November 7, 2014
On August 4, 2014, BATS Exchange, Inc. (“Exchange” or “BATS”) filed with the Securities and Exchange Commission (“Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) 
and Rule 19b-4 thereunder,
a proposed rule change to adopt new BATS Rule 14.11(k), which would permit the Exchange to list Managed Portfolio Shares, which are shares of actively managed exchange-traded funds (“ETFs”) for which the portfolio is disclosed quarterly, and to list and trade shares of certain funds of the Spruce ETF Trust (“Trust”) 
under proposed BATS Rule 14.11(k). The proposed rule change was published for comment in the Federal Register on August 13, 2014.
The Commission received one comment letter on the proposal.
On September 24, 2014, pursuant to Section 19(b)(2) of the Exchange Act,
the Commission designated a longer period within which to approve the proposed rule change, disapprove the proposed rule change, or institute proceedings to determine whether to disapprove the proposed rule change.
This Order disapproves the proposed rule change.
I. Description of the Proposal
The Exchange proposes to: (1) Add new BATS Rule 14.11(k) which would permit the listing of Managed Portfolio Shares; and (2) list and trade shares (“Shares”) of the following funds (each a “Fund” and, collectively, the “Funds”) under the proposed rule: Large Cap Fund, Large Cap Value Fund, Large Cap Growth Fund, Large/Mid Cap Fund, Large/Mid Cap Value Fund, Large/Mid Cap Growth Fund, Large Cap Long-Short Fund, Large Cap Value Long-Short Fund, Large Cap Growth Long-Short Fund, Large/Mid Cap Long-Short Fund, and Large/Mid Cap Value Long-Short Fund, Large/Mid Cap Growth Long-Short Fund, and Large Cap Growth Active Insights Fund. The discussion below summarizes the Exchange's proposal, details of which are described in the Notice.
A. Proposed Listing Rules
The Exchange's proposal would define the term “Managed Portfolio Share” as a security that (a) is issued by an investment company (“Investment Company”) organized as an open-end management investment company or similar entity, that invests in a portfolio of securities selected by the Investment Company's investment adviser consistent with the Investment Company's investment objectives and policies; (b) is issued in a predetermined Creation Unit 
size in Start Printed Page 68324exchange for a cash amount equal to the next determined Net Asset Value (“NAV”),
(c) pursuant to the “Small Allotment Redemption Option,” may be redeemed for cash by any Beneficial Owner 
in any size less than a Redemption Unit 
for a cash amount equal to the next determined NAV for at least 15 calendar days, in the event that for 10 consecutive Business Days, or such shorter period as determined by the issuer, the midpoint of the national best bid and offer at the time of the calculation of the NAV (the “Bid/Ask Price”),
for the security has a discount of 5% or greater from the NAV; and (d) when aggregated in a number of shares equal to a Redemption Unit, or multiples thereof, may be redeemed at an Authorized Participant's 
request, which each Authorized Participant would be paid through a blind trust established for its benefit a portfolio of securities and/or cash with a value equal to the next determined NAV.
Funds issuing Managed Portfolio Shares would be actively-managed, and in that respect would be similar to Managed Fund Shares, which are actively-managed funds listed and traded under BATS Rule 14.11(i). Managed Portfolio Shares, however, would differ from Managed Fund Shares in the following important respects. First, in contrast to Managed Fund Shares, for which a “Disclosed Portfolio” is required to be disseminated at least once daily,
the portfolio for an issue of Managed Portfolio Shares would be disclosed at least quarterly in accordance with normal disclosure requirements otherwise applicable to open-end investment companies registered under the 1940 Act.
Second, creations of Managed Portfolio Shares would generally be effected through a delivery of only cash, whereas creations of Managed Fund Shares are generally effected through an in-kind delivery of securities and cash. Third, in connection with the redemption of shares in Redemption Unit size, the in-kind delivery of any portfolio securities would generally be effected through a blind trust for the benefit of the redeeming Authorized Participant, and the blind trust would liquidate the portfolio securities pursuant to instructions from the Authorized Participant without disclosing the identity of those securities to the Authorized Participant. Fourth, pursuant to the Small Allotment Redemption Option, Beneficial Owners would be able to redeem shares for cash directly from a fund in any size less than a Redemption Unit at the fund's NAV in limited circumstances.
For each series of Managed Portfolio Shares, an estimated value, defined in the proposed rule as the “Intraday Indicative Value” (“IIV”), that reflects an estimated intraday value of a fund's portfolio would be disseminated. The IIV would be based upon all of a fund's holdings as of the close of the prior business day and would be widely disseminated by one or more major market data vendors at least every 15 seconds during the Exchange's Regular Trading Hours (normally, 9:30 a.m. to 4:00 p.m., Eastern Time).
The Exchange's proposal provides that the Exchange would file separate proposals under Section 19(b) of the Exchange Act before listing and trading any series of Managed Portfolio Shares.
B. Description of the Funds
BlackRock Fund Advisors would be the investment adviser (“Adviser”) to the Funds.
State Street Bank and Trust Company would be the administrator, custodian, and transfer agent for the Trust (“Custodian” or “Transfer Agent”). BlackRock Investments, LLC (“Distributor”) would serve as the distributor for the Trust.
Under normal circumstances,
each Fund would invest at least 80% of its net assets in a portfolio of long positions (or engage in borrowings for the purpose of establishing short positions for the Long-Short Funds) in U.S. equity securities.
The Funds may in some instances also invest in non-U.S. equity securities with similar market capitalization, liquidity, and risk-return profiles to the U.S. equity securities eligible for investment. Each Fund would hold equity securities of at least 13 non-affiliated issuers, primarily from the 1,200 largest U.S. stocks by market capitalization as determined by The Frank Russell Company annually. Generally, the Large/Mid Cap Funds would select securities from a universe of approximately the 1,200 largest equity securities traded on U.S. exchanges and the Large Cap Funds would select securities from a universe of approximately the 1,000 largest equity securities traded on U.S. exchanges.
A Fund may, to a limited extent (under normal circumstances, less than 20% of the Fund's net assets), engage in transactions in futures contracts, forward contracts, options, and swaps.
A Fund may also invest a portion of its assets in high-quality money market instruments.
II. Summary of the Comment Letter
The Commission received one letter opposing the proposed rule change, which raises several concerns.
First, Start Printed Page 68325the commenter asserts that there is a “significant risk” that the Internal Revenue Service (“IRS”) would deny the purported tax benefits of the Funds' distinctive in-kind redemption program.
Therefore, the commenter recommends that approval of the proposal be conditioned on the issuer obtaining a favorable IRS determination of the tax treatment through a Private Letter Ruling.
In addition, the commenter predicts that, compared to most existing ETFs, the Shares would probably trade with significantly wider bid-ask spreads, with more variable premiums and discounts, or with both, because of what the commenter characterizes as the unreliability of the Funds' proposed method for ensuring secondary market trading efficiency. The commenter states that the Funds' market makers would have only indirect, and likely imperfect, information about Fund holdings.
The commenter argues that effectively arbitraging the Funds would be significantly more difficult than the arbitrage for most existing foreign ETFs.
The commenter also argues that there is no support for the Exchange's contention that existing ETFs holding portfolios of foreign securities, such as index-based ETFs holding Asian stocks, have demonstrated efficient pricing characteristics even though, because foreign stocks do not trade during the same hours as U.S. ETFs, the ETFs holding foreign stocks do not provide opportunities for riskless arbitrage transactions during much of the trading day.
The commenter also cites a draft academic working paper 
for the propositions that market trading efficiency varies significantly by type and size of ETF; that funds with high share trading volumes, liquid underlying holdings, and efficient arbitrage mechanisms trade with relatively tight bid-ask spreads and more stable premiums and discounts; and that funds lacking these characteristics generally traded with wider spreads and more variable premiums and discounts.
The commenter also states its view that, for a number of reasons, the dissemination of an IIV by the Funds would likely prove ineffective in ensuring alignment of secondary market prices for the Shares with the values of the underlying portfolios. The commenter asserts that, during periods of rapid market movement, the use of last-sale prices to calculate an IIV, coupled with the dissemination of the IIV only every 15 seconds, would mean that the IIV would be a lagging indicator of actual portfolio values.
Additionally, the commenter asserts that the IIV may reflect clearly erroneous values for securities that have not yet opened for trading on a particular business day or that are subject to an intraday interruption in trading.
The commenter also states that no one would stand behind a Fund's IIV to ensure timeliness and accuracy.
The commenter predicts that, without a reliable IIV, the Shares cannot and would not trade acceptably in the secondary market.
The commenter predicts that frequent IIV errors would in turn cause “erroneous share trades” to be executed.
The commenter states that the proposal does not address the treatment of erroneous share trades resulting from a faulty IIV—namely, whether IIV errors and related erroneous trades would be detected by the Exchange, whether such trades would be cancelled, and whether the Exchange would apply a materiality standard for cancellations.
The commenter argues that, as a condition of approval, the Exchange should be required to monitor the timeliness and accuracy of IIV dissemination and to implement procedures to address trades when an erroneous IIV has been disseminated.
The commenter also predicts that the following elements of the proposed redemption arrangements would introduce additional costs and uncertainties for Authorized Participants:
- The Custodian would have a monopoly position as the sole eligible provider of trustee services for the blind trust;
- The Adviser, rather than the Authorized Participant, would negotiate the fees paid to the trustee;
- In contrast to existing ETFs, no Authorized Participant would have the potential ability to use its market knowledge and market position to enhance arbitrage profits (or offset arbitrage costs) by managing sales of the distributed securities to minimize market impact or to realize prices above the market close; and
- The Custodian, who stands in for the Authorized Participant in the sale of distributed securities, would have no apparent incentive to sell distributed securities with low market impact or at prices above the close and would experience little or no downside from doing the opposite.
The commenter also asserts that redeeming Authorized Participants would be exposed to potential costs and risks associated with not being able to control disposition of significantly more concentrated redemption proceeds, and the commenter argues that these extra costs and risks associated with the blind trust arrangement would be passed through to shareholders transacting in the secondary market, reflected as wider bid-ask spreads, more volatile premiums and discounts for the Shares, or both.
The commenter posits that the lack of portfolio transparency would favor market makers and other professional traders over other market participants, such as investors.
Notwithstanding the public dissemination of the IIV, the commenter argues that market makers and other professional traders would have a significant indirect information advantage over other participants because of their ability to glean information about a Fund's holdings through sophisticated data analysis of changes in the IIV.
In particular, the commenter asserts that IIV disclosures might enable market makers and professional traders to uncover a Fund's holdings and trading activity, rendering the Fund susceptible to the dilutive effects of front running.
The commenter asserts that, prior to approval, the proposal should be amended to include: (1) A discussion of the steps to be taken to minimize reverse engineering risk; (2) a discussion of how the Funds propose to resolve the conflict between providing market makers with adequate information to support efficient Share trading and protecting against reverse engineering; and (3) representations that the Funds would adequately disclose reverse-engineering risk and the conflicts the Start Printed Page 68326Funds face in seeking to provide for efficient market trading and protection against reverse engineering.
The commenter argues that the Commission should not grant the issuer's pending request for exemptive relief under the 1940 Act to maintain early Order Cut-Off Times for Fund redemptions, which are intended to facilitate the timely sale of distributed securities by the blind trusts that receive the proceeds of Authorized Participant redemptions and the efficient processing of redemptions by retail investors through the Small Allotment Redemption Option.
The commenter questions how the early Order Cut-Off Times would impact secondary market trading and the Funds' proposed arbitrage mechanism.
The commenter posits that a principal purpose of including the Small Allotment Redemption Option in the proposal is to provide comfort to the Commission and market participants that investors would be able to redeem Shares with the Fund at or near NAV whenever secondary market trading prices are at a significant discount to NAV.
The commenter argues that these provisions, as proposed, are inadequate for this purpose because: (1) Shares could trade at persistently wide discounts to NAV and still rarely, if ever, cause the Small Allotment Redemption Option to be invoked due to the triggering events thresholds; (2) the Small Allotment Redemption Option would be available only to a limited set of shareholders and would be restricted to redemptions of less than a Redemption Unit; (3) the expected early Order Cut-Off Time for redemptions under the Small Allotment Redemption Option means that an investor's ability to directly redeem Shares for cash would exist for only a portion of each business day; and (4) investors who redeem Shares would be subject to transaction fees imposed by the Fund of up to 2% and may also be subject to broker-dealer processing fees.
The commenter recommends that the Commission impose the following conditions for approval: (1) Modification of the triggering events; 
(2) extension of eligibility for the Small Allotment Redemption Option to all shareholders and establishment (and disclosure) of a reasonable upper limit on the value of Shares that are eligible; (3) establishing the close of the Exchange's Regular Trading Hours as the Order Cut-off Time for redemptions under the Small Allotment Redemption Option; and (4) establishment of a cap on transaction fees that the Funds may charge on direct redemptions of Shares.
The commenter believes that the Funds would be permitted to hold investments that are not well-suited to the continuous dissemination of timely and accurate IIVs throughout the trading day.
The commenter asserts that the Funds should: (1) Be required to limit their non-cash investments to U.S.-exchange-listed stocks with market caps of $5 billion or greater (consistent with the general understanding of large- and medium-cap stocks; a universe of about 700 stocks currently); (2) not be permitted to invest in illiquid assets; and (3) not be permitted to employ investment leverage or hold short positions.
The commenter notes that the Exchange would permit trading in the Shares between 8:00 a.m. and 5:00 p.m., but that the IIV would only be disseminated during the Exchange's Regular Trading Hours, which are between 9:30 a.m. and 4:00 p.m. The commenter asserts that the proposal does not adequately address the significant risk that the prices of Shares bought or sold in the Pre-Opening Session (8:00 a.m. to 9:30 a.m.) and After Hours Session (4:00 p.m. to 5:00 p.m.) would vary widely from underlying portfolio values because an updated IIVs would not be available.
Therefore, the commenter suggests that trading in Shares should be limited to the Exchange's Regular Trading Hours.
The commenter states that, given the importance of the IIV to the decision-making process of current and prospective Fund investors, all Fund investors should have ongoing access to current IIV values.
The commenter suggests that each Fund's current IIV be provided at no charge on a public Web site and made available to the public no later than it is made available to any other market participant.
The commenter also suggests that the following information be published on the Funds' Web site: real time IIVs and historical IIV information; statistics regarding closing price premiums and discounts; statistics regarding intraday estimated premiums and discounts; statistics regarding bid-ask spreads; statistics regarding long or short equity market exposure and the amount of investment leverage employed; and statistics regarding transaction fees applicable to purchases of Shares, redemptions through the Small Allotment Redemption Option and Redemption Unit redemptions by Authorized Participants.
III. Discussion and Commission Findings
Under Section 19(b)(2)(C) of the Exchange Act, the Commission shall approve a proposed rule change of a self-regulatory organization if the Commission finds that the proposed rule change is consistent with the requirements of the Exchange Act and the rules and regulations thereunder that are applicable to that organization.
The Commission shall disapprove a proposed rule change if it does not make such a finding.
After careful consideration, the Commission does not find that the proposed rule change is consistent with the requirements of the Exchange Act and the rules and regulations thereunder applicable to a national securities exchange. In particular, the Commission does not find that the proposed rule change is consistent with Section 6(b)(5) of the Exchange Act, which requires that the rules of a national securities exchange be designed, among other things, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and to protect investors and the public interest.
Before an ETF can list and trade on a national securities exchange, the ETF must have exemptive relief under the 1940 Act, and a national securities exchange must have effective rules in place to list and trade the ETF.
As noted above, the Trust has filed an Exemptive Application under the 1940 Start Printed Page 68327Act.
As stated in the Notice of an Application for Exemptive Relief, however, “the Commission preliminarily believes that [the Trust's] proposed ETFs do not meet the standard for exemptive relief under section 6(c) of the  Act,” 
and accordingly, “absent a request for a hearing that is granted by the Commission, the Commission intends to deny [the Trust's] request for an exemption under section 6(c) of the  Act as not necessary or appropriate in the public interest and as not consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the  Act.” 
The purpose of the Exchange's proposed rule change is to allow the listing and trading of the proposed Funds and future funds of the same type. The Commission does not believe that approving this proposed rule change would be consistent with the requirement under the Exchange Act that an exchange's rules be consistent with the protection of investors and the public interest, because the Commission has stated its intention to deny the Trust's request for exemptive relief under the 1940 Act and because denying this exemptive relief would mean that the Funds could not legally operate.
For the reasons set forth above, the Commission does not find that the proposed rule change is consistent with the requirements of the Exchange Act and the rules and regulations thereunder applicable to a national securities exchange, and in particular, with Section 6(b)(5) of the Exchange Act.
It is therefore ordered, pursuant to Section 19(b)(2) of the Exchange Act, that the proposed rule change (SR-BATS-2014-018) be, and it hereby is, disapproved.
For the Commission, by the Division of Trading and Markets, pursuant to delegated authority.
Kevin M. O'Neill,
[FR Doc. 2014-26947 Filed 11-13-14; 8:45 am]
BILLING CODE 8011-01-P