In early 2017, the Securities and Exchange Commission (“SEC”) approved rule-change proposals submitted by NYSE Arca, Inc. (“Arca”), Bats BZX Exchange, Inc. (“Bats”)1, and NASDAQ Stock Market LLC (“Nasdaq”), (collectively, the “Exchange”). The amended rules, which became effective January 1, 2018, establish continued listing standards for passively and actively managed exchange-traded products (“ETP”). More specifically, the rules require ETP issuers and managers (collectively, “Managers”) to adopt new monitoring and oversight protocols to ensure continued compliance with the applicable listing standards. In the event an ETP falls out of compliance with the standards, the Manager must promptly notify the appropriate Exchange. As discussed in more detail below, the penalties for noncompliance could be detrimental to an ETP.
With the one-year anniversary of the continued standards rapidly approaching, Managers should evaluate the effectiveness of their monitoring programs, keeping in mind that they will need to attest to their compliance formally by sending a signed affirmation to the ETP’s respective Exchange no later than December 31, 2018, and annually thereafter.
What Are the Continued Listing Standards?
The continued listing standards largely mirror the initial listing standards ETPs had to meet when they were approved for listing on an Exchange. As such, passively managed, index-based ETPs should refer to the generic listing standards of their Exchange; actively managed ETPs should refer to the generic listing standards for active ETPs or the conditions set forth in their 19b-4 Order, whichever is appropriate. Broadly, these standards set forth specific composition requirements related to the underlying index or reference asset of passively managed ETPs and the portfolio holdings of actively managed ETPs. Because listing standards can vary by Exchange and are based on an ETP’s component stocks, Managers should consult their respective Exchange’s rulebook or their 19b-4 Order to determine what standards apply to them.
How Should Compliance Be Monitored?
As the SEC acknowledged when it extended the implementation date, these new standards impose “significant new compliance requirements on issuers that they have not been subject to previously.”2 To effectively monitor compliance, Managers should, if they have not already, adopt trade monitoring procedures to test their ETP composition against the listing standards. For index-based ETPs, effective monitoring requires a Manager to test the compliance of the ETP’s underlying index. This means passive Managers must work with third-party index providers to ensure they receive the data necessary to test the compliance of their ETP and their index.
Testing should be done:
- quarterly at minimum, and
- when the index undergoes material change, or
- at time of rebalancing, or
- at time of reconstitution
Additionally, because evidence of testing may be requested at the discretion of the Exchange, Managers should maintain records of such testing as required by their documentation-retention policy. We also advise Managers to adopt a policy that establishes reporting mechanisms and escalation protocols to accompany their trade-monitoring procedures. This will help ensure effective monitoring and the timely notification of key internal and external stakeholders. In instances where an ETP’s compliance depends on a third-party index provider, Managers should establish robust oversight protocols to validate the integrity of the data provided and the index provider.
Self-indexing Managers should be particularly mindful of how affiliated index providers relay data to them. In this respect, they should work with their compliance department to ensure information is shared in a manner consistent with the policies governing such information cross-sharing.
Finally, Managers who delegate some or all the investment management process to sub-advisers should be sure to communicate the applicable listing standards to these firms, as well as require representations from them that confirm their ongoing compliance monitoring.
What Happens If An ETP Falls Out of Compliance?
Managers must promptly notify the applicable Exchange if it determines that an ETP or its underlying index no longer meets the continued listing standards. Once notified, the Exchange will conduct an independent compliance review and determine the steps to be taken next.
Exchanges consider the following factors when determining whether to give a noncompliant ETP Manager an opportunity to remediate:
- The nature of noncompliance
- The degree of noncompliance
- The expected time needed to regain compliance
Once the Exchange confirms that an ETP no longer meets the continued listing standards, it will affix a flag to the ETP ticker that alerts market participants to the noncompliance. How Managers go about regaining compliance will depend on the deficiency. For example, if an index-based ETP is deemed to be noncompliant because of an issue with the underlying index, the Exchange may expect the index to cure the deficiency at its next rebalancing. In contrast, a noncompliant actively managed ETP will be required to submit a written remediation plan.
Should an ETP fail to regain compliance or not be afforded an opportunity to do so, the Exchange will commence its delisting procedures. As this may trigger many other legal requirements, Managers should work with legal counsel to determine if additional notifications such as public disclosures or other actions are required.
Many managers are likely now preparing to sign year-end attestations to their respective Exchange certifying compliance with their continued listing standards. As such, now is the ideal time to review the effectiveness of monitoring processes implemented with the rule change. To the extent Managers rely on data provided by third parties such as index providers and sub-advisers, the year-end reviews should also include (i) evaluations of such parties’ processes, (ii) tests of the quality of data these parties provide, and (iii) ongoing due diligence performed in a manner consistent with the Managers’ service provider oversight program.
About the Author
Veronica Popp joined ACA Compliance Group in September 2018 through the acquisition of Cordium. As a consultant working out of ACA's Boston office, Veronica works closely with their investment company practice. Veronica earned her J.D. degree from Suffolk University Law School and her Bachelor of Arts, Business Administraion and Management and Econimics from Regis College.
2 Release No. 34-81775; File No. SR-NYSEArca-2017-115, at pg. 3.