The Securities and Exchange Commission recently granted exemptive relief to Precidian ETFs Trust that permits an actively managed exchange-traded fund to operate without being subject to the daily portfolio transparency condition included in past active ETF orders. We anticipate that this structure may be attractive to many active managers that may seek to offer their strategies as ETFs, including potentially through the conversion of an existing traditional open-end fund into an ETF.
This article discusses the role of an open-end fund’s board in the process of converting such a fund into an ETF. We outline the various approvals that may be required and elaborate on some of the key underlying considerations. Parts of the discussion below will be familiar to many fund boards, as similar concerns arise in connection with all reorganizations and mergers involving open-end funds. But the structural differences between ETFs and open-end funds introduce novel features that boards may wish to consider when presented with a proposed conversion of an open-end fund into an ETF.
The conversion of an open-end fund into an ETF can be effected through a direct conversion or a merger. In a direct conversion, the fund converts into an ETF by obtaining an exemptive order and amending its organizational documents to provide that shares are redeemable only in creation unit aggregations. In a merger, the fund merges into a shell ETF that has obtained the necessary exemptive order. In some cases, the “merger” may technically be effected through an asset sale.
Approvals and Determinations
A variety of board approvals will be necessary to complete a conversion. Which specific approvals are required will vary based on the structure of the conversion and the particular facts and circumstances.
- Approving conversion or merger. The open-end fund’s board will have to approve the conversion, and in the case of a conversion effected through a merger, the board of the ETF must also approve the merger. In doing so, the board of the open-end fund must find that the conversion is in the best interest of the fund and, for a merger, that the interests of existing shareholders will not be diluted. The “best interest” and “no dilution” standards are driven by Rule 17a-8 under the Investment Company Act of 1940, the exemptive rule that permits mergers between affiliated funds (including both traditional open-end funds and ETFs). While Rule 17a-8 under the 1940 Act would not apply to an open-end fund that proposed to convert directly into an ETF, the open-end fund’s board may wish to consider the same factors in considering whether the proposed conversion would be in the best interest of the fund.
- Authorizing various regulatory filings. The board will need to approve the filing of an exemptive order under which the ETF will operate. Certain types of ETFs may in the future be able to operate without an exemptive order pursuant to the SEC’s proposed ETF rule, which has not yet been adopted. If an open-end fund converts directly into an ETF, the converting fund would apply for the order; if the conversion were effected through a merger, the shell ETF would apply for the order.
The board also will have to approve various registration statement and prospectus filings. Among other things, the prospectus will have to be supplemented to announce the proposed conversion following the board’s approval. In addition, a registration statement must be filed for the ETF. In a direct conversion, the open-end fund’s registration statement would be amended to reflect its conversion into an ETF. If shareholder approval is needed for a merger, the ETF will need to register its shares on Form N-14, the heart of which is a joint prospectus/proxy statement.
- Shareholder vote. A key question in evaluating and structuring a potential conversion is whether approval by the shareholders of the open-end fund, the ETF, or both will be required. Shareholder approval may be required by the laws of the state in which the open-end fund is organized, its organizational documents, or by the 1940 Act.
Even if shareholder approval is not technically required, boards may choose to seek shareholder approval in order to provide additional assurance that shareholders are supportive of the conversion.
- Other approvals. Because ETFs do not typically have multiple share classes, the board of an open-end fund considering a direct conversion may need to approve an amendment to the fund’s multi-class plan to consolidate the classes immediately prior to the conversion. An open-end fund considering a merger may be able to effect the consolidation of classes through the merger agreement. Various other approvals also may be required in connection with a conversion, including approvals of compliance policies to reflect the conditions of the ETF exemptive order.
Boards may wish to pay particular attention to the structural differences between open-end funds and ETFs, and the impact they have on shareholders, when making the various approvals and determinations discussed above.
- Transactions in individual ETF shares. ETFs typically only sell and redeem shares in large, so-called “creation units” to and from certain authorized participants. Shares of ETFs are listed on a national securities exchange, where they can trade at a premium or discount to the ETF’s net asset value. As a result, shareholders of an open-end fund will typically not be able to redeem its shares directly with the ETF following a conversion and must buy and sell shares on the exchange if they wish to transact in ETF shares.
Boards will want to weigh shareholders’ loss of the right to redeem individual shares at NAV against the liquidity expected to be provided by the ETF structure, including the anticipated ability of the arbitrage mechanism to reduce both the bid/ask spread for the ETF’s shares on the exchange and the difference between the trading price and the ETF’s NAV. Depending on market conditions at the time an investor seeks to buy or sell ETF shares, the prices the investor receives may be more or less favorable than the ETF’s NAV. On the other hand, ETFs offer shareholders the ability to transact in ETF shares intra-day, rather than only at market close, and to use flexible order types in an effort to improve the execution of their orders.
By way of illustration, this could benefit an investor who purchases shares of an ETF early during a day in anticipation of an increase in the ETF’s NAV later in the day. By contrast, an investor who submits a purchase order for open-end fund shares in anticipation of a market movement will receive a price based on the end-of-day NAV calculated by the fund and thus be unable to benefit from accurately having predicted intra-day price movements.
- Tax efficiency. Boards should consider the potentially significant tax efficiencies enjoyed by ETFs. Because ETFs often do not have to sell securities (and thereby potentially realize capital gains) to meet redemption requests, they typically recognize fewer capital gains than equivalent open-end funds. ETFs also can reduce the realization of capital gains by satisfying redemption requests using the most appreciated lots of each instrument that is part of the ETF’s redemption basket. An open-end fund with significant unrealized capital gains or a tax-managed strategy may represent a compelling opportunity for a conversion, though the potential tax efficiency of an active non-transparent ETF may be limited if the ETF’s exemptive relief does not permit the use of custom baskets.
- Shareholder communications. Boards may wish to consider the plan for communicating with shareholders and whether shareholders will have sufficient notice and opportunity to redeem prior to the conversion and/or an opportunity to vote on the conversion. Details about the conversion could be communicated to shareholders in a prospectus supplement, or in an information statement or proxy statement, if one is needed. Boards may want to consider whether the sponsor may be willing to waive any redemption fees or contingent deferred sales load for shareholders who chose to redeem out of the open-end fund ahead of the conversion.
Boards may want to discuss with the sponsor whether there are steps the sponsor could take to ease the transition for shareholders that remain invested through the conversion. For example, open-end fund shareholders who hold their shares directly, rather than through a financial intermediary, may benefit from assistance in the process of opening up an account with an intermediary through which they can trade ETF shares.
- Cost implications. Boards may wish to consider any expected savings in operating costs, including transfer agency fees and/or 12b-1 fees, resulting from the conversion. ETFs do not typically have to maintain a cash position or sell securities to meet redemptions and therefore may operate with less cash drag and lower transaction costs than analogous open-end funds. Boards may also wish to consider the likelihood and magnitude of any economies of scale that are expected to result from the conversion.
The expected costs of the conversion to be borne directly or indirectly by shareholders also may be relevant to the board’s consideration. Among other things, a conversion will involve legal fees and may involve printing and proxy solicitation expenses. In addition, because ETFs typically do not issue fractional shares, any existing fractional shares of the open-end fund may need to be converted to cash prior to a direct conversion of an open-end fund into an ETF. Similarly, the terms of a merger may need to provide for the conversion to cash of fractional ETF shares that would otherwise have been issued in the merger. Any conversion of fractional shares to cash likely would be treated as a taxable event to the shareholders.
- Specific requirements under exemptive order. Boards will want to carefully consider the specific requirements under the SEC exemptive order pursuant to which the ETF will operate. The conditions may require significant changes to the open-end fund’s portfolio and may impose additional obligations on the board. For example, the Precidian application contemplates that, for the ETF’s first three years, whenever the arbitrage mechanism has failed to keep ETF shares’ premiums/discounts within 1% of the NAV for 30 or more days in any quarter or 15 days in a row, a board meeting will promptly be called and the adviser will present the board with recommendations for appropriate remedial measures.
While a conversion from a traditional open-end fund into an ETF will raise a variety of operational, business and compliance issues for consideration by fund boards and advisers, such a conversion may present an opportunity for fund boards and advisers to advance the interests of fund shareholders.
Brian McCabe (pictured, left) is a partner in Ropes & Gray’s Boston office. He focuses his practice on representing financial services clients, including investment advisers, broker-dealers and mutual funds and their directors. He has assisted in the formation and compliance maintenance of open- and closed-end investment companies, registered investment advisers, and a variety of unregistered pooled investment vehicles.
Teo Larsson-Sax (pictured, right) is an associate in Ropes & Gray’s Boston office. He represents U.S. and non-U.S. investment advisers, private investment funds, and registered open- and closed-end investment companies in a range of transactional, regulatory, and compliance matters.
 The board of the ETF may be the same as the board of the open-end fund, and Rule 17a-8 under the 1940 Act would require shareholder approval of mergers in which a majority of the open-end fund’s independent directors elected by shareholders is not a majority of the ETF’s independent directors.