SEC no-action letter: Exemption from Section 11(d)(1) for broker-dealer APs extending credit on ETF shares

November 21, 2005

Securities Industry Association Derivative Products Committee 120 Broadway, 35 Fl. New York, NY 10271-0080

Dear Ms. Bullitt, Mr. Vitha, and Ms. Medero:

In your letter, dated August 26, 2005, the Derivative Products Committee of the Securities Industry Association, with the support of Barclays Global Investors, N.A., requests an exemption from Section 11(d)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) in connection with certain extensions of credit on the shares of exchange-traded funds (“ETFs”). 1 Specifically, you request that the Commission extend the relief from Section 11(d)(1) currently available for broker-dealers that trade the shares of a particular ETF solely in the secondary market to include broker-dealers involved in the issuance and redemption of shares of such ETF as Authorized Participants (as described in your letter) of such ETF (“Broker-Dealer APs”).

Response

On the basis of your representations and the facts presented, we find that it is appropriate in the public interest and consistent with the protection of investors to grant, and hereby grant, an exemption from Section 11(d)(1) of the Exchange Act to permit broker-dealers to extend or maintain or arrange for the extension or maintenance of credit to or for customers on the shares of Qualifying ETFs (as defined below) for which such broker-dealers are Broker-Dealer APs, subject to the following conditions:

Neither the Broker-Dealer AP, nor any natural person associated with such Broker-Dealer AP, directly or indirectly (including through any affiliate of such Broker-Dealer AP), receives from the fund complex 2 any payment, compensation or other economic incentive to promote or sell the shares of the ETF to persons outside the fund complex, 3 other than non-cash compensation permitted under NASD Rule 2830(l)(5)(A), (B), or (C); 4 and

The Broker-Dealer AP does not extend, maintain or arrange for the extension or maintenance of credit to or for a customer on shares of the ETF before thirty days have passed from the date that the ETF’s shares initially commence trading (except to the extent that such extension, maintenance or arranging of credit is otherwise permitted pursuant to Rule 11d1-1).

For purposes of our response, Qualifying ETFs are ETFs that satisfy all three of the following conditions:

The ETF shares are issued by an open-end investment company or unit investment trust registered with the Commission under the Investment Company Act;

The ETF shares are listed and trade on a market that has obtained approval from the Commission pursuant to Section 19(b) of the Exchange Act of a rule change regarding the listing and trading of the ETF shares on the market (or that is relying on Rule 19b-4(e) to list and trade the ETF shares); and

The ETF (a) consists of a basket of twenty or more Component Securities, 5 with no one Component Security constituting more than 25% of the total value of the ETF, and is managed to track a particular index all of the components of which are publicly available; 6 or (b) solely for purposes of the exemptive relief for Broker-Dealer APs from Section 11(d)(1) of the Exchange Act, is an ETF with respect to which the staff of the Division of Market Regulation (“Staff”) has granted Non-AP Broker-Dealers (as defined below) relief from the requirements of Section 11(d)(1) in a letter dated prior to the date of this letter, provided that the ETF has not changed in such a way as to materially affect any of the facts or representations in such prior letter.

Prior No-Action Positions under Section 11(d)(1)

As noted in your letter, the Staff has confirmed on numerous occasions prior to the date of this response that it would not recommend enforcement action under Section 11(d)(1) to the Commission against broker-dealers that are not Broker-Dealer APs in a particular ETF,

but that effect transactions in shares of such ETF exclusively in the secondary market (“Non-AP Broker-Dealers”), and extend or maintain or arrange for the extension or maintenance of credit to or for customers on such ETF shares in connection with such secondary market transactions. Such relief is limited to Non-AP Broker-Dealers that do not (and whose associated persons who are natural persons do not), directly or indirectly (including through any affiliate of such Non-AP Broker-Dealer), receive from the fund complex any payment, compensation or other economic incentive to promote or sell the shares of the ETF to persons outside the fund complex, other than non-cash compensation permitted under NASD Rule 2830(l)(5)(A), (B), or (C). 7

Extension of Class Relief

We have provided exemptive, no-action and interpretive relief to ETFs, and to broker-dealers effecting transactions in ETF shares, with respect to various provisions of the securities laws. In particular, we provided, among other things, exemptive relief from Rule 10b-10 and no-action relief from Section 11(d)(1) and Rules 11d1-2, 15c1-5 and 15c1-6 in two class letters in 2001 and 2002. 8 Since the issuance of the Class Letters, we have continued to provide relief to ETFs that failed to meet one or more of the conditions specified in the Class Letters. With the additional experience we have gained in this area, and in light of the relief granted to Broker-Dealer APs above, we believe that it is appropriate to expand the scope of the relief in the Class Letters with respect to Section 11(d)(1) and Rules 10b-10, 11d1-2, 15c1-5 and 15c1-6 to include Qualifying ETFs, as detailed below. 9

Section 11(d)(1) and Rule 11d1-2

The Staff will not recommend enforcement action to the Commission against Non-AP Broker-Dealers that extend or maintain or arrange for the extension or maintenance of credit to or for customers on shares of Qualifying ETFs in connection with secondary market transactions in such ETF shares, provided that the Non-AP Broker-Dealer does not (and its associated persons who are natural persons do not), directly or indirectly (including through any affiliate of such Non-AP Broker-Dealer), receive from the fund complex any payment, compensation or other economic incentive to promote or sell the shares of the ETF to persons outside the fund complex, other than non-cash compensation permitted under NASD Rule 2830(l)(5)(A), (B), or (C). 10

The Staff also will not recommend enforcement action to the Commission under Section 11(d)(1) if broker-dealers treat shares of Qualifying ETFs, for the purposes of Rule 11d1-2 under the Exchange Act, as “securities issued by a registered open-end investment company or unit investment trust as defined in the Investment Company Act of 1940.”

Rule 10b-10

Because of the institutional nature of the market for ETF shares in Creation Unit (as defined in your letter) size aggregations and the public availability of information regarding the identity of the securities to be tendered or received by customers for purposes of ETF share issuance and redemption transactions, we find that it is appropriate in the public interest and consistent with the protection of investors to grant, and hereby grant, an exemption from Rule 10b-10 under the Exchange Act to permit broker-dealers that issue or redeem shares of Qualifying ETFs on behalf of their customers to confirm such issuance or redemption transactions without providing a statement of the identity, price or number of shares of each individual Component Security tendered to or delivered by the ETF pursuant to the issuance or redemption transaction. This exemption does not apply to purchases or sales of ETF shares in the secondary market and is subject to the following conditions:

Confirmation statements of issuance and redemption transactions in ETF shares will contain all of the information specified in paragraph (a) of Rule 10b-10 other than identity, price, and number of shares of each Component Security tendered or received by the customer in the transaction.

Any confirmation statement of an issuance or redemption transaction in ETF shares that omits the identity, price, or number of shares of Component Securities will contain a statement that such omitted information will be provided to the customer upon request; and

All such requests will be fulfilled in a timely manner in accordance with paragraph (c) of Rule 10b-10.

Rules 15c1-5 and 15c1-6

Primarily because of the composite nature of ETF shares and the relatively small proportionate share of any Component Security in an ETF share, the Staff will not recommend enforcement action to the Commission under Rule 15c1-5 if a broker-dealer executes transactions in shares of Qualifying ETFs without disclosing any control relationship with an issuer of a Component Security. Moreover, the Staff will not recommend that the Commission take enforcement action under Rule 15c1-6 if a broker-dealer executes transactions in shares of Qualifying ETFs without disclosing its participation or interest in a primary or secondary distribution of a Component Security.

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The foregoing exemption from Exchange Act Section 11(d)(1) for Broker-Dealer APs is based solely on your representations and the facts presented. 11 That exemption and the exemption from Rule 10b-10, and the no-action positions under Section 11(d)(1) and Rules 11d1-2, 15c1-5 and 15c1-6 are strictly limited to the application of the section and the rules to transactions involving shares of Qualifying ETFs under the circumstances described above and in your letter. In the event that any material change occurs with respect to any of those facts , representations, or circumstances, such transactions should be discontinued, pending presentation of the facts for our consideration. Requests for relief regarding transactions in shares of ETFs that do not satisfy the above criteria (or for products that are not within the scope of this relief 12 ) will continue to be considered on a case-by-case basis. 13

The foregoing exemptions are subject to modification or revocation if at any time the Commission determines that such action is necessary or appropriate in furtherance of the purposes of the Exchange Act. Moreover, the foregoing no-action positions are subject to modification or revocation as necessary or appropriate. The Staff expresses no view with respect

to any other questions the proposed transactions may raise, including, but not limited to, the adequacy of disclosure concerning, and the applicability of other federal and state laws or rules of any self-regulatory organization to, the proposed transactions.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority, 14

Catherine McGuire Chief Counsel

cc: Georgia Bullitt, Esq. Executive Director Morgan Stanley & Co. Incorporated 2000 Westchester Avenue Purchase, NY 10577

John R. Vitha, Esq. Vice President and Associate General Counsel Goldman, Sachs & Co. One New York Plaza 38 th Floor New York, NY 10004

Joanne T. Medero, Esq. Managing Director and General Counsel Barclays Global Investors, N.A. 45 Fremont Street San Francisco, CA 94105

As described more fully in your letter, ETFs are investment companies registered under the Investment Company Act of 1940 (the “Investment Company Act”) either as unit investment trusts or as open-end investment companies. Shares of ETFs are traded by both institutional and retail investors on securities exchanges and in the over-the-counter markets at negotiated prices. ETFs are designed to replicate the holdings or correspond to the performance and yield of a reference securities index or a highly correlated subset of the securities underlying the index.

For purposes of our response, the term “fund complex” means the issuer of the ETF shares, any other issuer of ETF shares that holds itself out to investors as a related company for purposes of investment or investor services, any investment adviser, Distributor (as defined in your letter), sponsor, depositor, or trustee (in the case of a unit investment trust) of any such issuer or any “affiliated person” (as defined in the Investment Company Act) of any such issuer or any such investment adviser, Distributor, sponsor, depositor or trustee.

We would consider an indirect payment to include a sales load, as that term is defined in Section 2(a)(35) of the Investment Company Act, on ETF shares. As noted in your letter, this condition would prohibit a broker-dealer relying on this relief from receiving 12b-1 fees.

ETFs may be formed as different series of shares issued by a single trust or company that is registered under the Investment Company Act. For purposes of our response, each such separate series would be viewed as a separate ETF. All classes of securities that are part of the same series would be deemed the same “ETF shares” for purposes of determining whether a Broker-Dealer AP or any associated person receives from the fund complex any payment, compensation or other economic incentive to promote or sell the ETF shares, even if the other classes of securities are not exchange-traded. Consequently, a broker-dealer’s receipt of compensation from the fund complex to promote one class of shares would disqualify the broker-dealer from extending credit in reliance on this letter on any ETF shares that are part of the same series, but would not affect the ability of the broker-dealer to extend credit in reliance on this letter on other ETF shares that are part of a different series issued by the same entity.

For purposes of our response, “Component Securities” are individual securities that comprise the ETF basket, e.g. , securities that are assembled to replicate the particular index that the ETF tracks.

For purposes of our response, whether any one Component Security constitutes more than 25% of the total value of the ETF shall be determined as of the most recent rebalancing of the ETF’s reference securities index.

See , e.g. , Letter re: SPDRs (Jan. 27, 1993) (“The only compensation a broker-dealer will receive for representing a customer in purchasing SPDRs is the commission charged to that customer -- most likely the same compensation the broker-dealer would receive in connection with any stock purchase by a customer. There is no special financial incentive to a broker-dealer, other than the broker-dealer's regular commission, to engage in secondary market transactions in SPDRs, whether as principal or agent.”); Letter re: iShares MSCI EAFE Growth Index Fund and iShares MSCI EAFE Value Index Fund (Aug. 4, 2005) (“The only compensation a broker-dealer will receive for representing a customer in purchasing iShares is the commission or asset-based brokerage account fee charged to that customer, which in all likelihood is the same compensation the broker-dealer would receive in connection with any stock purchase by a customer. There is no special financial incentive to a broker-dealer, other than the broker-dealer's regular commission, to engage in secondary market transactions in iShares, either as principal or agent.”). See notes 2-4, above, for additional information on this limitation.

See Letter re: American Stock Exchange LLC (August 17, 2001); Letter re: NASDAQ Stock Market, Inc. (Nov. 13, 2002) (together, “Class Letters”).

We are not expanding the scope of the Class Letters with respect to Exchange Act Rules 10a-1, 10b-17, or 14e-5, or Rules 101 or 102 of Regulation M at this time, but are currently considering whether such an expansion may be appropriate.

See notes 2-4, above, for additional information on this limitation.

For example, the 11(d)(1) relief granted in this letter would not be available to a broker-dealer for transactions in shares of an ETF on which a sales load is, or was during the initial distribution period, charged. The Staff would consider a request for 11(d)(1) relief regarding such an ETF on a case-by-case basis.

For example, the relief does not apply to transactions in securities issued by closed-end investment companies or trust-issued receipts issued by entities not registered as investment companies under the Investment Company Act. See , e.g. , Letter re: streetTRACKS Gold Trust (Nov. 17, 2004).

In addition, as noted above, we are not expanding the scope of the Class Letters with respect to Exchange Act Rules 10a-1, 10b-17, or 14e-5, or Rules 101 or 102 of Regulation M. Requests for relief under those rules also will continue to be considered on a case-by-case basis.

17 C.F.R. 200.30-3(32); 17 C.F.R. 200.30-3(63).

Incoming Letter:

The Incoming Letter is in Acrobat format.

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Associate Director and Chief Counsel
Division of Market Regulation
U.S. Securities and Exchange Commission
100 F Street, N.E.
Washington, DC 20549
Re: Request for Exemptive Relief Regarding Exchange-Traded Funds Dear Ms. McGuire:
The Derivative Products Committee of the Securities Industry Association,1 with the support of Barclays Global Investors, N.A.,2 is writing to seek relief from the requirements of Section 11(d)(1) under the Securities Exchange Act of 1934 (the “Exchange Act”) in connection with certain extensions of credit on exchange-traded fund (“ETF”) shares. Specifically, we request that the Securities and Exchange Commission (the “Commission”), pursuant to its authority under Section 36(a) of the Exchange Act, exempt from Section 11(d)(1) broker-dealers involved in the issuance and redemption of ETF shares that extend, maintain or arrange for the extension or maintenance of credit on such shares subject to the conditions described herein. For the reasons described more fully below, we believe the proposed exemption is necessary and appropriate in the public interest and is consistent with the protection of investors.
I. Background.
A. Overview of ETFs.
ETFs are investment companies registered under the Investment Company Act of 1940 (the “1940 Act”) either as unit investment trusts or as open-end investment companies.3 Shares of ETFs are traded by both institutional and retail investors on

(continued . . . )
1 The Securities Industry Association (“SIA”) brings together the shared interests of nearly 600 securities firms to accomplish common goals. SIA’s primary mission is to build and maintain public trust and confidence in the securities markets. At its core: Commitment to Clarity, a commitment to openness and understanding as the guiding principles for all interactions between investors and the firms that serve them. (More information about SIA is available at:
www.sia.com.)
Barclays Global Investors, N.A., through its affiliate Barclays Global Fund Advisors, is the sponsor or investment advisor for over 100 exchange-traded funds with total assets of over $140 billion at July 31, 2005. 3 Certain ETF securities may be issued in the form of units; for simplicity, this letter refers to all such securities as “shares.” The relief requested by this letter would not apply to transactions in

securities exchanges and in the over-the-counter markets at negotiated prices. ETFs are designed to replicate the holdings or correspond to the performance and yield of a reference securities index by purchasing either the component securities underlying the index or a highly correlated subset of the securities underlying the index. Over the past several years, ETFs have grown dramatically, both in number and volume, as investors have recognized the benefits of investing in ETF shares. These benefits to ETF investors include the following:4

• Diversification. ETFs are typically comprised of a basket of securities
  based on a broad index that offers investors significant diversification.
• Reduced Costs and Execution Risks. ETFs permit investors to gain
  exposure to the reference index at a cost that is generally lower than the all-in price of purchasing the component securities. In addition, ETFs generally offer no-load shares, with lower management fees than are usually charged by index-based mutual funds. As exchange-traded instruments, moreover, ETF shares can be traded among investors without imposing on the ETF the transaction costs associated with direct shareholder investments in and redemptions from an investment fund.
• Liquidity and Transparency. ETF shares are traded continuously and their
  prices are disseminated throughout the trading day. Estimated values for ETF shares are usually published in 15-second intervals and net asset value (“NAV”) is calculated and disseminated once per day. In addition, the reference index or portfolio typically consists of publicly-traded securities with liquid markets and transparent prices. A number of ETFs are consistently among the most actively-traded securities on the American Stock Exchange and several ETFs (e.g., Nasdaq 100 Index Tracking Stock and SPDRs) are among the most actively-traded securities in the U.S. equity markets.
• Tax Efficiency. In general, ETFs generate fewer capital gains than
  actively-managed mutual funds due to low turnover of the securities that constitute their portfolios. Furthermore, the unique in-kind issuance/redemption process for ETF shares, described more fully below, results in lower tax liabilities for the ETF (and indirectly, its investors) than an index-based mutual fund handling large inflows and outflows of cash. (. . . continued) securities issued by closed-end investment companies or trust-issued receipts issued by entities not registered as investment companies under the 1940 Act. See generally SEC Release 40-25,258 (Nov. 8, 2001), 66 Fed. Reg. 57,613 (Nov. 15, 2001) (concept release regarding actively-managed ETFs); Paul F. Roye, Regulatory Issues Involving Exchange Traded Funds, Speech at the American Stock Exchange Symposium on Exchange Traded Funds (Jan. 14, 2002).

The Commission and its staff have provided exemptive, no-action and interpretive relief to ETFs, and to broker-dealers effecting transactions in ETF shares, with respect to various provisions of the securities laws.5 B. Issuance and Redemption of ETF Shares. ETFs have unique issuance and redemption features that distinguish them from other investment companies. In particular, ETF shares are issued and redeemed only in large amounts (“Creation Units”) at prices based on the NAV of the ETF’s shares. Generally, these Creation Units are issued by the ETF in exchange for an in-kind deposit of securities that generally mirrors the composition of the ETF portfolio and are redeemed in exchange for an in-kind delivery of securities.6 ETF shares are issued or redeemed through a distributor that is designated as the ETF’s “principal underwriter” for purposes of the 1940 Act (the “Distributor”). Organizations that have entered into an agreement with the Distributor to become Authorized Participants (“APs”) of the ETF may place orders with the Distributor to purchase or redeem Creation Units. These APs, which generally are broker-dealers acting in a principal capacity,7 are not compensated by the ETF in connection with the issuance or redemption of ETF shares;8 in fact, APs may be required to pay fees to the ETF to cover the transaction costs of issuing and redeeming the shares. A number of broker-dealer APs typically are actively involved in trading the ETF shares. Broker-dealers, acting as APs, may place orders to purchase Creation Units of ETF shares to facilitate one or more customers that wish to exchange securities that mirror the composition of the ETF portfolio for ETF shares.9 Broker-dealers acting as APs may also purchase Creation Units of ETF shares for their own inventory – e.g., for proprietary trading, customer facilitation trades or risk management and hedging purposes. In addition, broker-dealers acting as APs may purchase or redeem Creation See, e.g., iShares Trust (avail. Jul. 25, 2002); Vanguard VIPERS Small-Cap Index Fund, Total Stock Market Index Fund, Extended Stock Market Index Fund (avail. May 21, 2001); CountryBaskets Index Fund, Inc. (avail. Mar. 22, 1996); American Stock Exchange (avail. Jan. 28, 1993). 6 The investment adviser or sponsor of the ETF announces the contents of the in-kind deposit/delivery at the beginning of each business day. Certain ETFs reserve the right to issue and redeem shares for cash. In addition, a small number of ETFs based on foreign securities indices issue and redeem shares only on a cash basis. APs generally are participants in the relevant clearing system (typically, DTC) for the shares. 8 However, some broker-dealers may be compensated by an ETF other than in connection with an issuance of ETF shares. See, e.g., note 15 below. Because of the size of Creation Units – typically in the range of 50,000 shares, with a market value frequently in excess of $1,000,000 – generally only large institutions are
involved in the issuance or redemption of ETF shares. In secondary market transactions, however, ETF shares may be traded in any quantity by institutional and retail investors.

Units of ETF shares to arbitrage any differences between the market price of an ETF share and the NAV of the ETF share. The participation by broker-dealers in the issuance and redemption of ETF shares offers a number of important benefits to investors and the marketplace. For example, through their arbitrage activities, these broker-dealers help ensure that ETF shares trade at or near their NAV.10 Moreover, by making ETF shares available to customers through the issuance process or in secondary market trading, these broker-dealers support the liquidity of the ETF shares, thereby promoting market efficiency and reduced spreads. Because broker-dealers that are APs are also among the most active traders of ETF shares, these broker-dealers are able to offer significant market and product expertise and efficient execution to investors.
C. Prior Commission Guidance Regarding Section 11(d)(1).
Section 11(d)(1) generally prohibits a person who is both a broker and a
dealer from extending or maintaining or arranging for the extension or maintenance of credit to or for a customer on any non-exempted security that is a part of a new issue in the distribution of which the broker-dealer participated as a member of a selling syndicate or group within the previous thirty days. The Commission has taken the position that shares of open-end investment companies and unit investment trusts registered under the 1940 Act, such as ETF shares, are distributed in a continuous manner, and that broker￾dealers selling such securities are therefore participating in the “distribution” of a new issue for purposes of Section 11(d)(1).11 The Commission has provided limited relief from the requirements of
Section 11(d)(1) for broker-dealers trading ETF shares. In particular, Commission staff
has confirmed that it would not recommend enforcement action against broker-dealers who engage in or effect transactions in ETF shares in the secondary market, but who do not act as APs.12 In addition, the staff has confirmed that broker-dealers that participate in the issuance of ETF shares may extend, maintain, or arrange for the extension or 10 Arbitrageurs play a crucial role in connection with the trading and pricing of ETF shares, which results in benefits for investors. See generally SEC Release No. 40-25,258 (Nov. 8, 2001), 66 Fed. Reg. 57,613 (Nov. 15, 2001). As described by the Commission, when an ETF trades at a price less than its NAV, broker-dealers may purchase individual ETF shares in the secondary market and, after accumulating enough shares to equal a Creation Unit, redeem them from the ETF at NAV, thereby acquiring the more valuable underlying securities. These redemptions reduce the supply of ETF shares and may raise the market price of such shares to a level closer to NAV. Conversely, if ETF shares trade at prices greater than NAV, arbitrageurs may purchase the underlying securities, use them to obtain the more valuable Creation Units from the ETF and then sell the individual ETF shares in the secondary market to realize a profit. As the supply of individual ETF shares increases, the price of the ETF shares may fall to levels closer to their NAV. Id. at 57,616. 11 See, e.g., SEC Release No. 34-6726 (Feb. 8, 1962), 27 Fed. Reg. 1415 (Feb. 15, 1962); SEC Release No. 34-21,577 (Dec. 18, 1984), 49 Fed. Reg. 50,174 (Dec. 27, 1984). 12 See e.g., letters cited in note 5 above.

maintenance of credit on such shares pursuant to Rule 11d1-2 if the shares have been owned by the customer for more than thirty days.13 To date, however, the Commission and its staff have not provided any additional relief from the restrictions of Section 11(d)(1) specifically addressing broker-dealer APs that trade ETF shares.
II. Rationale for Relief from Section 11(d)(1) for Broker-Dealer APs.
The Commission is authorized under Exchange Act Section 36(a) to issue orders exempting persons, securities or transactions from the requirements of the Exchange Act if such exemption “is necessary or appropriate in the public interest, and is consistent with the protection of investors.” In our view, it would be in the public interest and consistent with the investor protection objectives of the Exchange Act for the Commission to extend the relief from Section 11(d)(1) currently available for broker-dealers that trade ETF shares solely in the secondary market to include those broker-dealers that, as APs, also participate in the issuance of ETF shares. As discussed more fully below, broker-dealers involved in the issuance of ETF shares do not have incentives to use credit to “push” such shares. In addition, many unique features of ETF shares – including their liquidity and the transparency of their pricing – provide additional protections to investors beyond those available for most new issues. A. Broker-Dealer APs Do Not Have Incentives to Engage in “Share Pushing” of the Type that Section 11(d)(1) Was Intended to Address.
Section 11(d)(1) was intended to address conflicts of interest arising in
circumstances in which a person acts as both a broker and a dealer. The restrictions it imposes on the extension, maintenance, and arranging of credit in connection with a new issue of securities are designed to protect investors from “one of the greatest potential evils inherent in the combination of the broker and dealer function in the same person, by assuring that [a broker-dealer] will not induce his customers to buy on credit securities which he has undertaken to distribute to the public.”14 Section 11(d)(1) thus seeks to prevent broker-dealers from “share-pushing” by offering credit for the purchase of newly-issued securities. Broker-dealer APs do not have incentives to use credit to engage in the share pushing that Section 11(d)(1) was designed to address. First, broker-dealers participating in the issuance of Creation Units do not have the risk exposures that underwriters face in firm-commitment underwritings of new issues. For example, broker-dealer APs do not have capital at risk or market exposure of the type that an underwriter has with respect to its allotment of a new offering. APs are under no 13 Exchange Act Rule 11d1-2 provides an exemption from Section 11(d)(1) for broker-dealers who extend credit on securities issued by open-end investment companies or unit investment trusts registered under the 1940 Act to customers who have owned such securities for more than thirty days. 14 H.R. Rep. No. 1383, 73rd Cong., 22d Sess. at 22 (1934).

obligation to place orders for any amount of Creation Units, and therefore they act only on a demand-driven basis – APs purchase Creation Units of ETF shares only as and when they or their customers need the ETF shares for trading or investment purposes. As a result, broker-dealer APs do not have an incentive to extend, maintain, or arrange credit to induce purchases of securities in order to reduce funding and market risk exposures. Second, broker-dealer APs do not receive the types of special sales compensation typically paid to underwriters or placement agents. They are not paid an underwriting commission, concession or sales charge from the ETF or the Distributor in connection with the purchase of Creation Units of ETF shares from the ETF. As noted above, broker-dealers acting as APs generally are required to pay a transaction fee for the purchase of a Creation Unit. In addition, upon sale of the ETF shares comprising a Creation Unit to customers or other broker-dealers, a broker-dealer AP receives only a customary commission (if acting as agent) or mark-up/spread (if acting as principal), determined in the same manner as in any sale of stock by the broker-dealer in a secondary market transaction. These forms of compensation do not create any special incentives for a broker-dealer AP to extend, maintain, or arrange for the extension or maintenance of credit to investors in order to induce a purchase of the ETF shares.15 We note that upon the initial formation of an ETF, broker-dealer APs may invest in a substantial amount of ETF shares (in the form of Creation Units), among other reasons, to facilitate the launch of the new fund. In our view, there are important distinctions between the activities of such broker-dealers and those of firm-commitment underwriters – including that the broker-dealer APs are not compensated by the ETF for selling the new ETF shares to the public. In order to address any concerns that might arise regarding the incentives created by any such initial investment in the ETF, however, we believe it would not be inappropriate for the Commission to continue to apply Section 11(d)(1) to broker-dealer APs for a period of thirty days after the ETF shares initially commence trading. B. Certain Features of ETFs Offer Additional Protections to Investors Who Obtain Credit on ETF Shares from Broker-Dealer APs. Several features of ETF shares that distinguish them from other types of securities, including mutual fund shares, offer significant protections from inappropriate sales practices or other risks that Section 11(d)(1) would otherwise address. Section 11(d)(1) prevents broker-dealers from using financing to encourage a customer to purchase newly-issued securities for which there is no ready market.16 In the case of ETF 15 Some broker-dealers may be eligible to receive certain compensation for investor services pursuant to a plan adopted by an ETF under Rule 12b-1 of the 1940 Act (“12b-1 fees”). As discussed in more detail
below, the proposed relief would be conditioned on APs not receiving certain compensation from an ETF, including 12b-1 fees. 16 See, e.g., H.R. Rep. No. 1383, 73d Cong., 2d Sess. at 15 (1934) (referring to the difficulties for an underwriter in giving impartial advice, particularly with respect to “new securities for which there is no ready market”).

shares, however, there is significant price transparency and liquidity. There is little risk that customers would purchase ETF shares on excessive credit due to an inability to accurately value the shares. As noted above, prices for ETF shares are readily available from secondary market transactions on the relevant exchange or in the OTC markets, and the NAV of the ETF shares is published regularly. Moreover, the ETF itself generally consists of liquid securities trading in transparent markets. In addition, extensions of credit on ETF shares would not raise the types of concerns that the Commission staff has identified in the past when considering extensions of credit on mutual fund shares. In particular, Commission staff has expressed concern that if credit is extended on mutual fund shares, upon a decline in value of those shares investors faced with “margin calls” would seek to redeem the shares, forcing the mutual fund to liquidate its assets and potentially creating additional “downward” price pressure and related operational problems for the fund.17 We believe that this is less likely to occur in the context of ETFs because investors in ETF shares can sell those shares in a liquid secondary market rather than redeeming them. Moreover, even when redemptions are made by an ETF, the fact that they are made in kind prevents any disruption to the ETF’s investment strategy (since, unlike a mutual fund, the ETF would not need to liquidate some of its investments to fund a redemption payment made in cash). There is also little risk that any credit extended on ETF shares by broker-dealer APs would affect the prices of those shares. As noted above, the in-kind issuance and redemption features of ETFs offer arbitrage opportunities that significantly limit the extent to which ETF shares trade at a premium or discount to the NAV of the ETF shares. Consequently, credit on ETF shares is unlikely to affect the volatility of those shares or otherwise provide a mechanism through which broker-dealer APs or other market participants could affect the price of ETF shares by influencing their supply or demand.
III. Conditions to Relief.
In order to address any concerns the Commission may have regarding broker-dealer APs extending, maintaining or arranging for the extension or maintenance of credit on the shares of an ETF for improper reasons, the exemptive relief could be made subject to the following conditions:

1. Neither the broker-dealer AP nor any natural person associated with such
   broker-dealer AP, directly or indirectly (including through any affiliate of such broker-dealer AP), receives from the fund complex18 any payment, (continued . . . ) 17 Investment Company Institute (avail. Jan. 19, 1989) (“numerous and sudden redemptions of fund shares . . . [resulting] from forced close-outs of margin accounts if margin calls were not answered with respect to fund shares that were purchased on credit . . . could have a substantial and deleterious effect on the fund’s operations”). 18 For purposes of this letter, the term “fund complex” means the issuer of the ETF shares, any other issuer of ETF shares that holds itself out to investors as a related company for purposes of

compensation or other economic incentive to promote or sell shares of the ETF to persons outside the fund complex,19 other than non-cash compensation permitted under NASD Rule 2830(l)(5)(A), (B), or (C).20
2. The broker-dealer AP does not extend, maintain or arrange for the
extension or maintenance of credit to or for a customer on shares of the ETF before thirty days have passed from the date that the ETF’s shares initially commence trading (except to the extent that such extension, maintenance or arranging of credit is otherwise permitted pursuant to Rule 11d1-1).
3. The ETF shares are issued by an open-end investment company or unit
investment trust registered with the Commission under the 1940 Act.
4. The ETF shares are listed and trade on a market that has obtained approval
from the Commission pursuant to Section 19(b) of the Exchange Act of a rule change regarding the listing and trading of the ETF shares on the market (or that is relying on Rule 19b-4(e) to list and trade the ETF shares).
5. The ETF (a) consists of a basket of twenty or more component
securities,21 with no one component security constituting more than 25% of the total value of the ETF, and is managed to track a particular index (. . . continued) investment or investor services, any investment adviser, Distributor, sponsor, depositor or trustee (in the case of a unit investment trust) of any such issuer or any “affiliated person” (as defined in the 1940 Act) of any such issuer or any such investment adviser, Distributor, sponsor, depositor or trustee. 19 Indirect payments would include a “sales load,” as that term is defined in Section 2(a)(35) of the 1940 Act, on ETF shares. We understand that the requested relief from Section 11(d)(1) would not be available to a broker-dealer for transactions in shares of an ETF that charges a sales load either during the initial distribution period for the shares or thereafter, although requests for such relief would be considered by the Commission staff on a case-by-case basis. 20 ETFs may be formed as different series of shares issued by a single trust or company that is registered under the 1940 Act. For purposes of this letter, each such separate series would be viewed as a separate ETF. All classes of securities that are part of the same series would be deemed the same “ETF shares” for purposes of determining whether a broker-dealer AP or any associated person receives from the fund complex any payment, compensation or other economic incentive to promote or sell the ETF shares, even if the other classes of securities are not exchange-traded. Consequently, a broker-dealer’s receipt of compensation from the fund complex to promote one class of shares would disqualify the broker-dealer from extending credit in reliance on this letter on any ETF shares that are part of the same series, but would not affect the ability of the broker-dealer to extend credit in reliance on this letter on other ETF shares that are part of a different series issued by the same entity. 21 For purposes of this letter, the term “component securities” means the individual securities that comprise the ETF basket (e.g., securities that are assembled to replicate the particular index that the ETF tracks).

whose components are publicly available,22 or (b) is an existing ETF with respect to which non-AP broker-dealers are eligible for relief from the requirements of Section 11(d)(1) pursuant to a letter dated prior to the date of any exemptive relief granted in response to this letter.
IV. Conclusion.
For the reasons stated above, we respectfully request that the Commission, pursuant to its authority under Section 36(a) of the Exchange Act, exempt from Section 11(d)(1) broker-dealers involved in the issuance and redemption of ETF shares that extend or maintain or arrange for the extension or maintenance of credit on such shares subject to the conditions described in Part III above.

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If you have any questions, please do not hesitate to contact Jerry Quinn, Associate General Counsel of SIA, at 212-618-0507 or Robert W. Cook of Cleary Gottlieb Steen & Hamilton LLP, counsel to the SIA Derivative Products Committee in this matter, at 202-974-1538. Sincerely yours, /s/ Georgia Bullitt /s/ John R. Vitha Georgia Bullitt John R. Vitha Executive Director Vice President and Morgan Stanley & Co. Incorporated Associate General Counsel on behalf of the Goldman, Sachs & Co. SIA Derivative Products Committee on behalf of the SIA Derivative Products Committee /s/ Joanne T. Medero Joanne T. Medero Managing Director and General Counsel Barclays Global Investors, N.A. cc: Robert L.D. Colby, Deputy Director Michael A. Macchiaroli, Associate Director Brian A. Bussey, Assistant Chief Counsel Norman M. Reed, Special Counsel Division of Market Regulation

22 In our view, it would be appropriate to determine whether any one component security constitutes more than 25% of the total value of the ETF as of the most recent rebalancing of the ETF’s reference securities index.