A new Delaware law has made it much easier for closed-end funds based in the state to thwart activist shareholders seeking to exert unwanted influence, but activists and their attorneys aren’t giving up yet.
As of Aug. 1, closed-end funds domiciled in Delaware are covered by amendments to the state’s control share statute that give funds the ability to limit the voting rights of shareholders who accumulate shares above certain percentage thresholds, which are known as “control shares.” Funds don’t have to opt in as they must to take advantage of similar laws in Maryland or Massachusetts.
The Delaware law offers funds a greater ability than any previous regulation to insulate themselves from activists with big holdings–even activists like Saba Capital Management, whose campaigns sometimes involve control of up to 30% of the shares in a closed-end fund.
In Delaware, activists must now get the approval of a two-thirds majority of “non-interested” shareholders—not including the activist and corporate insiders–before they can vote their control shares.
Until recently Maryland’s control-share law made it the most popular choice among activist-averse closed-end funds. Delaware’s law, which went into effect Aug. 1, beats Maryland’s effort in two important ways:
1. More hurdles for activists to clear.
Control-share laws in both Maryland and Delaware set multiple thresholds beyond which the owner of control shares would have to seek the permission of other shareholders for voting those shares. Delaware has twice as many thresholds.
In Maryland, the first threshold requires that activists get permission to vote after acquiring 10% of voting shares. They also need to ask after acquiring any amount larger than 33%, and do the same again when they acquire any majority of the voting shares. In Delaware, the thresholds are set at 10% , 15% , 20% , 25%, 30% and then at a majority.
“Shareholders can have the opportunity to evaluate the plans and the intentions of the activist or the acquiring person at each one of those levels,” said Kenneth Burdon, counsel at Skadden Arps.
“The activist will have to keep coming back and making its case to the shareholder base that what it wants to do is beneficial to them,” he said. And that could take time: Each special shareholder meeting for a vote can be scheduled in as little as six weeks, but most take several months.
2. The Delaware law provides tools for the fund board.
Under the Delaware control share statute, the fund board can request information from an acquiring shareholder to give them a better idea of when a shareholder approaches an acquisition threshold. The acquiring shareholder is obligated to respond to requests for information from the board, and to inform the board when it goes over one of the thresholds.
“A lot of times it’s difficult for fund boards to figure out how much the activist actually owns, controls or influences,” Burdon said. “This provides the boards with the tools to get at the real information about how much the activist really does control or is aligned with the acquiring person.”
Delaware inches ahead
Only recently have fund boards had to weigh whether to use a control share statute, because prior to two years ago, regulators had prohibited registered funds from using them.
SEC staff had opined in its 2010 Boulder Total Return Fund letter—known as the Boulder no-action letter—that closed-end funds that opted into control share statutes would be in violation of the Investment Company Act of 1940. After the Division of Investment Management withdrew the Boulder no-action letter in 2020, closed-end funds again had the option of opting in into control-share provisions in Maryland and Massachusetts.
The rescission of the letter set off a wave of activity in the fund world that even saw some fund families redomicile in Maryland.
The Delaware law seems to be an effort by the state to keep up with the competition as it tries to entice closed-end funds to domicile there, said Adam Finerman, partner at the Baker Hostetler law firm.
“This is just Delaware trying to stay competitive with other closed-end fund host states like Maryland and Massachusetts,” he said.
Maryland had been the most desirable domicile for closed-end funds with concerns about activist takeovers, but Delaware has now inched ahead thanks to the changes to its law, Burdon said. Whether funds choose to relocate will depend on the costs and other factors, but new funds will probably now choose Delaware if activist activity is their chief concern.
“I would be more apt to advise someone to go with Delaware, whereas perhaps in the past I think Maryland might have been the more desirable jurisdiction if these were the types of issues you were worried about,” Burdon said.
In deciding whether to enact control share provisions for a fund—by opting into Maryland’s control share statute or switching domiciles to Delaware, for example—board members need to determine what’s in the best interests of the fund and the shareholders at large, said Thomas DeCapo, partner at Skadden Arps.
Meanwhile, “activists will no doubt argue that the detriment here is that the activist can’t come in and save the fund from the evils of a discount or alleged mismanagement,” he said. But funds are structured as closed-end funds for the benefit of retail investors who otherwise aren’t allowed to access strategies like illiquid private investments and professionally managed levered strategies. Control-share statutes allow closed-end fund boards to focus more on these long-term strategies, which are necessary to achieve their funds’ goals, and less on the risk that those strategies will be disrupted by a short-term actor.
“The statutes make it less likely that an institutional activist investor will undo the program that has been set up for retail investors and that retail investors have chosen to invest in. And I personally find it hard to see that as a detriment,” DeCapo said.
The Delaware and Maryland statutes don’t eliminate activist actions in the closed-end fund space, but they make it very difficult for a single activist with a minority stake to control the outcome of a shareholders’ vote for all of the other investors, DeCapo said.
“It doesn’t mean that there can’t be change. It means that the activist now has to convince a sufficient number of other shareholders that the activist is right through the proxy process,” he said. “It simply means that the activist is less likely to be able to force that change on their own.”
“It leveled the playing field so that it makes it difficult for a single minority investor to force change on the majority. I don’t think it makes change impossible or activist-promoted change impossible. It just means that in all likelihood that they will need to convince other people that they’re right and to go along with them,” DeCapo said.
The Activists’ Argument
Critics of the new law deride it as a tool for rigging shareholder elections in favor of management and point to the disapproval proxy advisory firm Institutional Shareholder Services (ISS) has expressed toward similar provisions.
While ISS hasn’t weighed in specifically on the Delaware control share statute amendments, it has made its opposition clear on the general issue of limiting control shares.
Below are four recommendations that ISS makes regarding control shares in its “United States Proxy Voting Guidelines: Benchmark Policy Recommendations” for 2022:
- Vote for proposals to opt out of control share acquisition statutes unless doing so would enable the completion of a takeover that would be detrimental to shareholders.
- Vote against proposals to amend the charter to include control share acquisition provisions.
- Vote for proposals to restore voting rights to the control shares.
- For closed-end management investment companies (CEFs), vote against or withhold from nominating/governance committee members (or other directors on a case-by-case basis) at CEFs that have not provided a compelling rationale for opting-in to a Control Share Acquisition statute, nor submitted a by-law amendment to a shareholder vote.
ISS is slated to release its new and amended benchmark voting recommendations in late November or early December.
Michael Swartz, partner at Schulte Roth, expects that ISS will take a negative view of a fund board that does not opt out of the new Delaware law. Based on the ISS view that control shares represent a serious corporate governance deficiency, an ISS recommendation by itself could sway an election in favor of an activist’s position, he said.
“If the fund relies on control shares– not opting out or opting in as the case may be– that reflects poorly on the fund management, fund directors and trustees having a fair a free and fair vote. If they do, they’re clearly putting their thumbs on the scale to tilt it in their favor,” Swartz said.
Finerman agrees that ISS probably would recommend in favor of votes for closed-end funds to opt out of the Delaware control share statute.
“Their general mantra is: Give shareholders an opportunity to vote. And this is limiting their right to vote,” he said.
The 2022 U.S. proxy voting guidelines from ISS on control shares do contain some caveats. ISS recommends voting for proposals to opt out of control share statutes “unless doing so would enable the completion of a takeover that would be detrimental to shareholders.” It also recommends voting against directors of closed-end funds “that have not provided a compelling rationale for opting-in to a Control Share Acquisition statute, nor submitted a by-law amendment to a shareholder vote.”
As for potential legal challenges to the Delaware law, Swartz said they would likely follow the logic of Saba Capital CEF Opportunities 1, Ltd. et al v. Nuveen Floating Rate Income Fund et al, in which Saba argued that Nuveen’s adoption of a control share provision violated Section 18(i) of the Investment Company Act of 1940. In February, Saba won a summary judgement in the case, filed in U.S. District Court–Southern District of New York.
In a written statement after the court decision, Saba portrayed its win as a “significant victory” for the retail shareholders of closed-end funds with “far-reaching implications for other closed-end funds that have attempted to entrench trustees and investment advisors.”
“The ability for shareholders to vote all of their shares is one of the most essential elements of the Investment Company Act. Without it, shareholders lack the ability to hold management teams and trustees accountable for excessive fees, poor performance and governance failures,” wrote Michael D’Angelo, Saba partner and general counsel.
“We think that the Delaware statute is highly susceptible to challenge based on the Nuveen decision in the Southern District of New York,” Swartz said. “The context is only negligibly different.”
