Regulatory Changes with Compliance Implications for Exchange-Traded Funds


Veronica Popp

Publish Date


Compliance Alert


  • Compliance

Exchange-traded fund (“ETF”) sponsors and their managers are sure to be aware of the extended regulatory requirements covering such products—from the Investment Company Act of 1940 (“IC Act”) to stock-exchange listing standards to Regulation M. However, several new regulatory requirements and developments should be evaluated by certain ETF sponsors and advisers regarding changes to the stock-exchange listing standards and Regulation M. This article summarizes these developments and their potential compliance program implications.

Nasdaq Rule Changes Requiring Website Disclosure for Leveraged and Inverse ETFs

On March 19, 2019, the U.S. Securities and Exchange Commission (“SEC”) approved an amendment to Nasdaq Rules 5705 and 5710. These rules relate to the listing of Index-Fund Shares and Linked Securities (as such terms are defined in the rules).1 Specifically, the amended rules establish additional website disclosure requirements for leveraged and inverse ETFs.

Under the amended rules, leveraged or inverse ETFs must disclose if they seek returns for a single day and highlight the risks associated with holding ETFs with this type of investment objective for more than one day. In describing the risks associated with holding inverse or leveraged ETFs, this disclosure must explain the compounding returns and how holding an ETF that seeks daily returns for longer periods can result in significant deviations from the ETF’s target returns.

ACA Guidance for Nasdaq Rule Changes

Leveraged and inverse ETF Sponsors (and their distributor/principal underwriters) should immediately review their websites to ensure their site includes the following components:

  • A statement as to whether the ETF seeks returns for a single day, and if so, a disclosure highlighting the risks associated with holding this ETF for longer than one day
  • An explanation of the risks unique to leveraged and inverse ETFs—specifically that compounding returns may result in deviations from a fund’s target returns
  • The direction of investors to the ETF’s prospectus for additional information about the calculation of returns and the risks associated with investing in this type of product

ACA also advises a review of the risk disclosures in offering documents and marketing materials to ensure the disclosure language aligns with the disclosure language on the websites.

The SEC Division of Trading and Markets No-Action Letter Harmonizes Regulation M Exemptions for Actively Managed and Index-Based ETFs

On December 3, 2018, the SEC’s Division of Trading and Markets (“DTM”) issued a no-action letter (“2018 NAL”),2 which stated that the SEC staff would not recommend enforcement actions under Rules 101 and 102 of Regulation M if the petitioning index-based ETFs complied with conditions set forth for actively managed ETFs in previous DTM guidance (“Active ETF Relief”).3 The relief granted by the 2018 NAL allows ETFs to harmonize the compliance requirements and testing for actively managed and index-based funds.

Prior to the 2018 NAL, index-based ETFs operated in reliance on class-relief letters that set forth conditions the funds must satisfy to be exempted from Rules 101 and 102 (“Index-Based Class Relief”).4 These conditions included a requirement that such ETFs conduct average daily trading volume testing (“ADTV testing”). This testing is done to confirm that at least 70 percent of the fund’s underlying securities meet the minimum public float and minimum average daily trading volume thresholds under the “actively traded securities” definition found in Regulation M for excepted securities during each of the previous two months of trading prior to the formation of the relevant ETF. The purpose of this test is to ensure that an ETF’s component stocks and thereby the ETF itself have adequate liquidity. However, as the petitioner for the 2018 NAL noted, ETFs will soon be subject to more demanding liquidity requirements under Rule 22e-4 of the IC Act.5 The petitioner proposed that index-based ETFs be allowed to comply with the conditions set forth in the Active ETF Relief. The Active ETF Relief does not require ADTV testing but does require, among other things, that the identity and quantities of securities and assets held by an ETF be published prior to the commencement of trading on each day that the ETF shares trade. Currently, most index-based ETFs post the identity and quantities of securities and assets during the trading day.

ACA Guidance for the SEC Division of Trading and Markets No-Action Letter

Index-based ETFs wishing to rely on the 2018 NAL should review all conditions of the Active ETF Relief before ceasing ADTV testing to ensure they can comply with those terms. ETFs should also confirm that they can satisfy the representations made by the petitioning ETF issuer, as the 2018 NAL is narrowly drawn on the fact pattern described in the request for relief. Finally, ETFs and their managers, should review policies and procedures related to preventing manipulative trade practices to ensure the controls necessary to prevent such manipulation are in place, as stipulated by the SEC in the 2018 NAL.

The New York Stock Exchange Proposes Rule Changes Impacting Index-Based ETFs that Track Municipal Bond Benchmarks

On February 8, 2019, the New York Stock Exchange (“NYSE”) proposed a rule change to amend Arca Rule 5.2-E(j)(3) adopting generic listing standards for ETFs that are based on an index of municipal-bond securities (“Municipal-Bond ETFs”).6 Under the current rule, Municipal-Bond ETFs often cannot satisfy the conditions set forth in the NYSE’s initial listing standards related to the minimum holding size requirements for the component securities of the underlying index. As a result, these funds, and the NYSE, are required to seek approval from the SEC through a Rule 19b-4 Order under the Securities Exchange Act of 1934 before being listed on the NYSE Arca, a process that could be and frequently was time-consuming. The proposed amendment is currently under review by the SEC.

Under the proposed amendment, NYSE will conduct a two-part evaluation of a Municipal-Bond ETF and its underlying index to determine compliance with the generic listing standards. In the first part of the evaluation, the NYSE will examine the index against existing requirements for fixed-income indices, specifically whether 75 percent of the index holdings have a minimum original principal amount outstanding of $100 million or more. If the index does not satisfy this criterion, the NYSE will apply the alternative listing standards available to indices composed solely of municipal securities and cash. The table below summarizes these alternative listing standards.

 Current Listing Standards for Fixed-Income, Index-Based ETFsProposed New Listing Standards for Municipal-Bond ETFs and Their Underlying Index
Original Principal Amount OutstandingFixed-Income ETF components that in aggregate account for at least 75 percent of the Fixed-Income ETF portion of the weight of the index or portfolio each shall have a minimum original principal amount outstanding of $100 million or more.Municipal-Bond ETF components that in aggregate account for at least 90 percent of the Municipal-Bond ETF portion of the weight of the index or portfolio each shall have a minimum original principal amount outstanding of at least $5 million and have been issued as part of a transaction of at least $20 million.
Maximum Weight of Component SecuritiesNo component fixed-income security (excluding Treasury Securities and Government Sponsored Enterprise/GSE Securities) shall represent more than 30 percent of the Fixed-Income ETF’s portion of the weight of the index or portfolio, and the five most heavily weighted component fixed-income securities in the index or portfolio shall not in the aggregate account for more than 65 percent of the Fixed-Income ETF’s portion of the weight of the index or portfolio.No component municipal security shall represent more than 10 percent of the municipal securities’ portion of the weight of the index or portfolio, and the five most heavily weighted component municipal securities in the index or portfolio shall not in the aggregate account for more than 30 percent of the municipal securities’ portion of the weight of the index or portfolio.
Diversification of IssuersAn underlying index or portfolio (excluding one consisting entirely of exempted securities) must include a minimum of 13 non-affiliated issuers.7An underlying index or portfolio must include a minimum of 13 non-affiliated issuers.
Number of Components138500


Additionally, Municipal-Bond ETFs listed under the amended rule will be subject to requirements consistent with those that are already applicable to ETFs tracking U.S. equity securities, global equity securities, and fixed-income securities regarding:

  • index methodology and calculation
  • dissemination of information
  • initial shares outstanding
  • hours of trading
  • surveillance procedures
  • disclosures

NYSE notes that it may approve Municipal-Bond ETFs based on a combination of indexes, including an index composed of municipal securities (“Municipal-Securities Index”). However, to the extent a Municipal-Securities Index is included, the Municipal-Securities Index must adhere to all the new rule requirements related to index dissemination and the continued-listing standards. Municipal-Bond ETFs that rely on combination indexes that include Municipal-Securities Indexes will not be allowed to pursue strategies that seek to multiply performance directly or inversely of the combination indexes.

ACA Guidance for the New York Stock Exchange Proposed Rule Changes

Pending adoption of the amended rule, sponsors and advisers to Municipal-Bond ETFs seeking to rely on the NYSE’s initial listing standards should review all requirements contained therein to identify operational and investment process changes to ensure they can comply at the time of listing and thereafter. As discussed in a previous blog post, the continued-listing standards impose “significant new compliance requirements” that involve adopting comprehensive compliance-monitoring procedures and testing. Failure to adhere to the listing standards can result in penalties such as a notification of noncompliant status sent to market participants and delisting. Additionally, Municipal-Bond ETF managers should review material nonpublic information policies and procedures to ensure they have the necessary controls in place to mitigate risk effectively.

Additional Resources

How ETP Managers Can Ensure Compliance with Continued Listing Standards

About the Author

Veronica Popp joined ACA Compliance Group in September 2018 through the acquisition of Cordium. As a consultant working out of ACA's Boston office, Veronica works closely with their investment company practice.

Prior to joining Cordium, Veronica held compliance positions at Columbia Threadneedle Investments and State Street Global Advisors. During law school, she interned in the legal department at Eaton Vance for the Honorable Joan N. Feeney of the United States Bankruptcy Court for the District of Massachusetts.

Veronica earned her J.D. degree from Suffolk University Law School and her Bachelor of Arts, Business Administration and Management and Economics from Regis College.








7 Under current rules, indices composed entirely of municipal securities are exempt from this diversification requirement.

8 The current generic listing standards do not stipulate a minimum number of securities for an ETF’s index. However, the current rules do require indexes to have 13 non-affiliated issuers, and, as such, fixed-income, index-tracking funds are indirectly held to the same requirement.