Closed-end fund boards are considering new alternatives for fending off activist takeovers, following two recent court decisions against control-share strategies that funds had deployed to make proxy voting difficult for large shareholders.
Rulings by the U.S. District Court for the Southern District of New York and the U.S. Court of Appeals for the Second Circuit held that two implementations of the control-shares approach, in which boards limit the voting power of shareholders above a certain threshold, violated the Investment Company Act of 1940.
With two fairly high-profile cases invalidating control shares, fund boards will be reluctant to keep any control share bylaws they may have, said Deborah Bielicke Eades, an attorney at Vedder Price in Chicago.
In January, for example, the ClearBridge MLP and Midstream Fund Inc., ClearBridge Energy Midstream Opportunity Fund Inc., and ClearBridge MLP and Midstream Total Return Fund Inc. all announced that their boards had repealed bylaws that had opted them into Maryland’s control share statute.
Now, said Eades, “people will go back to that toolkit and look at is there anything else they could do.”
Deploying the Poison Pill
One such tool to defend against activists is borrowed from operating companies: shareholder rights plans, also known as poison pill plans. And already the strategy is being challenged in court.
Activist hedge fund manager Saba Capital announced a Southern District court lawsuit in January against SA Gold and Precious Metals Limited and its board members, accusing them of violating the 1940 Act with their shareholder rights plan. At the time of the lawsuit filing, Saba reported it had a 16.9% stake in the fund.
Typically, the idea with a shareholder rights plan is to draft it and have it “on the shelf” ready to be adopted by the fund board when an activist has targeted the fund and is building an ownership position, said Keith Gottfried, a Maryland-based attorney who advises funds and companies on activist defenses.
When a shareholder rights plan is adopted, every shareholder gets the right to purchase the fund’s shares on Day 1. If any shareholder then acquires more than a certain percentage of the fund’s shares — 10%, for example — then their position is economically diluted “in a very significant amount that’s intolerable,” Gottfried said.
“That’s supposed to deter them from going over that threshold, because all these bad things happen if they go over that threshold,” Gottfried said.
The shareholder rights plan can accomplish this in two ways. One example: If the shareholder — the activist — goes over the threshold, its rights to purchase stock is void, but all of the other shareholders have the right to purchase stock at a 50% discount, he said. Or the plan could call for every shareholder — other than the one that has gone above the threshold — to automatically double their shares in the fund.
In 2022, the board of Twitter, Inc. — then a publicly traded company — adopted a one-year poison pill/shareholder rights plan to fend off a potential hostile takeover by Elon Musk, who then owned 9% of Twitter. The poison pill would have kicked in if Musk had reached 15% ownership, and it allowed the board to continue to negotiate a sale.
A shareholder rights plan for a closed-end fund is slightly different than that of an operating company. For a company, the rights plan could range from less than a year to three years. But because of limitations from the 1940 Act, the initial term is typically 120 days for a fund’s shareholder rights plan, and then the plan can be renewed in 120-day increments.
“There are some nuances, but they’re not hard to navigate around,” Gottfried said.
When a fund board decides to have a poison pill at the ready, it should have its attorneys draft a customized shareholder rights plan and prepare it for adoption, gather all of the documents that will be needed to file with the stock exchange or SEC, vet the plan with the fund’s transfer agent, and walk the board members through the plan.
Then “stick it on your hard drive; stick it in a drawer,” he said.
Typically these shelf rights plans are not disclosed to shareholders. “It’s something you keep in your back pocket,” Gottfried said.
“The true idea of a shelf plan is that when you do need it, you want to be able to pull it down and get it adopted in 72 hours,” he said. “Everything should be ready to go, super quick.”
A closed-end fund board would first consider taking it off the shelf when a shareholder files a Schedule 13D with the SEC to go over the 5% ownership threshold in the fund. If the fund board does adopt a poison pill/shareholder rights plan, it should be prepared for potential litigation or backlash over corporate governance issues or the appearance that the board is trying to entrench itself, Gottfried said. That’s why the plans are not permanently adopted.
“It would not be acceptable to have a forever shareholder rights plan. There would be a lot of criticism,” he said.
The roadmap for building a closed-end fund shareholder rights plan is provided by two court cases from the U.S. District Court for the District of Maryland that upheld the strategy, Gottfried said: Neuberger Berman Real Estate Income Fund Inc. v. Lola Brown Trust No. 1B in 2004 and the identically named case from 2007. Unlike shareholder rights plans for operating companies, the closed-end fund’s plan has to meet requirements in the 1940 Act, such as the 120-day restriction.
“There’s all kinds of flexibility that you can build into it and make it adapt to a situation,” he said. “It’s definitely a tool that has probably been underused in the fund space,” he said.
Activist proponents have a different view of shareholder rights/poison pill plans, not surprisingly.
“The SEC is not going to look kindly on those types of plans,” said an attorney who has represented activist investors and who asked not to be named.
Courts will view shareholder rights/poison pill plans for closed-end funds similarly to their rulings against control shares, according to the activist attorney. “I think there’s a number of areas where this violates the 1940 Act,” they said, including its “one share, one vote” provision.
If a fund board adopts a shareholder rights plan, the attorney said, “I think it brings substantial litigation risk; I think it brings substantial regulatory risk.”
A Glimmer of Hope for Control Shares
In spite of the Southern District and Second Circuit court decisions against closed-end funds on control shares, Gottfried said one application of the control share strategy—through a Delaware law—could still be an option for closed-end funds.
The idea behind control shares for a closed-end fund is that any shareholder that acquires shares above a certain threshold — typically 10% of the fund — is prevented from voting the shares above the threshold unless that shareholder wins approval to do so from a majority of the other shareholders.
The Southern District court, ruling Dec. 5 in favor of activist hedge fund manager Saba Capital, agreed with Saba’s contention that closed-end funds managed by BlackRock and others violated the 1940 Act when they opted into a control-share strategy under Maryland law. Similarly, on Nov. 30, also in favor of Saba, the Second Circuit court upheld an earlier decision that Nuveen funds domiciled in Massachusetts violated the 1940 Act by adopting control-share bylaws allowed by control-share law.
Gottfried said that a control-shares strategy for a closed-end fund domiciled in Delaware — technically as a business trust — might still hold up to a court challenge because that state’s law makes control shares mandatory for the fund. In Maryland and Massachusetts, it’s optional: A fund must pass a bylaw to adopt control shares.
Fund boards should consider changing their domicile to Delaware to take advantage of mandatory control shares, he said, though he admits “it’s still risky.”
For the attorney on the activist side, the Delaware domicile makes little difference. “In my view, there’s no scenario where Delaware, if it were to be challenged, would hold up,” they said.
Other Defensive Measures
Besides considering shareholder rights plans, closed-end fund boards should be upgrading their data and information gathering on shareholder ownership to help defend against potential activist takeovers, Eades said. More analytical reporting on shareholders — knowing who they are and who they’re associated with — could help forewarn the board when an activist and its allies are building a larger position.
Another defensive option could be setting higher voting thresholds for contested board seat elections, such as requiring that if no candidate in a contested election wins a majority vote, the board seat reverts back to the incumbent, she said.
Fund boards can also strengthen their bylaws, including advance notice provisions that set out procedures and specific information required for submitting a proposal at a shareholder meeting, which can make it more difficult for an activist to obscure its true intentions, Eades said.
Some funds have also explored restricting who can run for a board seat, aiming to stop activists shareholders from nominating their own executives, which Saba has done several times.
The Allspring closed-end funds recently announced new bylaws requiring that a trustee nominee not be a shareholder or part of a group of shareholders with 5% or more ownership of the fund. The bylaws also stated candidates couldn’t be an employee, partner or adviser of a 5% shareholder, among other restrictions.
Trustee qualifications seem unlikely to prevent activist attacks, however, according to Gottfried.
“If you’re focused on things to create barriers, you’re focused on solving the wrong problem,” he said.
Instead of adopting qualification restrictions, funds should focus on eliciting information about an activist’s true intentions through detailed nominee questionnaires, so the board can make informed recommendations and shareholders can make informed decisions, he added.
Closed-end fund boards can also focus on making their funds less attractive to activists by lowering their net-asset-value discounts, Gottfried said, even if it means proactively lowering assets under management or merging the fund. That can be counterintuitive for a fund manager that is incentivized to grow assets.
Boards with funds in sectors that have been suffering from huge NAV discounts need to be especially aware that they are a potential target, he said. “If you don’t think about self-help, then someone’s going to step forward and want to help to do that, and at that point you’re going to lose control of the situation.”
