As readers know, our firm mission is to empower investors through education. We live that mission every day.
Turns out that our “investment business” mission applies to ETF Architect. ETF Architect is the trade name for our fast-growing ETF white-label business, which seeks to deliver high-quality, affordable, one-stop-shop access to the ETF market.
We are ramping up our education mission on the “launching an ETF” side of things. And while some may not consider this useful knowledge from a pure investing standpoint, we do believe it is important to be knowledgeable regarding the institutional details of how investment strategies are delivered (and not just the investments themselves).
Here is our series thus far on the mechanics of how to launch an ETF and ETF operations:
- An Introduction to ETF White Label Services
- Can you convert your managed accounts, hedge fund, or mutual fund into an ETF?
- ETF Architect homepage
- #258 episode on why to start an ETF
- #347 episode on how to start an ETF
In this piece, we walk through the inside baseball on why some people (mistakenly) believe it is easy to steal an ETF and why this might be a bit overblown. Let’s dig in.
The HACK ETF Saga:
Potential fund sponsors sometimes think that a white-label platform can “steal an ETF.” In this case, stealing means a fund Sponsor hires a white label platform, launches a successful ETF, then gets “fired” as the Adviser and replaced with someone else (with all fund profits being channeled to that new sponsor / adviser). With this assumption, we have seen several folks assume they need to take on the personnel to build a Trust themselves (along with hiring more staff). It gets expensive…real quick.
The mythology behind “its easy to steal an ETF” is driven by the “HACK story.” Walk with me…
The infamous HACK scenario involved a white-label platform (ETF Managers Group, “ETFMG”). ETFMG was being sued for “stealing” an ETF by Nasdaq (and Andrew Chanin at PureShares). ETFMG believed Nasdaq/PureShares were in material breach of their obligations to HACK. Nasdaq/PureShares felt like ETFMG was simply trying to steal their hard-earned profits from building the fund in the first place. Turns out a judge agreed with Nasdaq/PureShares and ordered ETFMG to pay $78mm+. Yikes! (see here for the gory details). Kids, this legal memo is what we call in the biz “getting taken to the woodshed.”
What’s the lesson learned from the HACK case?
Well, it turns out that you shouldn’t steal. Or more importantly, you shouldn’t even be perceived as stealing in the eyes of a courtroom. In this case, the judge viewed the rights of the Sponsor to be so sacrosanct as to award almost $80M in damages to the plaintiffs.
Using the power of the 40Act (representing shareholders, acting as a fiduciary) can not be used as a blunt instrument to bully commercial partners (e.g., fund Sponsors). Seizing funds, assets, management fees, whatever is verboten. And thus, the first commandment of white label platforms was chiseled in stone for all to see:
Thou shalt not use the 40Act to mess with Sponsors.
OK, great. But who is going to battle someone for years and incur that expense? The possibility is still there, right? Never fear my white label friends, there’s ample protection for the little guy and gal too.
Six Reasons Why an ETF White-Label Platform Can’t Steal Your ETF
This goes without saying, but integrity is everything in business and in life — this is especially true for those of us who have been in the Service. If you don’t have integrity, you really don’t have anything.
But let’s pretend for a moment that an ETF White-Label operation lacked integrity and was actively trying to screw one of their platform operators.
How plausible is it that this nefarious operation will succeed?
Let’s walk through some high-level details on why that is challenging. Hopefully, this will better illuminate how ETFs are operated and managed. 1
- Boards have to represent shareholders only. The 40 Act, which governs investment funds, prohibits compelling a Board to do anything, contractually. (All mutual funds and ETF are required to have a Board with independent Trustees to make sure the fox doesn’t get in the hen house). The Board’s obligation is to shareholders and shareholders alone. Even if a business group forms their your own trust (i.e., Alpha Architect / ETF Architect), this fact remains. The Trust must consider its obligations to shareholders ONLY. The Board does not work for the business owner, they work for the shareholders. Failure to do that = lawsuitville.
To me, this is one of the most critical misunderstandings of ETF Trust and Platforms generally. ALL boards are only beholden to shareholders, and any GOOD board member knows that. Even if you form your own trust, serve as an Adviser vs. Sub-Adviser, whatever, the independent Board of Trustees has a fiduciary obligation to shareholders only. We, the white label “conductor”, can get kicked off the train just as easily as one of the passengers.
- The Platform Agreement vaccinates a Fund Sponsor from HACK like illnesses. A commercial platform agreement, which governs the relationship between ETF white-label platforms and potential ETF sponsors, is a binding legal contract whereby a fund sponsor gets the rights to residual profits after certain expenses are paid. This agreement protects the enterprise value of the fund Sponsor, because the agreement outlines economic obligations on behalf of the ETF white-label platform (e.g., pay me if X bills paid in full, etc). This document is the key vaccine against the HACK virus. Change of control, assignment, expectation to act in good faith, licensing marks, etc., are all key clauses to look at.
- Adviser agreement + Platform agreement clearly lay out the ecosystem. The key to ensuring there is balance between the ETF white-label firm and the ETF sponsor? Analyze contracts together. Sponsors are typically an Adviser or Sub Advisor on the ETF Trust (which is overseen by the Board…discussed above). Two roles, one entity: The 40 Act gives power to shareholders via the Board; the commercial agreement gives power to the Sponsor. Note: you can be an Adviser or Sub-Advisor on a Trust, but we recommend serving as a sub-advisor to maximize efficiency. Contact us for details.
- White Label “Advisers” or Trust Officers are bound to a fiduciary standard with shareholders. The white label firm (e.g., ETF Architect), which serves as the legal Advisor/Fiduciary to shareholders, and has a good faith obligation to the ETF Sponsor. This means that an ETF Sponsor can petition the White-label/Adviser to do things, and and Adviser is obligated to consider these concepts, so long as they are in compliance with the 40 Act, in the best interest of shareholders, and reviewed/approved by the independent trustees on the Board.
- Good Faith obligations in contracts mean you can’t do shady things. The white label platform is obligated to act in good faith, but can’t present anti-shareholder requests (violates fiduciary duty). Even if they did, the Board must fulfill their duties and are guided by external counsel who ensures they are doing the right thing for shareholders.
- This is a small industry and word travels fast. A great way to torpedo your white label business is to pull this crap. HACK happened many moons ago, and yet, it’s all over the industry. We are still talking about this single case, a single time. Reputation incentives and settled precedent ensure that ETF sponsors are protected when working with white label firms. The key is to work with good people, understand the culture/reputation of the ETF Board, review service contracts, and understand the legal implications of both documents. When things are done in a professional manner, and you are working with high integrity operators and board members, the risk of “having your ETF stolen” is pretty low. And you’d be better served focusing on the real risks of running an ETF — ensuring that you are delivering unique differentiated ideas and convincing people of your value proposition!
Reach out if you have any questions. Thanks
- Disclaimer: the items below are not meant to be full-blown legal advice (that’s why lawyers make the big bucks). The bullets below are simply meant to provide a basic framework and understanding of how things are typically structured. ↩