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Corp Fin has issued a few new CDIs—two relating to Section 16 and one relating to beneficial ownership under Rule 13d-3. The new CDIs address issues in connection with exchange-traded funds, or ETFs, and the use of “informational barriers.”

Exchange Act Section 16

Section 109. Rule 16a-1 ? Definition of Terms

109.02  This CDI addresses the issue, for purposes of Rule 16a-1(a)(1), of whether an authorized participant (“AP”) in an ETF can “rely on informational barriers to determine whether the AP is a greater than 10% beneficial owner of the ETF’s portfolio securities that are acquired on its behalf in a Confidential Account on a disaggregated basis from other accounts of the AP.”  The CDI posits a situation where an ETF does not disclose on each trading day the identities and quantities of its portfolio securities, and, to maintain confidentiality, the AP effects creation and redemption transactions through a confidential brokerage account (“Confidential Account”) with an agent (“AP Representative”), for the AP’s benefit.  The AP will not know the identities and quantities of the ETF’s portfolio securities, but it will have some control over the timing of the purchases and sales as a result of its ability to place creation and redemption orders with the ETF.  According to Corp Fin, the AP can rely on informational barriers to determine whether it is a greater than 10% beneficial owner of the ETF’s portfolio securities for purposes of Section 16 if the arrangement is consistent with SEC guidance regarding the calculation and reporting of beneficial ownership status set forth in Release No. 34-39538 (Jan. 12, 1998), including the following conditions:

  • “the agreements governing the Confidential Account contain confidentiality provisions that operate as an effective informational barrier between the AP and the AP Representative and other persons with knowledge of the composition of the ETF’s portfolio;
  • the AP, AP Representative, and the ETF’s custodian are unaffiliated entities that do not share officers, directors, or employees with investment discretion over the Confidential Account and their respective directors, officers, and employees do not participate in common compensation pools; and 
  • the AP obtains an annual, independent assessment of the operation of the policies and procedures established to prevent the flow of information related to the Confidential Account.”

SideBar

In the context of attribution of beneficial ownership to parent entities, Release No. 34-39538 (Jan. 12, 1998), to which Corp Fin refers in the CDIs, states that

“[o]ne circumstance in which ownership may not be required to be attributed to the parent entities is when these entities have in place certain informational barriers that ensure that the voting and investment powers are exercised independently from parent and affiliated entities. This approach assumes that there will not be arbitrary or artificial separation of business units.  One factor militating against separation would be participation in a common compensation pool that may align voting and investment decisions. When informational barriers are relied upon to avoid attributing beneficial ownership to the parent entities, the various companies or groups should maintain and enforce written policies and procedures reasonably designed to prevent the flow of information to and from the other business units, divisions and entities that relate to the voting and investment powers over the securities.  Those companies or groups also should obtain an annual, independent assessment of the operation of the policies and procedures established to prevent the flow of information among the related entities.  The frequency [with] which an informational barrier is crossed with respect to a particular security (and therefore beneficial ownership would be attributed for that security) would raise questions regarding the efficacy of the informational barrier overall.  However, an isolated instance in which this occurs would not necessarily impact the ownership treatment of securities of other issuers held by the reporting person.  Finally, the parent entities should have no officers or directors (or persons  performing similar functions) or employees (other than clerical, ministerial, or support personnel) who are involved in the exercise of the voting and investment powers in common with the shareholder. For example, the existence of an independent investment committee would be  evidence of an effective separation between the parent and the affiliated entities.”   

209.06   This CDI relates to how, under certain circumstances, an AP can avoid being deemed to have a pecuniary interest in an ETF’s creation or redemption basket. Where APs in an ETF have directors or officers, or the directors or officers of the AP’s parent holding company, that serve as a director of an issuer of securities purchased or sold as part of the ETF’s in-kind creation or redemption baskets, the AP or its parent holding company may be deemed to be a director of that issuer for the purposes of Section 16 based on expressly or impliedly “deputizing” that individual to serve as its representative on the issuer’s board of directors.  For the AP and its parent holding company to avoid being deemed to have a pecuniary interest in a security in the creation or redemption basket for the purposes of Rule 16a-1(a)(2), the ETF could substitute cash for that basket security, so that neither the AP, nor anyone transacting on the AP’s behalf, would purchase, receive or sell the security.  

Exchange Act Sections 13(d) and 13(g) and Regulation 13D-G Beneficial Ownership Reporting

Section 105. Rule 13d-3 ? Determination of Beneficial Ownership

105.07  This CDI  posits the same factual situation as in CDI 109.02 above, but addresses the issue of whether the AP can rely on informational barriers to calculate and report its Rule 13d-3 beneficial ownership of the ETF’s portfolio securities that are acquired on its behalf in a Confidential Account on a disaggregated basis from other accounts of the AP. Corp Fin advised that the AP may rely on informational barriers so long as the arrangement is consistent with the SEC’s guidance set forth in Release No. 34-39538, including the conditions described under the Section 16 CDI 109.02 above.

Posted by Cydney Posner

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