NASD Office of General Counsel, Regulatory Policy and Oversight
August 14, 2006
NASD staff is issuing this memorandum to address the application of NASD rules on secondary trading in shares of exchange-traded investment companies registered under the Investment Company Act of 1940 ("the Act").
Exchange-traded funds ("ETFs") are generally unit investment trusts ("UITs") or open-end management investment companies whose shares represent an interest in a portfolio of securities that typically track an underlying benchmark index of equity securities. Unlike other UITs or open-end management investment companies, shares of ETFs do not necessarily trade based on the current net asset value ("NAV") of the fund's shares; rather, they trade on an exchange at prices established by the market. Because shares may be sold at a price different than the fund's current NAV, such trading requires an exemption from Section 22(d) of the Act and Rule 22c-1 thereunder.
Section 22(d) provides that no registered investment company shall sell any redeemable security issued by it to any person except to or through a principal underwriter for distribution or at a current public offering price described in the prospectus. Rule 22c-1 provides, with certain exceptions, that no registered investment company issuing any redeemable security, no person designated in such issuer's prospectus as authorized to consummate transactions in any such security, and no principal underwriter of or dealer in any such security shall sell, redeem, or repurchase any such security except at a prices based on current NAV computed after receipt of a tender of such security for redemption or of an order to purchase or sell such security.
There are several NASD rule provisions that may apply where shares of a UIT or open-end management investment company are traded at a price other than its NAV. Rule 2830(c) provides in part that an underwriter of an investment company may not sell its securities to any dealer or broker at any price other than the public offering price unless the sale is in conformance with Rule 2420 (Dealing with Non-Members). Rule 2830(g) prohibits a member from purchasing from an underwriter the securities of an open-end investment company and an underwriter from purchasing such securities from an issuer except (1) for the purpose of covering purchase orders previously received or (2) for its own investment. Rule 2830(i) prohibits a member that is acting as a principal and is a party to an investment company sales agreement from purchasing any security issued by an open-end management investment company or UIT from a record holder at a price lower than the bid price next quoted by or for the issuer.
In addition, NASD Interpretive Material 2830-2 states that Section 22(d) of the Act, taken together with NASD Rule 2420, requires members to maintain the public offering price to customers and non-member broker-dealers. Rule 2830(b)(6) defines "public offering price" to mean the "public offering price as set forth in the prospectus of the issuing company."
Typically, dealers and other institutional investors purchase and redeem blocks of ETF shares, known as creation units, in accordance with the NAV offering price described in the prospectus. Yet, trading in the secondary market occurs at market prices that are determined by buyers and sellers participating on a securities exchange, which may result in a price that is at a discount or premium to the ETF's current NAV. These transactions at prices other than the ETF's current NAV potentially may create, depending on the circumstances, technical violations of paragraphs (c), (g) and (i) of Rule 2830 and IM-2830-2.
Provided that a member has received from the SEC an exemption from Section 22(d) of the Act and Rule 22c-1 thereunder to permit secondary market trading in specified ETFs, NASD staff will not interpret secondary trading in such ETFs to be in violation of paragraphs (c), (g) or (i) of Rule 2830 or IM-2830-2.