iShares ETFs Tied to Lehman Indexes Face Potential Regulatory Headache

By Eric Rosenbaum

Picking up bankrupt Lehman Brothers gives Barclays Capital (BCS) a beachhead in the U.S. investment banking market.

But it could also bring an unexpected headache to its sister Barclays Global Investors' iShares family of exchange-traded funds.

At issue is what's going to happen to the 14 iShares funds that use Lehman Brothers indexes. Those are some of the most well-known benchmarks in the marketplace, especially in fixed-income arenas.

"This is really out of Barclays' control... this headache can't be relieved without an exemptive order," said John McGuire, a securities lawyer at Morgan, Lewis & Bockius.

BGI is requesting that the Securities and Exchange Commission provide what's referred to as "exemptive relief" from rules that seek to create clear lines of demarcation between ETF managers and owners of benchmarks. As it stands now, asset managers who own their funds' underlying indexes are regulated differently than those that don't—or so-called "unaffiliated" managers.

The perceived risk, of course, is that direct stakes in both an ETF's assets as well as its benchmark could cause potential conflicts of interest. One of the most often mentioned is concern that such affiliated ETF fund managers might be able to game their indexes to compensate for poor market returns.

Tougher Regulations? 

For BGI, a change in designations could carry more-stringent SEC requirements—and ones that in the past have required a fairly detailed and lengthy review.

BGI representatives are only saying at this point that the asset manager is aware of the issues and working with regulators. An SEC spokesperson also declined to comment.

"This is not basic regulatory housekeeping for BGI," said an experienced industry lawyer who specializes in securities regulations, and requested anonymity due to existing working relationships with the company.

WisdomTree (WSDT.PK) was the first major regulatory test case for this affiliated index approach. At the time when the firm first approached the SEC in 2004, there were no ETF managers running ETFs based on indexes they had created on their own. 

The only way that WisdomTree found to satisfy the SEC's concerns was to outsource the calculation and dissemination of its index, as well as the portfolio management to a sub-advisor.

Industry experts are skeptical that outsourcing both portfolio management and index servicing will prove to be a realistic option for BGI. They point out that it already has an ETF infrastructure designed to achieve economies of scale in portfolio management, administration and distribution.

Also, it's unclear whether BGI is yet in a position to decide on the placement of the Lehman index services unit. The group was housed within Barclays Capital at the time of the Lehman purchase.

Public Disclosure 

As part of its exemptive order, WisdomTree's benchmarking side must also publicly disclose any changes to underlying indexes at the same time it discloses the changes to the fund management side. The SEC requires 60-day advance notice with any material rules change to an index.

As far as regular rebalancing, WisdomTree publishes a list of additions and deletions on its Web site before it is actually implemented in the index, which in WisdomTree's case is done annually. So a list is usually publicly posted in December.

In BGI's favor is the fact that the SEC has now been through this process several times, most notably, when working with WisdomTree over a period of years to approve its family of ETFs based on its own, newly created indexes.

Furthermore, the Lehman indexes are well-known, with the tag of industry standards. This is in contrast to the WisdomTree case, in which the SEC was being asked to approve a new asset manager and new index series. 

"For WisdomTree it was a multiyear process. It was new, and it was at a time when there was great deal of review given to everything non-plain vanilla," said an industry insider familiar with the details of the exemptive order.

"Since then, there have been a lot of innovative structures coming through the SEC, and so, even what WisdomTree did—and certainly what Barclays is being forced to do here by way of the Lehman deal—is really more akin to today's plain-vanilla offerings."

More recently, Van Eck Global's Market Vectors family had to go to the SEC for exemptive relief when it launched its Market Vectors RVE Hard Assets Producer ETF (AMEX: HAP), pegged to an index created by the manager and commodities guru Jim Rogers.

WisdomTree and Van Eck officials said they would not comment on the exemptive process.

At an even larger level, the issue of affiliated versus nonaffiliated indexes is slated to change with the introduction of the SEC's fast-track rule for ETFs.

The proposed rule will require the same level of disclosure of all index funds—more than required currently—but less than required of WisdomTree. It is viewed as a middle ground, more or less, between where WisdomTree was forced to go when no active funds existed, and where the need for disclosure will be greatest in the future.

"Barclays can try to make the case that due to time constraints on this, and needing to get approval done quickly, the SEC should issue a no-action position immediately, and then BGI will adhere to whatever standard is set by the final form of the rule," said securities lawyer McGuire.

The SEC had planned to release the rule in the fourth quarter, and while industry lawyers who are working on the issue don't expect a major wall to arise in front of the proposed rule's release date, they said more pressing market issues—like the money fund problems—could delay the rule's introduction for some period of time.

Myriad Factors At Play 

A combination of market meltdown priorities and the need to weigh the more controversial aspects of the rule, relating to holdings disclosure, are all in play. The SEC received many comment letters about the disclosure part of the rule, including from the fund industry's largest trade group, The Investment Company Institute, and indexing pioneer The Vanguard Group. 

What this means for BGI is that in the immediate future, to keep in line with the closing of the Lehman deal, and to satisfy regulators, it could be held to the WisdomTree standard for its affiliated index ETFs, even if that standard becomes more strict than required by the eventual release of the SEC's ETF rule.

Stacy Fuller, a securities regulations attorney at K & L Gates, said that while most of the rule's components are fairly uncontroversial, the disclosure issue may require more work before settling on a satisfactory middle ground between the SEC and the industry.

Even more pressing right now, however, is that the lawyer who is working most directly on the ETF rule's release has also been put in charge of the money fund issue at the SEC, says Fuller.

She adds that at the least, the SEC should release part of the new rule on schedule, even if that means leaving the disclosure portion of it for a later release.

The SEC should make an exception for Barclays, due to the convergence of thorny issues, and try as hard as possible to release an exemptive order without delay, says lawyer McGuire.

"They don't want to spend time and effort on whether they should be changing standards related to indexes if the new SEC rule proposal will treat affiliated and nonaffiliated indexes in a similar way," McGuire said.