Jim Wiandt

ETF Regulatory and Tax Complications

The following article is an excerpt from the book by Will McClatchy and Jim Wiandt, Exchange Traded Funds - An Insider's Guide to Buying the Market, published by John Wiley & Sons. The book was shipped today, November 9, 2001 and is available for purchase on Amazon.com.

Many of the early developers of ETFs say that it took a miraculous convergence of determination and circumstance to ultimately garner the approval of the SEC and get the new products off the ground. The basic structure of ETFs runs counter to some important SEC regulations. Therefore, every time a new ETF hits the market, it has to seek special exceptions from the SEC to these regulations.

Down to the Nitty Gritty

Here is how the complicated process goes from a legal standpoint, from conception of a fund to its launch on a stock exchange.

While much of the trail has already been blazed by the early ETFs, every prospective fund still has to go through a series of organizational and regulatory procedures before it can be launched. Briefly, here are the legal tasks that must be dealt with before a fund can begin trading.

• The firm that wants to launch the ETF must set up an investment company in the same way you would with an ordinary mutual fund.
• The ETF organizer must file an exemptive order with the SEC's Division of Investment Management to ask for exemptive relief from certain sections (details follow) of the 1940 act.
• The ETF organizer must file an exemption request for the 1934 act to the SEC Division of Market Regulation to allow trading exemptions (details also follow).
• For a domestic fund, the exchange that the ETF will trade on must have current rules that allow the operation of that specific type of ETF. If the rules do not already exist, the exchange must apply on the fund's behalf to a different section of the SEC's Division of Market Regulation to approve the rule changes.
• Relief must be applied for to the National Association of Securities Dealers (NASD) to make sure that the shares trading on the secondary market are permitted to trade at a price other than the NAV.
• Typically, no special IRS relief is required under a typical investment company structure.
• The fund advisor must set up relationships with the Depository Trust and Clearing Corporation (DTCC[en]NSCC/DTC) so that the logistics of ETF trading are possible.

The most contentious regulatory issues in the early days of ETF development revolved around issues that are always important to the SEC: transparency and thoroughness of reporting. Before granting any exceptions, the SEC had to be convinced that the products would be fair and that they would work. Less transparency or efficiency is not acceptable to the Securities and Exchange Commission.

"Prospectus delivery relief was a huge point of discussion. Another was certainly the concept of secondary market shares trading differently than NAV, how different they would trade from NAV, and would the arbitrage mechanism work. We had to meet with the SEC staff and explain to them why we thought hypothetically it ought to work." Kathleen Moriarty, partner at Carter, Ledyard & Milburn

Tax Efficiency: A benefit gained without a regulatory battle

Although ETFs are able to achieve tax efficiencies that traditional open-ended mutual funds do not enjoy, no landmark IRS decision was required to launch the new products. The fact is, existing funds are allowed to trade equities in-kind, but very rarely do, as most investors are looking for cash when they redeem their investments. Because tax must ultimately be paid on all gains, the in-kind process does not provide a legal hurdle. It is just an interesting (and unforeseen, according to the early developers of the SPDRs) benefit of ETF structure. As Nate Most, president and chairman of iShares Trust said, "We did not consider the tax advantages of the structure while we were developing it, that only became clear later."

For more information on why the tax advantage gained by the ETF structure is not a clever loophole, but actually allows for a more democratic allotment of tax exposure to shareholders, read our previous article covering the tax efficiencies of ETFs.

Copyright Index Funds, Inc., and John Wiley & Sons. The article is an excerpt from the book by Will McClatchy and Jim Wiandt, Exchange Traded Funds - An Insider's Guide to Buying the Market, published by John Wiley & Sons. The book was shipped today, November 9, 2001 and is available for purchase on Amazon.com.