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Pillsbury warns hedge funds about ETF ownership limits


Law firm Pillsbury says hedge funds should be aware that substantially increasing their long positions in exchange-traded funds could result in a violation of the ownership limit set forth in the Investment Company Act of 1940.

The report, by Jay B. Gould, Ildiko Duckor, Clint A. Keller and Michael G. Wu, says in recent years, many hedge funds have significantly increased their holdings in ETFs.

Historically, hedge funds primarily acquired short positions in ETFs to hedge their long positions in a particular industry segment by obtaining short exposure to an entirely different industry segment.

However, many hedge funds are now acquiring long positions in ETFs as part of their core investment strategies.

The report says hedge funds and their managers should be aware that substantially increasing their long positions in ETFs could result in such hedge funds violating the ownership limit set forth in Section 12(d)(1)(A)(i) of the Investment Company Act of 1940.

Under the Investment Company Act, private investment funds are generally prohibited from acquiring more than three per cent of an ETF’s shares.

In order to allow purchases of their shares in excess of the three per cent limit, many ETFs have sought exemptive relief from the Securities and Exchange Commission. However, obtaining such exemptive relief generally requires satisfying a substantial number of conditions, which are similar to those that would apply to an investment company seeking relief to invest in unaffiliated traditional mutual funds, including a number of conditions designed to limit the influence that an acquiring fund may exercise over a particular ETF.

In response to complaints from the industry that many of the conditions for such exemptive relief are unnecessary and unduly burdensome, the SEC proposed new rules in March 2008 that would relax the three per cent limit as it applies to investments in ETFs.

Specifically, proposed Rule 12d1-4 under the Investment Company Act would allow investment companies to make investments in ETFs that exceed the three per cent limit, subject to the following conditions: (i) the acquiring fund does not exercise controlling influence over the ETF’s management or policies, (ii) the acquiring fund may not redeem the shares acquired in reliance on the proposed rule, and must instead sell its shares in the secondary market, (iii) the ETF is not a fund of funds and (iv) in order to avoid duplicative or layered fees, the sales charges and service fees charged by the acquiring fund are subject to the Financial Industry Regulatory Authority’s sales charge rule.

The SEC has not contemplated any further action regarding the proposed rule, so hedge fund managers will need to continue to comply with the three per cent Limit.

Pillsbury recommends that a manager of a hedge fund with a significant position in an ETF regularly determine whether its hedge fund is in compliance with the three per cent limit.

If a hedge fund holds a long position in a particular ETF and exceeds the three per cent limit, the hedge fund is in violation of Section 12(d)(1)(A)(i) unless exemptive relief was sought and obtained from the SEC. A hedge fund manager should implement policies and procedures to regularly monitor each of its hedge fund’s long positions in ETFs, particularly if the hedge fund invests in niche ETFs with smaller asset levels.

Section 12(d)(1)(A)(i) does not specifically discuss whether short positions in ETFs are subject to the three per cent limit. As a general matter, the industry practice is to only subject long positions in ETFs to the three per cent limit. Although the SEC is aware that this issue regarding short positions in ETFs has not been formally addressed, the SEC has not indicated that the industry’s approach is incorrect.

Section 12(d)(1)(A)(i) applies to offshore hedge funds as well as US domiciled hedge funds. Accordingly, if an offshore hedge fund has a long position in a particular ETF and exceeds the three per cent limit, the hedge fund is in violation of Section 12(d)(1)(A)(i) unless exemptive relief was sought and obtained from the SEC.

As Section 12(d)(1)(A)(i) only applies to holdings of “outstanding voting stock,” holdings of options on ETFs would not be counted towards the three per cent limit. Derivatives that provide their holder with voting rights, however, would generally be considered “voting stock.”

An investment company must count all its holdings of an investment company’s voting securities for the purposes of the three per cent limit. This is the case even if the investment company employs multiple sub-advisers.

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