SEC Shutdown's Impact On ETFs

January 22, 2019

The government shutdown is taking its toll on all corners of the U.S. economy, including the ETF industry.

Delayed or suspended approvals, long wait times, and uncertainty over the status of pending filings are just some of the ETF-specific problems being reported during the government shutdown, which, as of this writing, is now 26 days long and is the longest such shutdown in U.S. history.

The longer the shutdown goes on, the likelier the problems will escalate. "If the SEC comes back six months from now, it could be mayhem," said one industry executive.

SEC Furloughs 94% Of Staff

As of Dec. 27, 2018, the Securities and Exchange Commission (SEC) had put 94% of its staff on furlough, leaving at the agency a skeleton crew of just under 300 employees to manage its essential operations. According to the agency's website, this includes "emergency situations involving market integrity and investor protection, including law enforcement."

All other employees have been told not to go into the office or use their government-issued work computers and phones. Nor may they answer calls or emails, not even on a volunteer basis.

Fortunately for investors, no trading disruptions were immediately apparent, and several new ETF launches have gone on as scheduled, including new products from Direxion, ProShares, First Trust and Innovator ETFs. There has even been a new entrant into the ETF industry, Syntax, though the firm's debut launch had been in the pipeline well in advance of the shutdown (read: "Newcomer's ETF Reweights S&P 500").

Yet the furlough has effectively put the SEC's filing process on autopilot. During the shutdown, new ETF-related filings may be made, and certain types of ETFs may be launched, but nothing that requires SEC review or approval can move forward.

"If you had a new product in the pipeline, then you're really in a crunch," said Fatima Sulaiman, partner at law firm K&L Gates.

No New ETF Issuers During Shutdown

Obviously the most important SEC filings are those concerning the launch of new ETFs. Launching funds, especially as a new issuer, is no simple matter, and often the process requires several rounds of back-and-forth with the SEC.

Before a prospective issuer can launch its own ETFs, it must first obtain from the SEC what is known as "exemptive relief"—literally an exemption from certain provisions of the 1940 Act, which governs how open-ended funds operate.

Unfortunately, however, no new applications for exemptive relief may be reviewed or approved during the furlough, effectively preventing any would-be issuers from entering the market.

Under the SEC's proposed ETF Rule, this exemptive relief requirement would be eliminated, and issuers could launch ETFs just like any other open-ended fund (read: "SEC Backs Major ETF Rule Change").

However, the review of this rule has been suspended indefinitely, due to the shutdown.

ETF Launches Become Largely Automatic

After issuers obtain their exemptive relief, they must then establish a trust for the specific purpose of launching ETFs and submit relevant paperwork to the SEC—which is no longer around to approve it; meaning, at the moment, no new ETF trusts may be approved.

However, existing trusts may file to launch new ETFs as usual. Most ETFs registered by existing trusts don't require explicit SEC approval, instead becoming automatically effective after a 60- or 75-day waiting period. (No approval is necessary because they tend to be substantively similar to existing funds that have already received the greenlight from the SEC.)

During the furlough, existing ETF issuers can and have made filings to launch new funds on the Electronic Data Gathering, Analysis and Retrieval (EDGAR) system, the SEC database in which new and existing fund prospectuses and other relevant filings are published.

EDGAR is operated by a contractor and therefore remains functional, though disruptions to EDGAR service have been reported. Lag times and time-outs have increased, with some users reporting having to wait hours to access the system.

ETF.com reached out to a number of ETF issuers, and none of them reported hiccups in their filing or launch process. However, all the issuers contacted reported having no contact with SEC officials since the shutdown began.

New Trusts Going Without SEC Approval

In the case of a newly established trust seeking to launch its first products, issuers will typically write what's known as a "delaying amendment," said Sulaiman.

The delaying amendment, which pushes back the intended product launch by a few weeks, gives the SEC the chance to review the fund filing and make sure everything checks out. If not, the agency can seek clarification and provide guidance as to what ought to be changed before launch.

"Basically, [the delaying amendment] says that this ETF will not become effective until the SEC issues an order declaring its effectiveness," Sulaiman added.

With nobody at the SEC to issue those orders, the SEC has suggested that sponsors rescind their delaying amendments, according to a FAQ on the SEC's Division of Corporate Finance's website.

If done, then any funds launched from these brand-new trusts would become effective automatically after a 75-day waiting period, just as for existing trusts. Yet they'd lack the benefit of SEC comments.

On the surface, that sounds like a golden opportunity for sponsors eager to launch their products. However, once the shutdown has ended, if the SEC were to review the filing and find omissions or mistakes, it could result for the sponsor in costly, time-consuming modifications to disclosures, documentation, marketing materials, etc. In a worst-case scenario, it might even mean the fund is pulled from market.

"Legally, you can go forward with that process," said Sulaiman. "But you risk the possibility that when the SEC does come back, they'll have an objection that needs to be addressed."

Post-Effective Amendments Not Impacted

To make changes to ETFs that have already launched, issuers often file "post-effective amendments." Examples of post-effective amendments include a substantial expense ratio drop, or a change in a fund's investment objective.

Depending on the nature of the filing, a post-effective amendment becomes effective either immediately after filing or after a certain number of days have passed (usually 60 or 75), even with the SEC shutdown.

However, issuers often seek out SEC approval for these changes, even though it's not strictly required.

"From a legal perspective, there's nothing stopping you" from going forward, said Sulaiman. But as with the delaying amendments, the SEC could always review a post-effective amendment at a later date and demand changes from the sponsor.

Bitcoin ETF By Default?

There are also SEC filings that govern where and how an ETF might trade. All ETFs must list on a stock exchange—it's right there in the name "exchange-traded fund"—meaning that these products must meet their intended exchange's so-called generic listing standards.

Sometimes, though, a proposed ETF doesn't meet those standards. If that happens, then the exchange must file with the SEC a Form 19b-4 proposing a rule change that would allow the ETF to be listed. After the 19b-4 is filed, a public comment period follows; once that window closes, the SEC has a set number of days (usually 90 or 270) to review the filing and either approve or reject it.

For example, in the case of bitcoin ETFs, the SEC has already reviewed and rejected several 19b-4 filings already. However, a 19b-4 filing that would allow a proposed Van Eck/Solid X bitcoin ETF to list and trade on Cboe Global Markets is still active; it has a deadline for SEC approval set for the end of February. (Cboe Global Markets is the parent company of ETF.com.) (Read: "VanEck, Solid X Team Up On Bitcoin ETF.")

Should the government shutdown continue for that long, it is unclear whether the proposed bitcoin ETF would be automatically approved or disapproved.

"One camp believes that if the SEC doesn't act, then the fund becomes automatically approved," said one industry source in providing background information. "The other camp believes that the exchange has no obligation to act until the day the SEC reopens."

What Happens When The Doors Reopen?

For her part, Sulaiman doesn't expect issuers to be able to squeak through controversial funds. "Presumably, even now the [SEC] staff is making any type of bitcoin ETF, marijuana ETF or controversial product at the top of their priority list," she said.

What's certain is that once the government shutdown ends and the SEC resumes normal operations, it will likely take some time for the agency to churn through its backlog of filings and demands.

"There just won't be that capacity for business as usual yet," said Sulaiman.

Contact Lara Crigger at [email protected]

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