Securities Exchange Act of 1934
Section 16 — Directors, officers and principal stockholders
January 28, 2012
Response of the Office of Chief Counsel
Division of Corporation Finance
Davis Polk & Wardwell LLP
Incoming letter dated January 23, 2013
You have asked for the Division’s views with respect to a Broker-Dealer’s pecuniary interest, as defined in Exchange Act Rule 16a-1(a)(2), in any Insider Security in certain transactions in the component securities of an ETF. In the subject transactions, the Broker-Dealer would engage in the following activities as an authorized participant (“AP”):
- Creation of ETF shares (including related hedging activity);
- Redemption of ETF shares (including related hedging activity); and
- Hedging exposure to Insider Securities due to ETF Rebalancing during the pendency of an ETF Loan Transaction.
Capitalized terms have the same meanings as defined in your letter.
Based on the representations in your letter, the Division is of the view — with respect to activities in Insider Securities as a result of an ETF Loan Transaction or ETF Cash Transaction in response to a third-party non-affiliated customer order entered with or by the Broker-Dealer (i.e., either to fulfill such order, or to hedge exposure created by a transaction between the Broker-Dealer or its affiliate and the non-affiliated third party customer) — that a Broker-Dealer acting as AP would not have a pecuniary interest in an Insider Security:
- obtained by the Broker-Dealer to create a Deposit Basket to be delivered to an ETF Agent in exchange for ETF shares in connection with an ETF Cash Transaction or ETF Loan Transaction;
- transferred in a Deposit Basket by the Broker-Dealer to an ETF Agent in exchange for ETF shares when creating an ETF in connection with an ETF Cash Transaction or ETF Loan Transaction;
- received in a Deposit Basket by the Broker-Dealer from an ETF Agent when redeeming an ETF in connection with an ETF Cash Transaction or ETF Loan Transaction;
- transferred by the Broker-Dealer to its clients or others in a disposition of the component securities received from an ETF Agent after redeeming the ETF;
- purchased or sold in order to hedge against exposure to intraday trading prices of component securities in the period between the customer order of an ETF share and the end of the day of the order when ETF shares are created or redeemed; and
- in connection with an ETF Loan Transaction, purchased or sold in order to hedge against market risk in relation to ETF Rebalancing.
The Division’s view will not apply in the following circumstances:
- with respect to proprietary ETF Loan Transactions or proprietary ETF Cash Transactions where one or more of the securities underlying the ETF is an Insider Security;
- to the disposition of Insider Securities previously held by the Broker-Dealer in its own inventory that may be used in the creation of an ETF share, or to the acquisition of Insider Securities in the Broker-Dealer’s inventory upon ETF share redemption;
- if the Broker-Dealer, or any parent, affiliate or subsidiary thereof, were to develop, compile, create, sponsor or maintain an underlying Index for an ETF for which it serves as an AP or market maker; and
- to activities involving ETFs that are actively managed and do not track an Index, ETFs with component securities that are issued by foreign private issuers, or ETFs with debt instruments.
In reaching these interpretive positions, we note particularly your representations that:
- each step in the creation, redemption and hedging activities for which the Broker-Dealer seeks relief will comply with the Diversity Standards;
- the use of “cash-in-lieu amount” transactions would be inconsistent with the Diversity Standards and could result in decreased liquidity for ETF creation or redemption orders;
- an ETF’s rebalancing decisions are made without any input from or participation by any AP or other third party, and must be consistent with the ETF’s governing documents as disclosed to investors, so that hedging related to ETF Rebalancing is not initiated by the Broker-Dealer on the basis of knowledge of any fact or information specific to or relating to any Insider Security; and
- the Broker-Dealer commits that, when hedging its exposure to ETF Rebalancing, it will not trade in derivative securities that would limit the Broker-Dealer’s risk to Insider Securities.
These positions are based on the representations made to the Division in your letter. Different facts or conditions might require different conclusions.
Senior Special Counsel
The Incoming Letter is in Acrobat format.