Recent court cases may have crushed the hopes of closed-end fund boards relying on changes to proxy voting rules to defend themselves against proxy campaigns by activist investors.
In January and February, judges in separate cases pitting the Saba Capital hedge fund versus Nuveen and Eaton Vance CEFs ruled that “control-share” bylaw amendments passed by the closed-end fund boards restricted shareholder voting rights in violation of the Investment Company Act of 1940.
In both cases, control-share amendments passed by the boards of the closed-end funds (CEFs) prevented any shareholder from voting the shares they had acquired above a 10% threshold, unless that shareholder had won approval to do so from a majority of the other shareholders.
However, the two cases did not address control-share statutes—laws in Delaware and Maryland that allow CEFs to restrict the voting of shareholders that acquire shares above certain specified percentage thresholds.
The Nuveen and Eaton Vance funds are domiciled in Massachusetts, which does not have a control-share statute but does have a state law that, prior to the court decisions, had allowed the funds to create terms in their bylaws to mimic control-share statutes. Nuveen has appealed the federal court decision, from the U.S. District Court for the Southern District of New York; the Eaton Vance decision was in a Massachusetts state court.
Whether a fund board tries to restrict large-shareholder voting through a bylaw amendment or through a state’s control-share statute is an important distinction, says Kenneth Fang, associate general counsel at the Investment Company Institute, a Washington, D.C., industry group that represents regulated investment funds.
That’s because the Investment Company Act, under its Section 18(i), states that all shares issued by a registered management company shall have voting rights equal to that of other outstanding shares, except as otherwise required by law.
“That ‘otherwise required by law’ provision may enable funds to feel more comfortable relying on either the Maryland or the Delaware control share statute,” Fang said, warning that neither he nor the ICI could offer legal advice on the issue.
Under the reading of Section 18(i) by the closed-end fund advocates, the control-share statutes are the “otherwise” laws, allowing CEFs in those two states to set voting rights that are not equal for certain shares.5i
Activists don’t see it that way. “I don’t think a state law can trump a federal law like the 1940 Investment Company Act,” says Phillip Goldstein, principal of the activist hedge fund Bulldog Investors. “Otherwise a state could say: ‘Well, there’s no voting right.’ I don’t think that’s going to work.”
The goal is to restrict the voting power of activists, but the rules would affect any large shareholders with actual or potential ownership of 10% or more of a closed-end fund who want to vote their shares , Goldstein says—investors like 1607 Capital Partners, City of London Investment Management, Karpus Investment Management and Sit Investment Associates.
“The securities laws are not designed to protect management or the board; they’re designed to protect investors. So let the investors vote,” Goldstein says. “That’s why there is a one share, one vote requirement.”
The same argument for allowing shareholders to vote their shares applies to boards of all public companies, not just CEFs, Goldstein says. “Let’s say there’s a company and the stock is trading for 20 and you see sales of comparable companies go for 40. Do you think the shareholders should just sit there and just say: ‘No, I don’t want to do anything about it?’ Or should they be able to throw the bums out? This has to do with: Who’s the board running the company for?”
Advocates of control-share strategies for fund boards argue that activist takeovers can hurt smaller investors who sought to invest with a long-term horizon in mind.
The traditional approach for activists investing in a closed-end fund depends on their ability to buy shares at a discount to NAV— a situation that is so common that 80% of CEFs regularly trade shares at a discount, according to an ICI report analyzing share data between 1995 and 2021
Activist investors that could acquire enough votes could then force the fund to buy those shares back at prices much closer to NAV, or liquidate fund assets so they could pay shareholders a cash distribution that would make up the difference. They could also force a vote that would convert to an open-end fund and redeem shares at NAV, Fang says.
More recently, activists have also begun to target even high-performing funds in order to take control of their boards, remove the adviser, take over the role themselves and change the fund’s investment strategy to one that would benefit activist investors to the detriment of shareholders who are “getting the carpet pulled out from under them,” Fang says. “They believed they were investing in one product and now they’re investing in a completely different one.”
If CEFs aren’t allowed to employ defenses like control-share statute strategies, “then it could be an existential threat,” Fang says. “Activists have forced CEF sponsors to really consider whether or not they want to enter into the space and to devote resources to the area.”
Assets in CEFs climbed to $309 billion in 2021 from $244 in 2011, but the number of funds dropped to 461 from 634—an indication of the industry’s activist problem, Fang says. Currently, there are about 440 CEFs . He estimates that about a hundred of the funds are now dealing with activist challenges.
Goldstein says the number is more like ten. “They’re just crying wolf.”
Goldstein says that for his activist strategy to work with a particular CEF , he needs to have value—an intrinsic value that is greater than the market price—and he needs to be able to take a large position on his own or have a shareholder base that he can convince to vote with him.
Without the discounted share price, he has no interest, he says, and if the shareholders are mostly retail investors who are too passive to care about a large discount, “it’s not a good target for activism.”
“You need people who actually care about making money,” he says. “There are certain funds with a big, big discount, but just a terrible shareholder base.”
Activists can play an important role in making sure that CEF managers adhere to the strategies that CEFs are designed for: to invest in less-liquid assets and to invest with professionally managed leverage on behalf of retail investors who otherwise cannot access those strategies, says Thomas DeCapo, a retired Skadden Arps partner who tracks control-share statute issues.
The problem is that when CEFs aren’t allowed to protect themselves, activists can always just disassemble them, DeCapo says. “You have to find that happy balance that lets activists do their job and perform their function, but not willy-nilly, across the board, affect all funds out there. Only the funds that aren’t doing what they should be doing.”
As CEF boards consider other defensive measures they can implement against activist takeovers—even beyond control-share measures—they need to do their homework, know the facts, solicit information from other legal and marketplace sources besides the manager, and document their decision-making process in detail to show how their actions benefit the fund as a whole, even if those actions may be injurious to some shareholders, DeCapo says.
Aside from control-share actions, some fund boards have implemented simple ownership limits for shareholders, which avoids the voting issue, according to an attorney who works with fund boards, who asked not to be identified. For example, a shareholder can’t exceed a certain percentage ownership in the fund; otherwise those shares are held by a receiver named by the board, voted by that receiver if necessary, and the shares are sold for the benefit of the shareholder.
Other funds have listed their shares off of national exchanges—allowing them to trade only over the counter—which makes it very difficult for an activist to acquire large blocks of stock without dramatically moving the market and pushing the share price higher, the attorney says. The downside to that approach is the discount may become even larger than if the shares were trading on a national exchange.
“It depends on what your shareholder base wants,” the attorney says. “Finding a long-term net asset value liquidity point for retail shareholders and at the same time cutting back on daily stock market liquidity would be helpful to both shareholders in the long term and to fund managers.”
Another option to make it more difficult for activists to take control of a board: Establish a requirement in the fund’s governing documents that a director must be elected with an absolute majority of all the fund’s shares, not just a majority of the shares that are voted, says another attorney who has advised fund boards.
Boards can also head off activists by aggressively doing everything they can to maximize value for their shareholders as a whole, says Adam Finerman, partner at Baker Hostetler. That should include monitoring managers and their success relative to the market, examining different capital market strategies for the fund and taking advantage of excessive share discounts by conducting share buybacks.
“What does the most to create value for stockholders?” Finerman asks. “In the end, activists are looking for profit for their investors. If they make money, all shareholders make money.”
As for the courtroom battles, the next frontier could be challenges to the state laws that expressly allow CEFs to restrict shareholder voting. CEF board advocates argue that the control share statutes of Delaware and Maryland should stand up to legal scrutiny because they fall under the “otherwise required by law” provision of the 1940 Investment Company Act. The activists say their arguments from the two Massachusetts court decisions also hold true against the control share statutes: that the state laws enable the same kind of vote-rigging that the 1940 federal law was intended to stamp out.