 
greater than the costs associated with the proposed rule.
    We request comment on this analysis. Would ETFs that currently rely 
on an order bear lower costs if they relied on the proposed rule? Would 
an ETF have to change its operation in any way to comply with the 
proposed rule?
    Prospectus Delivery. The proposed rule does not provide an 
exemption from prospectus delivery that most ETFs and their sponsors 
have requested and we have provided in our orders. Most of our orders 
have exempted broker-dealers selling ETF shares from the obligation to 
deliver prospectuses in most secondary market transactions.\304\ Those 
applicants have represented that broker-dealers would instead deliver a 
``product description'' containing basic information about the ETF and 
its shares.\305\ Because proposed rule 6c-11 would not contain a 
similar exemption, broker-dealers would be required to deliver a 
prospectus meeting the requirements of section 10 of the Securities Act 
to investors purchasing ETF shares.\306\ We believe an exemption 
allowing broker dealers to deliver product descriptions would be 
unnecessary given our proposal regarding summary prospectus disclosure. 
If we adopt the Enhanced Disclosure Proposing Release, broker-dealers 
selling ETF shares could deliver a summary prospectus in secondary 
market transactions.\307\ Although there may be costs associated with 
printing and delivering prospectuses to secondary market purchasers, we 
expect these costs to be minimal. We understand that many, if not most, 
broker-dealers selling ETF shares in secondary market transactions, in 
fact, transmit a prospectus to purchasers, and thus they may not have 
relied on the exemptions provided in the orders. In addition, we 
anticipate these costs could be offset by the fact that the ETFs would 
not have to prepare product descriptions and by the simplified 
prospectus disclosure in this proposal.\308\
---------------------------------------------------------------------------

    \304\ The orders have granted exemptions from section 24(d) of 
the Act, which makes inapplicable the dealer exception in section 
4(3) of the Securities Act to transactions in redeemable securities 
issued by an open-end investment company. 15 U.S.C. 80a-24(d); 15 
U.S.C. 77d(3); see, e.g., WisdomTree Order, supra note 12. ETFs that 
have this exemption, however continue to be subject to prospectus 
delivery requirements in connection with sales of creation units and 
other non-secondary market transactions. Our most recent orders, 
however, do not provide an exemption from prospectus delivery 
requirements. See Actively Managed ETF Orders, supra note 20.
    \305\ See, e.g., Ziegler Notice, supra note 110. The product 
description provides a summary of the salient features of the ETF 
and its shares, including the investment objectives of the fund, the 
manner in which ETF shares trade on the secondary market, and the 
manner in which creation units are purchased and redeemed. National 
securities exchanges on which ETFs are listed have adopted rules 
requiring the delivery of product descriptions. See, e.g., American 
Stock Exchange Rules 1000 and 1000A.
    \306\ 15 U.S.C. 77j. We also are proposing to amend our orders 
to exclude the section 24(d) exemption we have issued to existing 
ETFs. Accordingly, the prospectus delivery requirement would apply 
to all ETFs, including ETFs operating under current exemptive 
orders. See supra Section III.E for a discussion of this proposed 
amendment to existing orders.
    \307\ See supra notes 145-152 and accompanying text. The summary 
prospectus would contain material information that may not appear in 
a product description, but like a product description, would be in a 
form that would be easy to use and readily accessible.
    \308\ The preparation of a product description can cost 
approximately $360 to $11,000 per ETF. These figures are based on 
conversations with attorneys and ETF employees.
---------------------------------------------------------------------------

    We anticipate that any cost associated with this requirement may be 
justified by the benefits to ETF investors. Prospectuses provide ETF 
investors with standardized information about an investment in an ETF 
and the differences between an ETF and a traditional mutual fund. 
Because prospectuses are standardized forms the content of which has 
been prescribed by the Commission, their delivery could promote greater 
uniformity in the content and level of disclosure among existing and 
future ETFs. Finally, our proposed amendments to the prospectus should 
provide more useful information to investors who purchase and sell ETF 
shares on a national securities exchange, while simplifying 
prospectuses by permitting ETFs to exclude information related to the 
purchase and redemption of creation units.
    We request comment on this analysis. Are we correct in assuming 
that prospectus delivery costs would be offset by the elimination of 
product descriptions?
    Conditions. All ETFs seeking to rely on the rule would have to be 
listed on an exchange that disseminates the per share NAV of the ETFs' 
baskets at regular intervals. This condition was included in our 
exemptive orders and, therefore, should not result in an increased cost 
to existing ETFs. Each ETF also must, in any sales literature (as 
defined in the rule), identify itself as an ETF, which does not sell or 
redeem individual shares, and explain that investors may purchase or 
sell individual shares on national securities exchanges. This condition 
is similar to one included in our exemptive orders and, therefore, 
should not result in an increased cost to existing ETFs. In addition, 
the ETF would be required either to (i) disclose on its Internet Web

[[Page 14648]]

site each business day the identities and weightings of the component 
securities and other assets held by the fund, or (ii) have a stated 
objective of obtaining results that correspond to the returns of a 
securities index whose index provider discloses on its Internet Web 
site the identities and weightings of the component securities and 
other assets of the index.\309\ Index-based ETFs comply with the latter 
requirement and, therefore, this condition should not result in an 
increased cost to ETFs that would track a transparent index. ETFs that 
choose to rely on the former condition, including the actively managed 
ETFs subject to the recent exemptive orders we issued, would incur 
costs in connection with developing a Web page for this disclosure and 
updating the disclosure daily.\310\ We expect these costs to be of the 
same magnitude as the costs borne by index providers in making their 
indexes transparent. Although this may be a reallocation of costs from 
index providers to those ETFs that choose to fully disclose their 
portfolios, we do not believe that this change would significantly 
affect the costs borne by ETF investors. The new disclosure costs for 
ETFs that choose to disclose their portfolios rather than track a 
transparent index would be offset by the lack of index licensing fees 
that are generally charged to index-based ETFs.
---------------------------------------------------------------------------

    \309\ Proposed rule 6c-11(e)(4)(iv).
    \310\ For purposes of the Paperwork Reduction Act, the staff 
estimated that each ETF would spend approximately $22,520 to develop 
the Web site. The staff also estimates that each ETF would spend 200 
hours annually to update the site daily. See supra notes 267-268 and 
accompanying text.
---------------------------------------------------------------------------

    We request comment on whether investors in an actively managed ETF 
would incur any additional costs as a result of the portfolio 
disclosure. We also request comment on our analysis.

B. Amendments to Form N-1A

1. Benefits
    As discussed above, most of our orders have exempted broker-dealers 
selling ETF shares from the obligation to deliver prospectuses in 
secondary market transactions. Applicants for those orders have 
represented that they would instead require that broker-dealers deliver 
a product description containing basic information about the ETF and 
its shares. We are not including a similar exemption in proposed rule 
6c-11, and thus a broker-dealer would be required to deliver a 
prospectus meeting the requirements of section 10 of the Securities Act 
to investors purchasing ETF shares. In light of this requirement, we 
also are proposing amendments to Form N-1A, and the summary prospectus, 
designed to meet the needs of investors (including retail investors) 
who purchase shares in the secondary market rather than institutional 
investors purchasing creation units from the ETF.
    Material Information to ETF Investors. We expect that the primary 
benefit of our proposed amendments would be to provide ETF investors 
purchasing shares in the secondary market with information on the 
investment that currently is not included in product descriptions, such 
as the fund's fee table and the name and length of service of the 
portfolio manager. This should provide ETF investors with information 
necessary to understand an investment in an ETF. This information also 
may be helpful to investors in making portfolio allocation decisions.
    Simplified Disclosure. Our proposed amendments are designed to 
simplify prospectus and periodic report disclosure in two ways. First, 
the proposal would allow ETFs to exclude from the prospectus 
information on how to purchase and redeem creation units, including 
information on fees and expenses associated with creation unit sales or 
purchases. Current ETF prospectuses and periodic reports include 
detailed information on how to purchase and redeem creation units. The 
fee table and example include information on transaction fees payable 
only by creation unit purchasers. Our proposed amendments would permit 
ETFs with creation units of at least 25,000 shares to exclude this 
information because it is not relevant (and potentially confusing) to 
investors purchasing in secondary market transactions.\311\ This 
proposed provision should simplify ETF prospectuses without 
compromising the disclosure provided to investors who purchase ETF 
shares in secondary market transactions.
---------------------------------------------------------------------------

    \311\ See supra notes 158-161 and accompanying text for a 
discussion of this proposed amendment.
---------------------------------------------------------------------------

    Second, the proposed amendment would incorporate current disclosure 
requirements mandated by our exemptive orders into the prospectus 
instead of in a supplemental section where ETFs currently locate it. 
Our exemptive orders require ETFs to include in their prospectuses and 
annual reports returns based on market price in addition to returns 
based on NAV, which as discussed above, may be different than the 
fund's NAV and better relate to an ETF investor's experience in the 
fund.\312\ The condition in our exemptive orders did not specify where 
this information must be located in the prospectus. As a result, ETFs 
have included an additional table in the prospectus, rather than 
including market price returns in the average annual returns table 
required by Item 2 of the Form. The lack of specificity also resulted 
in ETFs using different time periods for the disclosure, with some 
using calendar years and others fiscal years. The proposed amendment 
would eliminate use of a second table, which may confuse investors. It 
also would require all ETFs to present the information using calendar 
years, standardizing the reporting period used by ETFs. The proposed 
amendments would mandate uniform disclosure in the prospectus, which 
should benefit investors by allowing them to compare ETFs more easily.
---------------------------------------------------------------------------

    \312\ See supra notes 163-165 and accompanying text for a 
discussion of this proposed amendment.
---------------------------------------------------------------------------

    Similarly, our exemptive orders required ETFs to include in their 
prospectuses and annual reports premium/discount information to alert 
investors of the extent and frequency with which market prices deviated 
from the fund's NAV.\313\ ETFs have generally included this information 
in a supplemental section of the prospectus and annual report.\314\ The 
proposed amendments would incorporate this disclosure in the 
Shareholder Information section (Item 6 of Form N-1A) of the prospectus 
and the Management's Discussion of Fund Performance (Item 22(b)(7) of 
the annual report). We anticipate that this would benefit ETF investors 
by simplifying the prospectuses and annual reports of ETFs while 
codifying important disclosures mandated by our exemptive orders.
---------------------------------------------------------------------------

    \313\ See supra notes 166-170 and accompanying text for a 
discussion of this proposed amendment.
    \314\ See e.g., iShares MSCI Series, Prospectus 62-65 (Jan. 1, 
2007); iShares MSCI Series, 2006 Shareholders Annual Report 130-136 
(Aug. 31, 2006).
---------------------------------------------------------------------------

2. Costs
    The primary goal of our proposed amendments is to provide investors 
in ETF shares with more valuable information regarding an investment in 
an ETF. We do not expect that the proposed amendments would result in 
significant additional costs to ETFs.\315\ As noted above, our proposed 
disclosure amendments generally would codify disclosure requirements in 
existing ETF exemptive orders. To the extent the proposed amendments

[[Page 14649]]

contain new disclosure requirements, such as, for example, the 
requirement that ETFs include market price returns in addition to NAV 
returns in Item 8 of Form N-1A, any costs related to these additional 
disclosures should be offset by our proposal to exempt ETFs with 
creation units of 25,000 or more shares from including creation unit 
purchase and redemption information in their prospectuses and annual 
reports. Most, if not all ETFs, would be able to rely on this 
exemption.\316\ We anticipate that future ETFs would offer creation 
units of 25,000 shares or more.
---------------------------------------------------------------------------

    \315\ Existing ETFs would face a one-time ``learning cost'' to 
determine the difference between the current Form N-1A requirements 
as modified by their exemptive orders and the proposed amendments. 
We do not anticipate that this cost would be significant given the 
similarity of the amendments to the conditions in existing exemptive 
orders.
    \316\ Existing ETFs typically offer creation units of 50,000 or 
more shares, and the lowest number of shares permitted under current 
exemptive orders is 25,000
---------------------------------------------------------------------------

    We request comment on this assumption. If ETFs are likely to offer 
smaller creation units, what is the fewest number of shares likely to 
be offered in a creation unit?
    In addition to codifying disclosure requirements of existing 
exemptive orders, we are proposing several new disclosure requirements 
in Form N-1A. First, we propose to require that ETFs include an 
additional total return calculation under Item 8 using market price 
returns, which would result in an additional bar chart under Item 
2(c)(2)(i) of Form N-1A.\317\ Because most ETFs currently calculate and 
present market price returns in the prospectus pursuant to their 
exemptive orders, this additional bar chart should result in minimal 
additional costs because it only requires duplicating the presentation 
of information in another location. Second, we would require an index-
based ETF to compare its performance to its underlying index rather 
than a benchmark index.\318\ This amendment would permit use of a 
narrow-based or affiliated index and eliminate the opportunity for an 
index-based ETF to select an index different from its underlying index, 
which would better reflect whether the ETF's performance corresponds to 
the index which performance it seeks to track. This amendment replaces 
the type of index used to present performance data currently required 
under Form N-1A and, therefore, should not increase the compliance 
burden for ETFs. Finally, we would require each ETF to identify the 
principal U.S. market on which its shares are traded and include a 
statement to the effect that ETF shares are bought and sold on national 
securities exchanges and that ETF investors trading in these exchanges 
may be required to pay brokerage commissions.\319\ Including these 
additional statements should present minimal, if any, printing costs.
---------------------------------------------------------------------------

    \317\ See supra note 163.
    \318\ See supra notes 173-174 and accompanying text.
    \319\ See supra note 161 and note 282 and accompanying text.
---------------------------------------------------------------------------

    As noted above, any additional costs incurred by an ETF in 
complying with these additional disclosures should be offset by the 
cost-savings of our proposal, which would allow most, if not all, ETFs 
to exclude creation unit purchase and redemption information in their 
prospectuses.\320\
---------------------------------------------------------------------------

    \320\ For purposes of our Paperwork Reduction Act analysis, we 
have estimated that our proposed amendments would not change the 
current Form N-1A compliance costs. See supra discussion at Section 
VII of this release.
---------------------------------------------------------------------------

C. Rule 12d1-4

1. Benefits
    Proposed rule 12d1-4 would codify much of the relief in orders that 
we have issued permitting funds to invest in ETFs beyond the limits of 
section 12(d)(1), while eliminating most of the conditions included in 
the orders. Proposed rule 12d1-4 would permit fund investments in ETFs 
beyond the limits of section 12(d)(1) if: (i) The acquiring fund (and 
any entity in a control relationship with the acquiring fund) could not 
control the ETF; \321\ (ii) the acquiring fund does not redeem certain 
shares acquired in reliance on the rule; \322\ (iii) the fees charged 
by the acquiring fund do not exceed the FINRA sales charge limits; 
\323\ and (iv) the acquired ETF is not itself a fund of funds (i.e., 
the rule would prohibit a fund of funds of funds, or three-tier fund, 
structure).\324\ In addition, an ETF could not redeem and its principal 
underwriter, a broker or a dealer could not submit an order for 
redemption of certain shares acquired by an acquiring fund in reliance 
on proposed rule 12d1-4.\325\ The rule provides a safe harbor for any 
of those entities if it has: (i) A representation from an acquiring 
fund that none of the shares to be redeemed was acquired in excess of 
the limits of section 12(d)(1)(A)(i) of the Act in reliance on proposed 
rule 12d1-4; and (ii) no reason to believe that the shares to be 
redeemed were acquired in excess of the limits of section 
12(d)(1)(A)(i) in reliance on the proposed rule.\326\
---------------------------------------------------------------------------

    \321\ Proposed rule 12d1-4(a)(1). See supra notes 215-219 and 
accompanying text for a discussion of the proposed condition.
    \322\ Proposed rule 12d1-4(a)(2) See supra note 220 and 
accompanying and following text for a discussion of the proposed 
condition.
    \323\ Proposed rule 12d1-4(a)(3). See supra notes 230-233 and 
accompanying text for a discussion of the proposed condition. Unlike 
the orders, however, the proposed rule would not require directors 
to make any special findings that investors are not paying multiple 
advisory fees for the same services.
    \324\ Proposed rule 12d1-4(a)(4). See supra notes 225-229 and 
accompanying text for a discussion of the proposed condition.
    \325\ Proposed rule 12d1-4(b)(1). See supra note 221 and 
accompanying text for a discussion of the proposed condition.
    \326\ Proposed rule 12d1-4(b)(2). See supra note 222 and 
accompanying text for a discussion of the proposed safe harbor.
---------------------------------------------------------------------------

    We anticipate that acquiring funds, acquired ETFs, investment 
advisers, and shareholders of both acquiring funds and acquired ETFs 
would benefit from the proposed rule. Acquiring funds would be able to 
purchase and ETFs would be able to sell ETF shares beyond the limits of 
section 12(d)(1) without obtaining an exemptive order, which can be 
costly to ETFs and their shareholders.\327\ The exemptive application 
process also involves other indirect costs. ETFs that apply for an 
order to permit other funds to make additional investments in the ETFs 
beyond the limits of section 12(d)(1) and funds that would rely on the 
order issued to the ETF forgo potentially beneficial investments until 
the ETFs receive the order,\328\ while other ETFs (and funds that would 
rely on the order if issued to the ETF) forgo the investment entirely 
rather than seek an exemptive order because they have concluded that 
the cost of seeking an exemptive order would exceed the anticipated 
benefit of the investment.
---------------------------------------------------------------------------

    \327\ We estimate, based on discussions with fund 
representatives, that the cost of obtaining an exemptive order 
permitting an acquiring fund to invest in an ETF beyond the limits 
of section 12(d)(1) ranges from approximately $75,000 to $200,000.
    \328\ Although these applications for relief are typically 
processed expeditiously, Commission staff estimates, based on orders 
issued in the past, that the exemptive application process (from 
initial filing to issuance of order) has taken on average about 15 
months. During that time, Commission staff review and comment on 
applications, applicants submit responses to comments, and the 
completed application is summarized in a notice to the public. If an 
application contains a request for relief in addition to the relief 
from section 12(d)(1) of the Act, the application process has often 
taken longer than 15 months.
---------------------------------------------------------------------------

    Unlike the orders, proposed rule 12d1-4 would not provide an 
exemption permitting acquiring funds to redeem ETF shares acquired in 
excess of the three percent limit in section 12(d)(1)(A)(i) of the Act 
in reliance on the proposed rule. This was designed to limit the 
potential for an acquiring fund to threaten large-scale redemptions as 
a means of coercing an ETF.\329\ Accordingly, the conditions in the 
proposed rule differ from those in the exemptive orders. The proposed 
rule would not include: (i) The participation agreement requirement; 
(ii) the transmission by an acquiring fund of a

[[Page 14650]]

list of certain of its affiliates to the ETF; (iii) certain policies 
and procedures designed to limit the influence an acquiring fund can 
exert on the ETF; and (iv) limits on certain fees. Elimination of these 
conditions would reduce regulatory burdens and the cost of compliance 
for funds that seek to invest in ETFs, facilitating greater 
participation by funds in the purchase and sale of ETF shares both 
directly with the ETF and in secondary market transactions.\330\ 
Although the proposed rule would not allow acquiring funds to redeem 
certain shares from the ETF, we understand that acquiring funds 
generally sell ETF shares in secondary market transactions, rather than 
redeem them. Accordingly, we believe that this prohibition would have 
minimal impact on acquiring funds. Moreover, the adoption of proposed 
rule 12d1-4 would not preclude an acquiring fund from continuing to 
rely on exemptive orders we have previously issued or seeking new 
orders to permit funds to invest in ETFs in excess of the limits of 
section 12(d)(1) but which do not restrict their ability to redeem ETF 
shares, subject to the conditions set forth in the orders and described 
above.
---------------------------------------------------------------------------

    \329\ See supra note 220 and accompanying and following text.
    \330\ Based on discussions with fund representatives, we 
estimate that the cost of negotiating and entering into a 
participation agreement (and for an acquiring fund preparing the 
initial list of affiliates) required by our exemptive orders ranges 
from approximately $5,000 to $10,000. We estimate that the cost to 
an acquiring fund to review and update its list of affiliates each 
year as required by our exemptive orders ranges from approximately 
$4,000 to $15,000.
---------------------------------------------------------------------------

    In order to allow acquiring funds to take full advantage of the 
exemptive relief, proposed rule 12d1-4 also would provide limited 
relief from rule 17e-1 under the Act. If an investment company in one 
complex acquired more than five percent of the assets of an ETF in 
another complex, any broker-dealer affiliated with that ETF would 
become a (second-tier) affiliated person of the acquiring fund.\331\ As 
a result of the affiliation, the broker-dealer's fee for effecting the 
sale of securities to (or by) the acquiring fund would be subject to 
the conditions set forth in rule 17e-1, including the quarterly board 
review and recordkeeping requirements with respect to certain 
securities transactions involving the affiliated broker-dealer.\332\ 
The proposed rule would permit an acquiring fund to pay commissions, 
fees, or other remuneration to a (second-tier) affiliated broker-dealer 
without complying with the quarterly board review and recordkeeping 
requirements set forth in rules 17e-1(b)(3) and 17e-1(d)(2).\333\ This 
relief would be available only if the broker-dealer and the acquiring 
fund became affiliated solely because of the acquiring fund's 
investment in the ETF. We believe that this relief would enable more 
funds to take advantage of the exemption provided by the proposed rule.
---------------------------------------------------------------------------

    \331\ See supra note 239.
    \332\ See supra note 245.
    \333\ See supra note 247 and accompanying text.
---------------------------------------------------------------------------

2. Costs
    We do not believe that the rule will impose mandatory costs on any 
fund. As discussed above, the rule is exemptive, and we believe that a 
fund would not rely on it if the anticipated benefits did not justify 
the costs. We believe the costs of relying on the rule would be less 
than the costs to an acquiring fund (and ETF) that relies on an 
existing exemptive order to invest in (or sell) ETF shares because the 
rule includes substantially fewer conditions than existing orders that 
provide similar exemptive relief with respect to purchases and sales of 
ETF shares.
    In order to rely on the proposed rule for an exemption from section 
12(d)(1)(B) limits, an ETF may not redeem and its principal 
underwriter, or a broker or dealer may not submit for redemption any of 
the ETF's shares that were acquired by an acquiring fund in excess of 
the limits of section 12(d)(1)(A)(i) of the Act in reliance on proposed 
rule 12d1-4.\334\ The proposed rule provides a safe harbor for these 
entities if the entity has (i) received a representation from the 
acquiring fund that none of the ETF shares it is redeeming was acquired 
in excess of the limits of section 12(d)(1)(A)(i) in reliance on the 
rule, and (ii) no reason to believe that the acquiring fund is 
redeeming any ETF shares that the acquiring fund acquired in excess of 
the limits of section 12(d)(1)(A)(i) in reliance on the rule.\335\
---------------------------------------------------------------------------

    \334\ See proposed rule 12d1-4(b)(1).
    \335\ See proposed rule 12d1-4(b)(2). We believe that the costs 
associated with this safe harbor would not be significant. Only 
acquiring funds that intend to redeem less than three percent of an 
ETF's shares could provide the representations required under the 
safe harbor.
---------------------------------------------------------------------------

    As noted above, we understand that acquiring funds that invest in 
ETFs generally do not redeem their shares from the ETF, but rather sell 
them in secondary market transactions. We also believe that an 
acquiring fund that would not rely on proposed rule 12d1-4 to acquire 
ETF shares (i.e., an acquiring fund that acquires 3 percent or less of 
an ETF's outstanding voting securities) would be less likely to redeem 
shares because it would be less likely to have a sufficient number of 
shares to permit the acquiring fund to redeem its shares.\336\ We 
estimate that ETFs, their principal underwriters, and brokers and 
dealers in the aggregate would choose to rely on the safe harbor to 
redeem or submit a redemption order with respect to ETF shares that 
were not acquired in reliance on proposed rule 12d1-4 on average two 
times each year with respect to each ETF.\337\ We believe that the 
total annual cost for making this representation would be $70,080.\338\
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    \336\ ETF shares are generally redeemed only in creation unit 
aggregations. A creation unit typically consists of at least 25,000 
shares. See supra note 113.
    \337\ We recognize that some ETFs may receive more redemption 
requests from acquiring funds and may rely on the safe harbor more 
often, while other ETFs may receive no redemption requests or may 
not choose to rely on the safe harbor when they receive a redemption 
request from an acquiring fund.
    \338\ See supra notes 294-296 and accompanying text.
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    We request comment on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide specific data 
that would allow us to make more accurate estimates.
    The rule would affect different types of sponsors or advisers in 
different ways. A sponsor or adviser that has not sought and would not 
seek exemptive relief to permit another fund to invest in its shares 
beyond the limits of section 12(d)(1) of the Act would not be affected 
by the rule. The cost for a sponsor or adviser that currently relies on 
exemptive relief covered by the rule would be less than the costs of 
relying on its exemptive order because the proposed rule contains 
substantially fewer conditions than existing orders. In addition, a 
sponsor or adviser that currently relies on an exemptive order could 
satisfy all the conditions of the proposed rule that provides similar 
exemptive relief with respect to purchases and sales of ETF shares 
without changing its operation. Finally, a sponsor or adviser that has 
not relied on an exemptive order and that intends to rely on the 
proposed rule would avoid the cost of obtaining an exemptive order and 
would incur lower continuing costs to comply with the conditions 
included in the proposed rule than it would have borne had it obtained 
an exemptive order.

D. Amendments to Rule 12d1-2

1. Benefits
    The proposed amendments to rule 12d1-2 would expand the type of 
investments that funds relying on the exemptive relief in section 
12(d)(1)(G) of the Act could make. The proposed amendments would allow 
acquiring funds that invest in affiliated funds in

[[Page 14651]]

reliance on section 12(d)(1)(G) to invest in unaffiliated ETFs beyond 
the statutory limitations as long as the funds comply with the 
conditions of proposed rule 12d1-4.\339\ We also propose to amend rule 
12d1-2 to allow funds relying on section 12(d)(1)(G) to invest in 
assets other than securities.\340\ Under the proposed rule, funds 
relying on the exemptive relief in section 12(d)(1)(G) would be able to 
invest in, among other things, futures contracts, options, swaps, other 
derivative investments, and other financial instruments that do not 
qualify as a security under the Act. Those investments would, of 
course, have to be consistent with the fund's investment policies.\341\ 
We believe that including these types of investment opportunities would 
permit funds to allocate their investments more efficiently.
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    \339\ Proposed rule 12d1-2(a)(4).
    \340\ Proposed rule 12d1-2(a)(5).
    \341\ See Item 4 of Form N-1A (requiring disclosure of funds' 
investment objectives and principal investment strategies).
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2. Costs
    Rule 12d1-2 (and the proposed amendments to the rule) does not 
impose any conditions on its reliance and thus a fund would not incur 
any costs in relying on the rule.

E. Request for Comment

    The Commission requests comment on the potential costs and benefits 
of the proposed rules and rule amendments. We also request comment on 
the potential costs and benefits of any alternatives suggested by 
commenters. We encourage commenters to identify, discuss, analyze, and 
supply relevant data regarding any additional costs and benefits. For 
purposes of the Small Business Regulatory Enforcement Act of 1996,\342\ 
the Commission also requests information regarding the potential annual 
effect of the proposals on the U.S. economy. Commenters are requested 
to provide empirical data to support their views.
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    \342\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

IX. Consideration of Promotion of Efficiency, Competition and Capital 
Formation

    Section 2(c) of the Investment Company Act requires the Commission, 
when engaging in rulemaking that requires it to consider or determine 
whether an action is consistent with the public interest, to consider, 
in addition to the protection of investors, whether the action will 
promote efficiency, competition, and capital formation.\343\
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    \343\ 15 U.S.C. 80a-2(c).
---------------------------------------------------------------------------

A. Proposed Rules 6c-11

    Proposed rule 6c-11 would codify much of the relief and conditions 
of exemptive orders that we have issued to ETFs. The rule would provide 
relief to ETFs by permitting an ETF to operate without first obtaining 
an exemptive order from the Commission. As noted above, the direct and 
indirect costs of the exemptive application process may discourage 
potential ETF sponsors. The proposed rule also would not include 
conditions contained in exemptive orders designed to address particular 
concerns that we now believe are addressed by other provisions of the 
federal securities laws.\344\ Eliminating the need for individual 
exemptive relief and compliance with specific conditions may reduce 
costs of introducing and operating an ETF, and may permit additional 
opportunities for sponsors to introduce new ETFs, particularly smaller 
sponsors interested in offering smaller, more narrowly focused ETFs 
which may serve particular investment needs of certain investors. We 
therefore anticipate that the proposed rule would, over time, lead to 
an increase in ETFs.
---------------------------------------------------------------------------

    \344\ See supra Section III.B.5. of this release for a 
discussion of these conditions.
---------------------------------------------------------------------------

    We expect that the proposal is likely to increase competition and 
efficiency. By making it easier for sponsors, particularly smaller 
sponsors, to introduce ETFs, the proposal should allow more sponsors to 
enter the marketplace, thereby increasing competition among ETF 
sponsors. The resulting increase in ETFs that we expect also should 
increase competition and innovation among funds. The proposal also 
should promote efficiency because the increase in ETFs should provide 
investors with more investments that may be specifically tailored to 
their particular investment objectives. We do not expect the proposed 
rule would have an adverse impact on capital formation.

B. Amendments to Form N-1A

    The proposed amendments to Form N-1A are designed to provide more 
useful information to investors (including retail investors) who 
purchase shares in the secondary market, rather than institutional 
investors purchasing creation units from the ETF. The proposed 
amendments would require ETFs, in addition to providing returns based 
on NAV, to include returns based on the market price of fund shares, 
and to disclose in the ETF prospectus the number of trading days on 
which the market price of the ETF shares was greater than the ETF's NAV 
and the number of days it was less than the ETF's NAV (premium/discount 
information). This information should promote more efficient allocation 
of investments by investors and more efficient allocation of assets 
among competing ETFs because investors may compare and choose ETFs 
based on their market returns and deviations from NAV more easily. 
These amendments also should improve competition because they may 
prompt sponsors to launch ETFs that provide improved market price 
returns or lesser premiums/discounts. We do not believe the proposed 
amendments would have an adverse impact on capital formation.

C. Proposed Rule 12d1-4 and Amendments to Rule 12d1-2

    Proposed rule 12d1-4 and the proposed amendments to rule 12d1-2 
would expand the circumstances in which funds can invest in ETFs 
without the ETF first obtaining an exemptive order from the Commission, 
which can be costly and time-consuming. We anticipate that the proposed 
rule and amendments would promote efficiency and competition. Proposed 
rule 12d1-4 would permit funds to acquire shares of ETFs in excess of 
the limitations in section 12(d)(1) of the Act. This exemption should 
allow acquiring funds to allocate their investments more efficiently by 
expanding their investment options to include holdings in ETFs beyond 
the limits of section 12(d)(1) in order to meet the funds' investment 
objectives. We also anticipate that the proposed rule would promote 
efficiency because permitting funds to buy creation units might benefit 
other ETF investors buying and selling ETF shares in secondary market 
transactions by increasing the number of institutional investors 
participating in the arbitrage process. The proposed rule might promote 
competition by increasing the pool of ETFs that accept investments by 
other funds beyond section 12(d)(1) limits. Proposed rule 12d1-4 would 
eliminate the need for ETFs to obtain an exemptive order from the 
Commission, the cost of which might discourage ETFs, particularly 
smaller ETFs, from accepting or seeking fund investments beyond section 
12(d)(1) limits.\345\
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    \345\ As noted above, the proposed rule also would not 
incorporate many of the conditions contained in our exemptive 
orders. The compliance costs of such conditions might otherwise 
discourage ETFs, particularly small ETFs, from accepting or seeking 
fund investments beyond section 12(d)(1) limits. See supra note 330 
and accompanying and following text. By eliminating most of the 
conditions from our exemptive orders, more ETFs may accept and seek 
fund investments in their shares.

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[[Page 14652]]

    The proposed rule would provide relief from section 17(e) for funds 
that execute transactions with certain broker-dealers affiliated with 
ETFs in which the acquiring funds invest. This relief, which is not 
included in our exemptive orders, should allow more funds to take full 
advantage of the exemption provided by the rule, thereby increasing the 
potential that the proposed rule would promote efficiency and 
competition.\346\
---------------------------------------------------------------------------

    \346\ See supra Section IV.C.3 for a discussion of the proposed 
exemption.
---------------------------------------------------------------------------

    The proposed amendments to rule 12d1-2 expand the investment 
options for funds that rely on the exemption in section 12(d)(1)(G) of 
the Act to include investments in unaffiliated ETFs beyond the section 
12(d)(1) limits and assets other than securities. This expansion of 
investment opportunities could permit funds to allocate their 
investments more efficiently. This may allow a fund to compete more 
effectively. We do not expect that proposed rule 12d1-4 or the proposed 
amendments to rule 12d1-2 would have an adverse impact on capital 
formation.\347\
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    \347\ While proposed rule 12d1-4 may result in additional 
investments in ETFs, we do not anticipate that the rule would have a 
significant impact on capital formation.
---------------------------------------------------------------------------

X. Initial Regulatory Flexibility Analysis

    This Initial Regulatory Flexibility Analysis (``IRFA'') has been 
prepared in accordance with 5 U.S.C. 603. It relates to proposed new 
rules 6c-11 and 12d1-4 and proposed amendments to rule 12d1-2 under the 
Investment Company Act, and to Form N-1A under the Investment Company 
Act and the Securities Act.

A. Reasons for the Proposed Actions

1. ETFs
    As described more fully in sections I and III of this release, we 
are proposing rule 6c-11 to allow new ETFs to enter the market without 
first obtaining an exemptive order from the Commission.\348\ The 
proposed rule would codify and expand upon the exemptive orders we have 
issued to ETFs allowing them to form and operate. In conjunction with 
proposed rule 6c-11, we also are proposing amendments to Form N-1A, as 
described more fully in sections I and III.D of this release, to 
provide more useful information to investors who purchase and sell ETF 
shares on a securities exchange.
---------------------------------------------------------------------------

    \348\ Our exemptive orders have provided ETFs with relief from a 
number of sections in the Act in order to allow them to operate. See 
supra Section III.C.
---------------------------------------------------------------------------

2. Investment Company Investments in ETFs
    As described more fully in sections I and IV of this release, we 
are proposing new rule 12d1-4 to permit funds to invest in shares of 
ETFs beyond the limits of section 12(d)(1)(A) without first obtaining 
an exemptive order from the Commission. The proposed rule would codify 
exemptions provided in orders we have issued permitting funds to invest 
in ETFs beyond the Act's limits. We also are proposing amendments to 
rule 12d1-2, as described more fully in section V of this release, to 
expand the investment options available to funds that rely on section 
12(d)(1)(G) of the Act.

B. Objectives of the Proposed Actions

1. ETFs
    As described more fully in sections I and III of this release, the 
objectives of the proposed rule 6c-11 are to allow new ETF competitors 
to enter the market more easily and eliminate certain conditions 
contained in the outstanding orders that we now believe may be 
unnecessary. As described more fully in sections I and III.D of this 
release, the objective of the proposed amendments to Form N-1A is to 
provide more useful information to individual investors who purchase 
and sell ETF shares on national securities exchanges.
2. Investment Company Investments in ETFs
    As more fully described in sections I and IV of this release, 
proposed rule 12d1-4 is intended to allow funds to invest more easily 
in ETFs beyond the limits of section 12(d)(1) of the Act subject to 
certain conditions designed to protect investors. As more fully 
described in Section V of this release, the proposed amendments to rule 
12d1-2 are intended to expand the investments options available to 
funds that rely on section 12(d)(1)(G) to include: (i) Investments in 
unaffiliated ETFs beyond the limits of section 12(d)(1) of the Act 
consistent with proposed rule 12d1-4; and (ii) other non-securities 
assets, which do not appear to raise concerns that the investment 
limits of section 12(d)(1)(G) were intended to address. The proposed 
amendments to rule 12d1-2 would provide funds relying on section 
12(d)(1)(G) with greater flexibility to meet their investment 
objectives.

C. Legal Basis

    The statutory authority for proposed rules 6c-11 and 12d1-4 and the 
proposed amendments to rule 12d1-2 and Form N-1A is set forth in 
Section XI of this release.

D. Small Entities Subject to the Proposed Rule and Amendments

    A small business or small organization (collectively, ``small 
entity'') for purposes of the Regulatory Flexibility Act \349\ is a 
fund that, together with other funds in the same group of related 
investment companies, has net assets of $50 million or less as of the 
end of its most recent fiscal year.\350\ Of approximately 601 ETFs (593 
registered open-end investment companies and 8 registered UITs), only 1 
(an open-end fund) is a small entity.\351\ There are approximately 145 
fund complexes \352\ and 43 business development companies \353\ that 
are small entities that could choose to rely on proposed rule 12d1-4 to 
invest in ETFs beyond the limits of section 12(d)(1).
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    \349\ 5 U.S.C. 601-612.
    \350\ 17 CFR 270.0-10.
    \351\ For purposes of this IRFA, any series or portfolio of an 
ETF is considered a separate ETF.
    Therefore, there are 601 portfolios or series of registered 
investment companies operating as ETFs. For purposes of determining 
whether a fund is a small entity under the Regulatory Flexibility 
Act, however, the assets of funds (including each portfolio and 
series of a fund) in the same group of related investment companies 
are aggregated.
    \352\ The 145 fund complexes contain in the aggregate 160 funds 
that are small entities. This estimate is derived from data reported 
on Forms N-SAR and N-CSR filed with the Commission for the period 
ending June 30, 2007.
    \353\ This estimate is based on data reported on Forms 10-K and 
10-Q filed with the Commission for the period ending June 30, 2007.
---------------------------------------------------------------------------

1. ETFs
    Commission staff expects proposed rule 6c-11 and amendments to Form 
N-1A would have little impact on small entities. Like other funds, 
small entities would be affected by proposed rule 6c-11 and the 
proposed amendments to Form N-1A only if they determine to rely on rule 
6c-11 to operate as an ETF. Small entities that are open-end ETFs and 
currently rely on an exemptive order also would be affected by the 
proposed amendments to Form N-1A. Commission staff estimates that only 
one of the 61 orders permitting funds to operate as ETFs was issued to 
a small entity. The staff anticipates that the number of funds, 
including small funds, that would operate as an ETF under proposed rule 
6c-11 and also therefore be subject to the disclosure requirements 
contained in the proposed amendments to Form N-1A would

[[Page 14653]]

increase as compared with the number of applicants. Nevertheless, the 
staff believes that the proportion of small entities compared to the 
total number of funds that operate as ETFs would remain small.
2. Investment Company Investments in ETFs
    Commission staff expects proposed rule 12d1-4 and the proposed 
amendments to rule 12d1-2 to have little impact on small entities. Like 
other funds, small entities would only be affected by the rule and the 
amendments if they determine to rely on the exemptions provided by the 
proposed rule and amendments.\354\ Commission staff estimates that none 
of the approximately 15 exemptive orders issued to ETFs allowing other 
funds to invest in the ETFs beyond the limits of section 12(d)(1) was 
issued to a small entity. Similarly, none of the applications that has 
sought to allow a fund that relied on section 12(d)(1)(G) of the Act to 
invest in securities other than funds in the same complex, government 
securities, and short-term paper was a small entity. The staff 
anticipates that the number of funds, including small funds, that would 
rely on the proposed rule and rule amendments would be greater than the 
number of funds that currently rely on exemptive orders. Nevertheless, 
the staff believes that the proportion of small entities compared to 
the total number of funds that would rely on the proposed rule and rule 
amendments would be small.
---------------------------------------------------------------------------

    \354\ Small acquiring funds could choose to rely on the proposed 
rule to invest in ETFs beyond the limits of section 12(d)(1)(A) of 
the Act, and small ETFs could choose to rely on the rule to sell 
their shares to other funds beyond the limits of section 12(d)(1)(B) 
of the Act. Small acquiring funds that rely on section 12(d)(1)(G) 
of the Act could choose to rely on the proposed amendments to rule 
12d1-2 to invest in ETFs in reliance on proposed rule 12d1-4 and to 
invest in assets other than securities.
---------------------------------------------------------------------------

E. Reporting, Recordkeeping, and Other Compliance Requirements

1. ETFs
    Proposed rule 6c-11 would not impose any recordkeeping requirements 
on any person and would not materially increase other compliance 
requirements. Proposed rule 6c-11 would impose reporting requirements 
on funds that choose to rely on the rule.\355\ Funds relying on the 
rule would have to disclose: (i) The foreign holidays that would 
prevent timely satisfaction of a redemption request; \356\ (ii) the 
basket assets; \357\ (iii) the number of shares in a creation unit; 
\358\ (iv) the fund's NAV, the market closing price for its shares, and 
the premium/discount between its NAV and the market closing price daily 
on its Internet Web site; \359\ and (v) the identities and weightings 
of the component securities and other assets held by the fund.\360\ The 
proposed rule also would impose compliance requirements on ETFs that 
are essential to the operation of an ETF. A fund that chose to rely on 
the proposed rule would be required to have (i) its shares approved for 
listing and trading on a national securities exchange,\361\ and (ii) 
the Intraday Value of the basket assets disseminated at regular 
intervals during the day by a national securities exchange.\362\
---------------------------------------------------------------------------

    \355\ In addition to the reporting requirements, the proposed 
rule, unlike most of the ETF exemptive orders, would not include 
relief from section 24(d) of the Act and thus broker-dealers would 
be required to deliver prospectuses to investors in secondary market 
transactions. We also propose to amend the existing ETF exemptive 
orders issued to open-end funds to eliminate the section 24(d) 
exemptions and require ETFs relying on the orders to satisfy their 
prospectus delivery requirements. We understand that many, if not 
most, broker-dealers selling ETF shares in secondary market 
transactions, in fact, transmit a prospectus to purchasers. 
Therefore, we anticipate that the proposed amendment to the ETF 
orders would have little if any impact on ETFs, including small 
ETFs.
    \356\ Proposed rule 6c-11(c)(1). Funds would have to disclose 
this information in their registration statements (Form N-1A) and in 
any sales literature.
    \357\ Proposed rule 6c-11(e)(1).
    \358\ Proposed rule 6c-11(e)(3). Funds would have to disclose 
this information in their registration statements (Form N-1A) and in 
any sales literature.
    \359\ Proposed rule 6c-11(e)(4)(iii), (iv).
    \360\ Proposed rule 6c-11(e)(4)(iv)(A). If the fund has a stated 
investment objective of obtaining returns that correspond to the 
returns of a securities index, reliance on the proposed rule would 
be conditioned on the ETF tracking an index whose provider discloses 
on its Internet Web site the identities and weightings of the 
component securities and other assets of the index in lieu of 
disclosure on the fund's Internet Web site. Proposed rule 6c-
11(e)(4)(iv)(B).
    \361\ Proposed rule 6c-11(e)(4)(iii).
    \362\ Proposed rule 6c-11(e)(4)(i).
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    Proposed rule 6c-11 may benefit fund shareholders by allowing funds 
to operate as ETFs without incurring the costs and delays associated 
with the exemptive application process and without having to comply 
with some of the conditions included in the exemptive orders. While the 
rule would require ETFs to comply with reporting and compliance 
requirements, these requirements would not involve any new costs for 
ETFs because these requirements (as well as additional requirements) 
are included in the ETF exemptive orders.
    The proposed amendments to Form N-1A would impose reporting 
requirements on open-end funds that operate as ETFs. The proposed 
amendments would require an ETF to disclose in its prospectus and 
annual reports: (i) Returns based on the market price of its shares; 
\363\ (ii) the number of trading days on which the market price of its 
shares was greater than its NAV and the number of days it was less than 
its NAV (premium/discount information); \364\ and (iii) a comparison of 
its performance, if it is an index-based ETF, to its underlying index 
rather than a benchmark index.\365\ The proposed amendments also would 
require the ETF to disclose in its prospectus the trading symbol(s) and 
principal U.S. market(s) on which its shares are traded.\366\
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    \363\ Proposed Instruction 5(a) to Item 2(c)(2) of Form N-1A; 
Proposed Instruction 3(f) to Item 8(a) of Form N-1A; Proposed 
Instruction 12(b) to Item 22(b)(7) of Form N-1A. Form N-1A currently 
only requires an ETF to disclose in its prospectus its return based 
on its NAV. The annual reports also would have to contain a new line 
graph comparing the initial and subsequent account values using 
market price, following the line graph using NAV required by Item 
22(b)(7)(ii)(A) of Form N-1A. Proposed Instruction 12(a) to Item 
22(b)(7) of Form N-1A.
    \364\ Proposed Item 6(h)(4) of Form N-1A (requiring proposed 
premium/discount information in the prospectus to span the most 
recently completed calendar year and quarters since that year); 
Proposed Item 22(b)(7)(iv) of Form N-1A (requiring proposed premium/
discount information disclosed in annual reports to span five fiscal 
years). The ETF would be required to present premiums or discounts 
as a percentage of NAV and to explain that shareholders may pay more 
than NAV when purchasing shares and receive less than NAV when 
selling, because shares are bought and sold at market prices. 
Proposed Instructions 2,3 to Item 6(h)(4) of Form N-1A; Proposed 
Instruction (b), (c) to Item 22(b)(7)(iv).
    \365\ Proposed Instruction 5(b) to Item 2(c)(2) of Form N-1A; 
Proposed Instruction 12(c) to Item 22(b)(7) of Form N-1A.
    \366\ Proposed Item 6(h)(2) of Form N-1A.
---------------------------------------------------------------------------

    The proposed amendments to Form N-1A also would eliminate some 
disclosure requirements for ETFs with creation units of 25,000 or more 
shares and replace them with fewer disclosures. Under the proposed 
amendments, those ETFs would not have to: (i) Disclose information on 
how to buy and redeem shares of ETF; \367\ or (ii) include in its fee 
table in its prospectus or annual and semi-annual reports fees and 
expenses for purchases or sales of creation units.\368\
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    \367\ Proposed Item 6(h)(1) of Form N-1A. Instead ETF 
prospectuses could simply state that individual fund shares can only 
be bought and sold on the secondary market through a broker-dealer. 
Proposed Item 6(h)(3) of Form N-1A.
    \368\ Proposed Instruction 1(e)(i) to Item 3 of Form N-1A; 
Proposed Instruction 1(e)(i) to Item 22(d) of Form N-1A. An ETF 
would instead modify the narrative explanation preceding the example 
in the fee table to state that fund shares are sold on the secondary 
market rather than redeemed at the end of the periods indicated, and 
that investors in its shares may be required to pay brokerage 
commissions that are not reflected in the fee table. Proposed 
Instruction 1(e)(ii) to Item 3 of Form N-1A; Proposed Instruction 
1(e)(ii) to Item 22(d) of Form N-1A.
---------------------------------------------------------------------------

    The amendments to Form N-1A are designed to accommodate the use of 
the

[[Page 14654]]

form by ETFs and to meet the needs of investors (including retail 
investors) who purchase ETF shares in secondary market transactions 
rather than institutional investors purchasing creation units directly 
from the ETF. We believe that the amendments would have a negligible 
impact (if any) on the disclosure burdens on ETFs while providing 
necessary information to ETF investors. We do not believe that the 
proposed amendments to Form N-1A would disproportionately impact small 
funds.
2. Investment Company Investments in ETFs
    Proposed rule 12d1-4 and the proposed amendments to rule 121-2 
would not impose any reporting or recordkeeping requirements. The 
proposed amendments to rule 12d1-2 also would not impose any new 
compliance requirements on any person. Proposed rule 12d1-4 would 
impose compliance requirements on funds that choose to rely on it. 
Proposed rule 12d1-4 would permit fund investments in ETFs beyond the 
limits of section 12(d)(1) if: (i) The acquiring fund (and any entity 
in a control relationship with the acquiring fund) does not control the 
ETF; \369\ (ii) the acquiring fund does not redeem certain shares 
acquired in reliance on the proposed rule; \370\ (iii) the fees charged 
by the acquiring fund do not exceed the FINRA sales charge limits; 
\371\ and (iv) the acquired ETF is not itself a fund of funds (i.e., 
the rule would prohibit a fund of funds of funds, or three-tier fund, 
structure).\372\ In addition, an ETF could not redeem, and its 
principal underwriter, a broker or a dealer could not submit for 
redemption ETF shares acquired in reliance on proposed rule 12d1-
4.\373\ These compliance requirements, however, would not impose any 
new costs on acquiring funds or ETFs. Most of these conditions (as well 
as number of other conditions which are not included in the proposed 
rule) are included in the exemptive orders that currently permit fund 
investments in ETFs beyond the limits of section 12(d)(1). We do not 
anticipate that the additional conditions prohibiting redemptions would 
impose significant, if any, new costs on acquiring funds or ETFs 
because we understand that most funds do not redeem shares with ETFs, 
but sell their shares in secondary market transactions.
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    \369\ Proposed rule 12d1-4(a)(1). See supra notes 215-219 and 
accompanying text for a discussion of the proposed condition.
    \370\ Proposed rule 12d1-4(a)(2). See supra note 220 and 
accompanying and following text for a discussion of the proposed 
condition.
    \371\ Proposed rule 12d1-4(a)(3). See supra notes 230-233 and 
accompanying text for a discussion of the proposed condition.
    \372\ Proposed rule 12d1-4(a)(4). See supra notes 225-229 and 
accompanying text for a discussion of the proposed condition.
    \373\ Proposed rule 12d1-4(b)(1). See supra note 221 and 
accompanying text for a discussion of the proposed condition.
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F. Duplicative, Overlapping, or Conflicting Federal Rules

    The Commission has not identified any federal rules that duplicate, 
overlap, or conflict with the proposed rules or rule amendments.

G. Significant Alternatives

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. In 
connection with the proposed rules and amendments, the Commission 
considered the following alternatives: (i) The establishment of 
differing compliance or reporting requirements or timetables that take 
into account the resources available to small entities; (ii) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rule for small entities; (iii) the use 
of performance rather than design standards; and (iv) an exemption from 
coverage of the rule, or any part thereof, for small entities.
1. ETFs
    Proposed rule 6c-11 is exemptive and compliance with the rule would 
be voluntary. We therefore do not believe that special compliance, 
timetable, or reporting requirements, or an exemption from coverage of 
the proposed rule for small entities would be appropriate. In addition, 
as discussed above, only one fund that meets the definition of a small 
entity currently relies on an exemptive order to operate as an ETF. 
Therefore, few of the entities that would be affected by the proposed 
rule would be considered to be small entities. The Commission also 
believes that proposed rule 6c-11 would decrease burdens on small 
entities by making it unnecessary for them to seek an exemptive order 
from the Commission allowing them to operate as ETFS and by eliminating 
some of the conditions included in the exemptive orders from the 
proposed rule. As a result, we do not anticipate the potential impact 
of the proposed rule on small entities would be significant. For these 
reasons, alternatives to the proposed rule appear unnecessary and in 
any event are unlikely to minimize any impact that the proposed rule 
might have on small entities.
    The proposed amendments to Form N-1A would only apply to funds that 
choose to rely on proposed rule 6c-11 or that rely on an exemptive 
order to operate as an ETF. As discussed above, the proposed amendments 
to Form N-1A are designed to accommodate the use of the form by ETFs 
and to meet the needs of investors (including retail investors) who 
purchase ETF shares in secondary market transactions rather than 
institutional investors purchasing creation units directly from the 
ETF. Therefore, we believe that any further clarification, 
consolidation, or simplification of the proposed amendments would not 
be consistent with the protection of investors. An exemption for small 
entities also would defeat the purposes of the amendments.
2. Investment Company Investments in ETFs
    Proposed rule 12d1-4 and the proposed amendments to rule 12d1-2 are 
exemptive and compliance with proposed rule 12d1-4 and the proposed 
amendments to rule 12d1-2 would be voluntary. We therefore do not 
believe that special compliance, timetable, or reporting requirements, 
or an exemption from coverage of the proposed rule or the proposed 
amendments to rule 12d1-2 for small entities would be appropriate. The 
Commission believes that proposed rule 12d1-4 and the proposed 
amendments to rule 12d1-2 would decrease burdens on small entities by 
making it unnecessary for them to seek an exemptive order from the 
Commission allowing them to sell their shares to other funds beyond the 
limits in section 12(d)(1)(B) of the Act or to allow small entities 
that rely on section 12(d)(1)(G) to invest in assets other than 
securities and ETFs beyond the limits of section 12(d)(1). In addition, 
proposed rule 12d1-4 has a limited number of conditions, most of which 
are included in the exemptive orders. The proposed amendments to rule 
12d1-2 do not impose any compliance requirements. As a result the 
potential impact of the proposed rule and amendments on small entities 
should not be significant. For these reasons, alternatives to the 
proposed rule and amendments seem unnecessary and, in any event, 
unlikely to minimize any impact that the proposed rule and amendments 
might have on small entities.

H. Solicitation of Comments

    The Commission encourages the submission of comments with respect 
to any aspect of this IRFA. Comment is

[[Page 14655]]

specifically requested on the number of small entities that would be 
affected by the proposed rules and amendments, and the likely impact of 
the proposals on small entities. Commenters are asked to describe the 
nature of any impact and provide empirical data supporting its extent. 
These comments will be considered in connection with any adoption of 
the proposed rule and amendments, and reflected in a Final Regulatory 
Flexibility Analysis.
    Comments should be submitted in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090. Comments also may be submitted 
electronically to the following e-mail address: rule-comments@sec.gov. 
All comment letters should refer to File No. S7-07-08, and this file 
number should be included on the subject line if e-mail is used.\374\ 
Comment letters will be available for public inspection and copying in 
the Commission's Public Reference Room, 100 Fifth Street, NE., 
Washington, DC 20549-1520, on official business days between the hours 
of 10 a.m. and 3 p.m. Electronically submitted comment letters also 
will be posted on the Commission's Internet Web site (http://
www.sec.gov).
---------------------------------------------------------------------------

    \374\ Comments on the IRFA will be placed in the same public 
file that contains comments on the proposed rules and amendments.
---------------------------------------------------------------------------

XI. Statutory Authority

    The Commission is proposing rule 6c-11 pursuant to the authority 
set forth in sections 6(c) and 38(a) of the Investment Company Act [15 
U.S.C. 80a-6(c) and 80a-37(a)]. The Commission is proposing amendments 
to rule 12d1-2 and new rule 12d1-4 pursuant to the authority set forth 
in sections 6(c), 12(d)(1)(J), and 38(a) of the Investment Company Act 
[15 U.S.C. 80a-6(c), 80a-12(d)(1)(J), and 80a-37(a)]. The Commission is 
proposing amendments to registration form N-1A under the authority set 
forth in sections 6, 7(a), 10 and 19(a) of the Securities Act of 1933 
[15 U.S.C. 77f, 77g(a), 77j, 77s(a)], and sections 8(b), 24(a), and 30 
of the Investment Company Act [15 U.S.C. 80a-8(b), 80a-24(a), and 80a-
29].

List of Subjects

17 CFR Part 239

    Reporting and recordkeeping requirements, Securities.

17 CFR Parts 270 and 274

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

Text of Proposed Rules and Form Amendments

    For reasons set out in the preamble, Title 17, Chapter II of the 
Code of Federal Regulations is proposed to be amended as follows:

PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933

    1. The authority citation for part 239 continues to read, in part, 
as follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3, 
77sss, 78c, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll, 78mm, 80a-
2(a), 80a-3, 80a-8, 80a-9, 80a-10, 80a-13, 80a-24, 80a-26, 80a-29, 
80a-30, and 80a-37, unless otherwise noted.
* * * * *

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

    2. The authority citation for part 270 is amended by adding a 
specific authority citation for Sec.  270.6c-11 and revising the 
specific authority citation for Sec. Sec.  270.12d1-1, 270.12d1-2 and 
12d1-3 to read as follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *
    Section 270.6c-11 is also issued under 15 U.S.C. 80a-6(c) and 
80a-37(a).
* * * * *
    Sections 270.12d1-1, 270.12d1-2, 270.12d1-3, and 12d1-4 are also 
issued under 15 U.S.C. 80a-6(c), 80a-12(d)(1)(J), and 80a-37(a).
* * * * *
    3. Section 270.6c-11 is added to read as follows:

Sec.  270.6c-11  Exchange-traded funds.

    (a) Redeemable securities. Exchange-traded fund shares are 
considered ``redeemable securities'' for purposes of section 2(a)(32) 
of the Act (15 U.S.C. 80a-2(a)(32)).
    (b) Pricing. A dealer in exchange-traded fund shares is exempt from 
section 22(d) of the Act (15 U.S.C. 80a-22(d)) and Sec.  270.22c-1(a) 
with regard to purchases, sales and repurchases of exchange-traded fund 
shares in the secondary market at the current market price.
    (c) Postponement of redemption. If an exchange-traded fund includes 
a foreign security in its basket assets and a foreign holiday prevents 
timely delivery of the foreign security in response to a redemption 
request, the fund is exempt, with respect to the foreign security, from 
the prohibition in section 22(e) of the Act (15 U.S.C. 80a-22(e)) 
against postponing the date of satisfaction upon redemption for more 
than seven days after the tender of a redeemable security, if:
    (1) The exchange-traded fund discloses in its registration 
statement the foreign holidays that it expects may prevent timely 
delivery of foreign securities, and the maximum number of days that it 
anticipates it will need to deliver the foreign securities; and
    (2) Foreign securities are delivered no later than 12 calendar days 
after the tender of the exchange-traded fund shares.
    (d) Affiliated transactions. A person who is an affiliated person 
of an exchange-traded fund solely by reason of holding with the power 
to vote 5 percent or more, or more than 25 percent, of securities 
issued by the exchange-traded fund (or who is an affiliated person of 
such a person), or issued by an investment company under common control 
with the exchange-traded fund, is exempt from sections 17(a)(1) and 
17(a)(2) of the Act (15 U.S.C. 80a-17(a)(1) and (a)(2)) with regard to 
the deposit and delivery of basket assets. An investment company that 
has acquired exchange-traded fund shares in reliance on Sec.  270.12d1-
4 may not rely on this paragraph with regard to the purchase of basket 
assets.
    (e) Definitions. For purposes of this section:
    (1) Basket assets are the securities or other assets specified each 
business day in name and number by an exchange-traded fund as the 
securities or assets in exchange for which it will issue or in return 
for which it will redeem exchange-traded fund shares; provided that the 
fund may require or permit a purchaser (or redeemer) of a creation unit 
to substitute cash for some or all of the securities in the basket 
assets.
    (2) Business day means, with respect to an exchange-traded fund, 
any day that the fund is open for business, including any day on which 
it is required to make payment under section 22(e) of the Act (15 
U.S.C. 80a-22(e)).
    (3) Creation unit is a specified number of exchange-traded fund 
shares disclosed in the exchange-traded fund's prospectus that the fund 
will issue (or redeem) in exchange for the deposit (or delivery) of 
basket assets. The creation unit must be reasonably designed to 
facilitate the purchase (or redemption) of shares from the exchange-
traded fund with an offsetting sale (or purchase) of shares on a 
national securities exchange at as nearly the same time as practicable 
for the purpose of taking advantage of a difference in the current 
value of basket assets on a per share basis and the current market 
price of the shares.

[[Page 14656]]

    (4) Exchange-traded fund is a registered open-end management 
company that:
    (i) Issues (or redeems) creation units in exchange for the deposit 
(or delivery) of basket assets the current value of which is 
disseminated on a per share basis by a national securities exchange at 
regular intervals during the trading day;
    (ii) In any sales literature, identifies itself as an exchange-
traded fund, which does not sell or redeem individual shares, and 
explains that investors may purchase or sell individual exchange-traded 
fund shares on a national securities exchange;
    (iii) Issues shares that are approved for listing and trading on a 
national securities exchange under section 12(d) (15 U.S.C. 78l(d)) of 
the Securities Exchange Act of 1934 and rule 12d1-1 (17 CFR 240.12d1-1) 
thereunder;
    (iv) Discloses each business day on its Internet Web site, which is 
publicly accessible at no charge, the prior business day's net asset 
value and closing market price of the fund's shares, and the premium or 
discount of the closing market price against the net asset value of the 
fund's shares as a percentage of net asset value; and
    (v) Either:
    (A) Discloses each business day on its Internet Web site, which is 
publicly accessible at no charge, the identities and weightings of the 
component securities and other assets held by the fund, or
    (B) Has a stated investment objective of obtaining returns that 
correspond to the returns of a securities index specified in the fund's 
registration statement, and the index provider discloses on its 
Internet Web site, which is publicly accessible at no charge, the 
identities and weightings of the component securities and other assets 
of the index.
    (5) Exchange-traded fund share is an equity security issued by an 
exchange-traded fund.
    (6) Foreign security is any security issued by a government or any 
political subdivision of a foreign country, a national of any foreign 
country, or a corporation or other organization incorporated or 
organized under the laws of any foreign country, and for which there is 
no established United States public trading market as that term is used 
in Item 201 of Regulation S-K under the Securities Exchange Act of 1934 
(17 CFR 229.201).
    (7) Index provider is the person that determines the securities and 
other assets that comprise a securities index.
    (8) Sales literature means any advertisement, pamphlet, circular, 
form letter, or other sales material addressed to or intended for 
distribution to prospective investors other than a registration 
statement filed with the Commission under section 8 of the Act (15 
U.S.C. 80a-8).
    (9) Weighting of the component security is the percentage of the 
index's value represented, or accounted for, by such component 
security.
    4. Section 270.12d1-2 is amended by:
    a. Revising the heading to paragraph (a);
    b. Removing ``and'' at the end of paragraph (a)(2);
    c. Removing the period at the end of paragraph (a)(3) and adding a 
``;'';
    d. Adding paragraphs (a)(4) and (a)(5); and
    e. Revising paragraph (b).
    The additions and revisions read as follows:

Sec.  270.12d1-2  Exemptions for investment companies relying on 
section 12(d)(1)(G) of the Act.

    (a) Exemption to acquire other securities and assets. * * *
    (4) Securities issued by an exchange-traded fund, when the 
acquisition is in reliance on Sec.  270.12d1-4; and
    (5) Other assets.
    (b) Definitions. For purposes of this section, ``exchange-traded 
fund'' has the same meaning as in Sec.  270.12d1-4(d)(2) and ``money 
market fund'' has the same meaning as in Sec.  270.12d1-1(d)(2).
    5. Section 270.12d1-4 is added to read as follows:

Sec.  270.12d1-4  Exemptions for investments in exchange-traded funds.

    (a) Exemptions for acquisition of exchange-traded fund shares. 
Notwithstanding sections 12(d)(1)(A), 17(a)(1), and 57(a)(1) of the Act 
(15 U.S.C. 80a-12(d)(1)(A), 15 U.S.C. 80a-17(a)(1), and 15 U.S.C. 80a-
56(a)(1)), an investment company (``acquiring fund'') may acquire 
exchange-traded fund shares if:
    (1) Control. No acquiring fund or any of its investment advisers or 
depositors, and any company controlling, controlled by or under common 
control with the acquiring fund, or any of its investment advisers or 
depositors, each individually or together in the aggregate:
    (i) Controls the exchange-traded fund; and
    (ii) If, as a result of a decrease in the outstanding voting 
securities of the exchange-traded fund, any of those persons, each 
individually or together in the aggregate, become holders of more than 
25 percent of the outstanding voting securities of the exchange-traded 
fund, each of those holders of shares issued by the exchange-traded 
fund will vote its shares of the exchange-traded fund in the manner 
prescribed by section 12(d)(1)(E) of the Act (15 U.S.C. 80a-
12(d)(1)(E)).
    (2) No redemption. An acquiring fund that relies on paragraph (a) 
of this section to acquire exchange-traded fund shares in excess of the 
limits of section 12(d)(1)(A)(i) of the Act (15 U.S.C. 80a-
12(d)(1)(A)(i)) does not redeem any of those shares. For purposes of 
this paragraph, an acquiring fund will be deemed to have redeemed or 
sold the most recently acquired exchange-traded fund shares first.
    (3) Fees. (i) Any sales charge, as defined in rule 2830(b)(8) of 
the Conduct Rules of the NASD (``sales charge''), or service fee, as 
defined in rule 2830(b)(9) of the Conduct Rules of the NASD (``service 
fee''), charged in connection with the purchase, sale, or redemption of 
securities issued by the acquiring fund does not exceed the limits set 
forth in rule 2830(d)(3) of the Conduct Rules of the NASD; and
    (ii) With respect to a separate account that invests in an 
acquiring fund:
    (A) The acquiring fund and exchange-traded fund do not charge a 
sales load;
    (B) Any asset-based sales charge, as defined in rule 2830(b)(8)(A) 
of the Conduct Rules of the NASD, or service fee is charged only by the 
acquiring fund or the exchange-traded fund; and
    (C) The fees associated with a variable insurance contract that 
invests in the acquiring fund and the sales charges and service fees 
charged by the acquiring fund and the exchange-traded fund, in the 
aggregate, must be reasonable in relation to the services rendered, the 
expenses expected to be incurred and, with respect to the variable 
insurance contract, the risks assumed by the insurance company.
    (4) Complex fund structures. The exchange-traded fund has a 
disclosed policy that prohibits it from investing more than 10 percent 
of its assets in:
    (i) Other investment companies in reliance on section 12(d)(1)(F) 
or section 12(d)(1)(G) of the Act (15 U.S.C. 80a-12(d)(1)(F) or 15 
U.S.C. 80a-12(d)(1)(G)) or this section; and
    (ii) Any other company that would be an investment company under 
section 3(a) of the Act (15 U.S.C. 80a-3(a)) but for the exceptions to 
that definition provided in sections 3(c)(1) and 3(c)(7) of the Act (15 
U.S.C. 80a-3(c)(1) and 80a-3(c)(7)).
    (b) Exemptions for sale of exchange-traded fund shares. (1) 
Notwithstanding sections 12(d)(1)(B), 17(a)(1), 17(a)(2), 57(a)(1), and 
57(a)(2) of the Act (15 U.S.C. 80a-12(d)(1)(B), 15 U.S.C. 80a-17(a)(1), 
15 U.S.C. 80a-56(a)(1), and 15 U.S.C. 80a-56(a)(2)), an exchange-traded

[[Page 14657]]

fund, any principal underwriter thereof, and a broker or a dealer may 
sell or otherwise dispose of exchange-traded fund shares if the 
exchange-traded fund does not redeem, or the principal underwriter, 
broker or dealer does not submit for redemption any of the exchange-
traded fund's shares that were acquired by an acquiring fund in excess 
of the limits of section 12(d)(1)(A)(i) of the Act (15 U.S.C. 80a-
12(d)(1)(A)(i)) in reliance on paragraph (a) of this section. For 
purposes of this paragraph, an acquiring fund will be deemed to have 
redeemed or sold the most recently acquired exchange-traded fund shares 
first.
    (2) An exchange-traded fund, a principal underwriter thereof, or 
broker or dealer will be deemed to have complied with the condition in 
paragraph (b)(1) of this section if it has:
    (i) Received a representation from the acquiring fund that none of 
the exchange-traded fund shares it is redeeming was acquired in excess 
of the limits of section 12(d)(1)(A)(i) of the Act (15 U.S.C. 80a-
12(d)(1)(A)(i)) in reliance on paragraph (a) of this section; and
    (ii) No reason to believe that the acquiring fund is redeeming any 
exchange-traded fund shares that the acquiring fund acquired in excess 
of the limits of section 12(d)(1)(A)(i) of the Act (15 U.S.C. 80a-
12(d)(1)(A)(i)) in reliance on paragraph (a) of this section.
    (c) Exemption from certain monitoring and recordkeeping 
requirements under Sec.  270.17e-1. Notwithstanding the requirements of 
Sec. Sec.  270.17e-1(b)(3) and 270.17e-1(d)(2), the payment of a 
commission, fee, or other remuneration to a broker shall be deemed as 
not exceeding the usual and customary broker's commission for purposes 
of section 17(e)(2)(A) of the Act (15 U.S.C. 80a-17(e)(2)(A)) if:
    (1) The commission, fee, or other remuneration is paid in 
connection with the sale of securities to or by an acquiring fund;
    (2) The broker and the acquiring fund are affiliated persons 
because each is an affiliated person of the same exchange-traded fund; 
and
    (3) The acquiring fund is an affiliated person of the exchange-
traded fund solely because the acquiring fund owns, controls, or holds 
with power to vote five percent or more of the outstanding securities 
of the exchange-traded fund.
    (d) Definitions. For purposes of this section:
    (1) Depositor includes the person primarily responsible for the 
organization of the unit investment trust, the person who has 
continuing functions or responsibilities with respect to the 
administration of the affairs of the trust, and the sponsor or manager 
of the trust.
    (2) Exchange-traded fund has the same meaning as in Sec.  270.6c-
11(e)(4) and also includes a registered unit investment trust that 
satisfies the criteria set forth in Sec.  270.6c-11(e)(4).
    (3) Exchange-traded fund share has the same meaning as in Sec.  
270.6c-11(e)(5).

PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933

PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940

    6. The authority citation for part 274 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m, 
78n, 78o(d), 80a-8, 80a-24, 80a-26, and 80a-29, unless otherwise 
noted.
* * * * *
    7. Form N-1A (referenced in Sec. Sec.  239.15A and 274.11A) is 
amended by:
    a. Adding the definitions ``Exchange-Traded Fund'' and ``Market 
Price'' in alphabetical order to General Instructions A;
    b. Adding paragraph 5 to the Instructions to Item 2 paragraph 
(c)(2);
    c. Adding paragraph 1(e) to the Instructions to Item 3;
    d. Revising paragraph 1(a) and adding paragraph (h) to Item 6;
    e. Adding paragraph 3(f) to the Instructions to Item 8(a); and
    f. Adding paragraph 12 to the Instructions to paragraphs (b)(7)(i) 
and (ii), paragraph (iv) to paragraph (b)(7), and paragraph 1(e) to the 
Instructions to paragraph (d) of Item 22.
    The additions and revisions read as follows:

    Note: The text of Form N-1A does not, and this amendment will 
not, appear in the Code of Federal Regulations.

Form N-1A

* * * * *

General Instructions

A. Definitions

* * * * *
    ``Exchange-Traded Fund'' means a Fund whose shares are traded on a 
national securities exchange and satisfies the criteria set forth in 
rule 6c-11(e)(4) (17 CFR 270.6c-11(e)(4)).
* * * * *
    ``Market Price'' refers to the last price at which Exchange-Traded 
Fund shares trade on the principal U.S. market on which the Fund's 
shares are traded during a regular trading session.
* * * * *

Item 2. Risk/Return Summary: Investments, Risks, and Performance

* * * * *
    (c) Principal risks of investing in the Fund.
* * * * *
    (2) Risk/Return Bar Chart and Table.
* * * * *

Instructions

* * * * *
    5. Exchange-Traded Funds.
    (a) Add a caption in the ``Average Annual Total Returns'' table 
directly above the caption titled ``Index''. Title the caption 
``Returns--Market Price''. Disclose in the caption the Fund's average 
annual total return based on the Market Price for the periods 
indicated. In a footnote to the caption, explain how Market Price 
returns are calculated and how they differ from NAV returns.
    (b) If the Fund has an investment objective of obtaining returns 
that correspond to the returns of a securities index, the table must 
show the average annual total returns of the securities index specified 
in its registration statement for the same periods. The Fund may 
exclude the returns of an appropriate broad-based securities market 
index as defined in Instruction 5 to Item 22(b)(7) for the same 
periods.

Item 3. Risk/Return Summary: Fee Table

* * * * *

Instructions

    1. General.
* * * * *
    (e)(i) If the Fund is an Exchange-Traded Fund and issues or redeems 
shares in creation units of not less than 25,000 shares each, exclude 
any fees charged for the purchase and redemption of the Fund's creation 
units.
    (ii) Modify the narrative explanation to state that Fund shares are 
sold on a national securities exchange at the end of the time periods 
indicated, and that brokerage commissions for buying and selling Fund 
shares through a broker are not reflected.
* * * * *

Item 6. Shareholder Information

    (a) * * *
    (1) An explanation that the price of Fund shares is based on the 
Fund's net asset value and the method used to value Fund shares (market 
price, fair value, or amortized cost); except that if the Fund is an 
Exchange-Traded Fund, an explanation that the price of Fund shares is 
based on Market Price.
* * * * *
    (h) Exchange-Traded Funds.

[[Page 14658]]

    (1) If the Fund issues or redeems Fund shares in creation units of 
not less than 25,000 shares each, the Fund may omit from the prospectus 
the information required by Items 6(a)(2), (b) and (c).
    (2) Identify the principal U.S. market or markets on which the Fund 
shares are traded and the trading symbol(s) for those shares, unless 
the information appears on the front cover page.
    (3) Specify the number of Fund shares that the Fund will issue (or 
redeem) in exchange for the deposit (or delivery) of basket assets as 
defined in rule 6c-11 [17 CFR 270.6c-11] (i.e., a creation unit) and 
explain that individual Fund shares may only be purchased and sold on a 
national securities exchange through a broker-dealer.
    (4) Premium/Discount Information. Provide a table showing the 
number of days the Market Price of the Fund shares was greater than the 
Fund's net asset value and the number of days it was less than the 
Fund's net asset value for the most recently completed calendar year, 
and the most recently completed calendar quarters since that year, or 
the life of the Fund (if shorter).

Instructions

    1. Provide the information in tabular form.
    2. Express the information as a percentage of the net asset value 
of the Fund, using separate columns for the number of days the Market 
Price was greater than the Fund's net asset value and the number of 
days it was less than the Fund's net asset value. Round all percentages 
to the nearest hundredth of one percent.
    3. Adjacent to the table, provide a brief explanation that: 
Shareholders may pay more than net asset value when they buy Fund 
shares and receive less than net asset value when they sell those 
shares, because shares are bought and sold at current market prices.
    4. Include a statement that the data presented represents past 
performance and cannot be used to predict future results.
* * * * *

Item 8. Financial Highlights Information

    (a) * * *

Instructions

* * * * *
    3. Total Return. * * *
    (f) Exchange-Traded Funds. (i) Change the caption ``Total Return'' 
to ``Total Return--NAV''.
    (ii) Add a caption following ``Total Return--NAV'' titled ``Total 
Return--Market Price''. Disclose in the caption the Fund's total return 
using Market Price, assuming a purchase of Fund shares at the Market 
Price on the first day and a sale of the shares on the last day of each 
period shown.
* * * * *

Item 22. Financial Statements

* * * * *
    (b) Annual Report. * * *
    (7) Management's Discussion of Fund Performance. * * *

Instructions

    12. Exchange-Traded Funds.
    (a) Include a second line graph immediately following the line 
graph required by paragraph (b)(7)(ii)(A) of this Item, assume an 
initial investment of $10,000 was made at the Market Price on the 
business day before the first day of the first fiscal year, and base 
the subsequent account values on the Market Price on the last business 
day of the first and each subsequent fiscal year. Calculate the final 
account value by assuming the investor sold all Exchange-Traded Fund 
shares at the Market Price on the last business day of the most recent 
fiscal year.
    (b) For purposes of the table required by paragraph (b)(7)(ii)(B) 
of this Item, add a caption titled ``Returns--Market Price''. Disclose 
in the caption the Fund's average annual total return based on Market 
Price for the periods indicated. In a footnote to the caption, explain 
how Market Price returns are calculated and how they differ from 
returns based on net asset value.
    (c) If the Fund has an investment objective of obtaining returns 
that correspond to the returns of a securities index, the table must 
show the average annual total returns of the securities index specified 
in its registration statement for the same periods. The Fund may 
exclude the returns of an appropriate broad-based securities market 
index as defined in Instruction 5 to paragraph (b)(7)(i) and (ii) of 
this Item for the same periods.
* * * * *
    (iv) Premium/Discount Information. Provide a table showing the 
number of days the Market Price of the Fund shares was greater than the 
Fund's net asset value and the number of days it was less than the 
Fund's net asset value for the most recently completed five fiscal 
years (or the life of the Fund if shorter), but only for periods 
subsequent to the effective date of the Fund's registration statement.

Instructions

    (a) Provide the information in tabular form.
    (b) Express the information as a percentage of the net asset value 
of the Exchange-Traded Fund, using separate columns for the number of 
days the Market Price was greater than the Fund's net asset value and 
the number of days it was less than the Fund's net asset value. Round 
all percentages to the nearest hundredth of one percent.
    (c) Adjacent to the table, provide a brief explanation that: 
Shareholders may pay more than net asset value when they buy Fund 
shares and receive less than net asset value when they sell those 
shares, because shares are bought and sold at current market prices.
    (d) Include a statement that the data presented represents past 
performance and cannot be used to predict future results.
* * * * *
    (d) Annual and Semi-Annual Reports. * * *

Instructions

    1. General.
* * * * *
    (e) (i) If the Fund is an Exchange-Traded Fund and issues or 
redeems shares in creation units of not less than 25,000 shares each, 
exclude from the narrative explanation and the Example any fees charged 
for the purchase and redemption of the Fund's creation units.
    (ii) Modify the narrative explanation to state that Fund shares are 
sold on a national securities exchange at the end of the time periods 
indicated, and that brokerage commissions for buying and selling Fund 
shares through a broker are not reflected.
* * * * *

    Dated: March 11, 2008.

    By the Commission.
Nancy M. Morris,
Secretary.
 [FR Doc. E8-5239 Filed 3-17-08; 8:45 am]

BILLING CODE 8011-01-P