NYSE petition, House bill may help CEFs fight activists for fund-board control

Closed-end fund boards worried that losses in court have robbed them of their best defense against activist takeovers may find hope in defenses being developed in Congress and by the New York Stock Exchange (NYSE).

Recent court rulings have invalidated both fund bylaws and laws of individual states as a basis for control-share strategies that would make CEF takeovers more difficult by limiting the voting power of activists holding large blocs of shares.

Many CEF boards passed control-share bylaws after the SEC rescinded its decade-long prohibition of the approach in 2020, but found the approach almost unusable following a series of federal-court decisions that struck down fund bylaws and then laws enacted by Maryland and Massachusetts as a legal basis for control-share tactics.

The losses led increasingly desperate CEF boards to explore poison-pill strategies and other long-shot options and made clear that the pursuit of short-term gains by activist investors had become an existential threat to a market that saw a drop of 40% since 2007in the number of new CEFs being formed every year, according to a May report from the Investment Company Institute (ICI) that called for intervention from Congress to address the threat.

There is some promise of help from bills first filed in both the House and Senate in 2021, but the New York Stock Exchange (NYSE) has also stepped up with a proposal to the SEC that would limit activist campaigns by capping the percentage of shares an activist investor can vote in shareholder elections and by canceling the annual shareholder meeting requirement for listed funds.

Closing a loophole

ICI recently applauded the House Committee on Financial Services for approving for consideration by the full house a bill called the Increasing Investor Opportunities Act that was first proposed in 2021 to allow CEFs to invest shareholder money in private funds, but would also address the activist problem by limiting the voting power of large-bloc shareholders.

The bill would subject activist and other private funds to the same restrictions the Investment Company Act of 1940 imposed on registered funds, according to Kevin Ercoline, assistant general counsel at ICI, a Washington, D.C., industry group representing closed-end funds, mutual funds and ETFs.

If it becomes law the bill would protect retail investors in closed-end funds from activists that seek to take advantage of the CEF  tendency to trade at a NAV discount to rack up short-term gains by buying up large blocs of shares and using that leverage to force boards to agree to tender offers, liquidations or fund mergers.

 “It’s worth noting that if [activists] used registered products to run this strategy, it would be illegal,” Ercoline said.

Private funds are currently restricted to owning no more than 3% of any registered fund, though private funds don’t have to aggregate affiliated funds in counting toward that 3% threshold, according to Kenneth Burdon, a fund attorney and partner at Simpson Thacher. That allows an activist hedge fund to work with multiple affiliates to amass large positions in a closed-end fund, as long as each affiliate doesn’t individually exceed 3%.

The House version of the bill would impose a 10% ownership threshold for the private fund when its shares are aggregated with other funds with the same adviser, subjecting the private fund to the same ownership restrictions currently in place for registered investment companies, Burdon said.

ICI was “very encouraged” by House approval of the bill, which was passed as an amendment to the Expanding Access to Capital Act, with support from all House Republicans voting and 57 Democrats as well, according to Wyatt Stewart, ICI’s government affairs officer. The bill eventually passed the House as an amendment to the Expanding Access to Capital Act.

A similar bill was proposed in the Senate in 2021, but ICI is pushing for bi-partisan support for the House legislation which may pass as part of a banking- or financial-services amendment to some other major piece of legislation that might come up after the election but before the end of 2024, Stewart said.

“If the legislation passes, that would be a big win for the closed-end fund industry,” Burdon said. “That would go a long way towards addressing this issue.”

NYSE looks for faster-track solution

The NYSE, meanwhile, took a more direct approach to the defense of CEF boards in June by petitioning the SEC  for permission to change its listing requirements for closed-end funds by eliminating the requirement that they hold annual shareholder meetings.

Closed-end funds are currently the only listed investment funds with the annual meeting requirement, Burdon said. ETFs, for example, have no such requirement.

And as the NYSE notes in its petition, the ’40 Act already defines when CEFs must hold shareholder meetings – to elect directors or approve a new investment-manager agreement, for example – which would make an NYSE requirement for annual meetings superfluous.

“I think that would be an excellent second choice to Congress passing the legislation,” he said. “That would go a long way toward solving the activist problem, because the activists would not have an annual opportunity to create these disruptions.”

Putting the burden on activists to go through the corporate governance process to call for shareholder meetings themselves, rather than waiting for the meeting held by the board every year, would present “a fundamentally different strategic calculus for the activist,” he said.

Eliminating annual meetings would also make it more difficult for activists to coordinate campaigns that may involve the purchase of shares across a family of funds that can be used as leverage by withholding votes on non-controversial issues relating to one fund in order to extract concessions from another fund holding a shareholder meeting at around the same time,  Ercoline said.

“We do think aligning listing requirements with that of every other registered investment product for listed closed-end funds will help alleviate some of that, arbitrary chaos,” Ercoline said.

It also makes sense that closed-end funds should be treated similarly to open-end funds, according to Paulita Pike, a managing partner at Ropes & Gray in Chicago.

“There’s nothing in the structure of an open-end versus a closed-end fund in my mind that should require an annual meeting from a governance perspective,” Pike said. “While I think that requirement makes a lot of sense for operating companies from a governance perspective, it makes no sense for closed-end funds.”

SEC perspective

Some proponents of closed-end funds believe that the SEC should already have been offering more support to CEFs battling activists for control, however.

A basic premise of the ’40 Act is that the broad base of investors in a set of funds needs to be protected against a self-interested investment advisor or its affiliates engaging in self-dealing, Pike said.

“Investment companies are vehicles of mass consumption, there is a need to protect the people consuming those products, and you need to protect them from others who might be able to affect the fund in their own self-interest,” Pike said. “That’s exactly what activist investors want to do. They want to control a fund either to put their own investment advisor in the saddle, or they want to control the fund to try to open end it; arbitrage the fund.”

Over the years, the fund industry has tried to engage the SEC in conversations about this conflict with activists, but the SEC doesn’t seem inclined to view activist investors differently than any other investors in a closed-end fund, Pike said. “If that’s the case, then, I don’t think the SEC is inclined to get involved, in litigation or otherwise,” she said.

The best way to know for sure how sympathetic the SEC is or isn’t toward industry concerns that activist investors are misusing closed-end funds is to wait and see how the commission responds to the NYSE’s petition.  

“Here is a live proposal that is now in front of them, and so they will have to act one way or the other. And I think that will tell everybody a lot about how they view this,” Pike said.

The SEC could issue guidance on the ’40 Act that would favor closed-end funds in their struggle with activists, by treating coordinating activists as a single company as defined in the ’40 Act, for example, Burdon said.

“You’re running one investment program as an organized group of persons, therefore it’s a company under the Act. That company is investing in securities, so it’s an investment company,” Burdon said. “It’s just applying that same concept to the activists.”

The SEC wouldn’t need a prescriptive rule targeting particular circumstances. It could simply issue a statement of guidance saying if you do acts, this is how we may scrutinize it, giving examples that perhaps include activism and other things that aren’t activism.

Burdon said he thinks it unlikely the SEC will offer much support without legislation from Congress requiring it, however.

The SEC may be afraid to issue guidance on the subject because of the fear that it could get sued by an activist claiming that the agency is effectively trying to create a rule without going through the Administrative Procedure Act process, sources said.

The SEC may also be abstaining from weighing in on the conflict because the looming Presidential election could reverse any guidance made now.

“The SEC makeup could change, the staff makeup could change, their regulatory philosophy could change– there’s just a lot of uncertainty over the course of the next year,” Burdon said.