Both major associations representing fund boards have weighed in with their opposition to proposals in an upcoming Supreme Court case that could subject all ’40-Act funds to the same activist-threat nightmares that currently affect only closed-end funds.
Both the Investment Company Institute (ICI) and MFDF filed amicus briefs Sept. 3 in a Supreme Court case that pits much-feared activist investor Saba Capital Management against FS Credit Opportunities Corp. in a fight that began as a disagreement over how far the board of a closed-end fund (CEF) could go to defend against takeover by activist investors.
A long series of legal setbacks has shown that shareholders in CEFs have a lot of leeway to push for influence or sue the board to get results.
There is far less opportunity for shareholders to sue open-end funds, however, according to ICI general counsel Paul Cellupica.
Shareholders have the right to sue over some things – primarily those involving the setting of fees or for a few rare, egregious issues such as the recovery of short-swing profits by insiders, for example.
Otherwise, shareholders have very few rights of action – the ability to sue a fund over a result they dislike – under the ’40 Act, Cellupica said.
“The Act created a successful regulatory framework that has led to the fabulous growth of the fund industry over the last 80-plus years,” he said. “Under that framework, we look to the SEC as the agency that enforces activity under the ’40 Act.”
Arguments in the case the Supreme Court agreed to hear on June 30, however, go a lot further by asking the court to decide whether Section 47(b) of the ’40 Act gives shareholders a private right of action that would allow them to sue fund boards or fund advisers to demand they rescind governance rules or decisions they think violate requirements of the ICA.
There is nothing in the text of Section 47(b) that explicitly provides for shareholder rights of action, but if the court agrees with the argument that a right of action should be implied, it could undermine the whole regulatory framework of the industry, Cellupica said.
“We wrote in our amicus brief that it would cause chaos in the industry because you could have shareholders suing for any number of issues,” agreed MFDF president Carolyn McPhillips.
“Closed-end funds are the issue in this case, but there is nothing in the provision that would make it applicable only to closed-end funds,” she said. “It could potentially impact the industry in almost unimaginable ways.”
Registered funds are designed to operate with almost no full-time employees, so all the services required to run them come from fund advisers, administrators, distributors and other service providers – all of whom operate under contract.
A right of action under Section 47(b), however, would allow shareholders to sue for any aspect of any of those contracts a particular group of shareholders considers to be in violation of the ’40 Act in any way, McPhillips said.
Fund boards, by statute and rule, exist explicitly to defend the interests of shareholders, and most funds have a supermajority of directors who are independent, which further increases their ability to act in the interest of shareholders rather than in the interest of the adviser, Cellupica said.
Those boards could still be inundated with “a large number of lawsuits, many of which would be mostly or entirely frivolous, that would impose significant costs to defend against,” Cellupica said. “It would call into question almost all the arrangements fund complexes make for their own operations.”
Fight for control of CEFs bleeds over
The case itself is the latest iteration of a years-long battle between CEF boards and activist investors, including Saba, over defensive efforts CEF boards have tried to take that primarily involve limiting the voting ability of large investors to keep from overwhelming the voice the mass of smaller investors in shareholder elections.
FS Capital is one of 11 CEFs that tried to take advantage of favorable laws passed by the states of Delaware and Maryland that would have allowed them to limit the voting power of major shareholders in an effort to keep Saba or other activist investors from using their stake to influence or take over the board.
On June 26 the US Court of Appeals for the Second Circuit rejected an appeal of a 2019 ruling confirming the tactic as a violation of the ’40 Act because it violates the one-share-one-vote principle of shareholder democracy.
The loss is only the latest in a long string of legal setbacks suffered by CEF boards struggling to find effective defenses against activist investors, but the question remains unsettled due to differences in the rulings from different circuit courts.
The case might not even have reached the Supreme Court if various circuit courts had ruled more consistently on previous cases.
The Third and Ninth Circuits have both ruled on similar cases without accepting any broad rights of action for shareholders, but the Second Circuit, relying on its own precedent from six years before, decided in a more recent ruling that the effort to use control-share statutes from Maryland or Delaware amount to contracts that violate the provisions of the ’40 Act, Cellupica said.
“Until the Second Circuit’s 2019 Oxford University Bank decision, courts interpreted this language not to create a new right of action but rather to provide a potential remedy (rescission) if a party already had a right of action,” according to a July 14 analysis from law firm Goodwin Procter. “The Second Circuit nonetheless concluded that Section 47(b) “creates an implied private right of action for a party to a contract that violates the ICA to seek rescission of that violative contract.”
Without that precedent it might not have happened; with it, the disagreement of the three circuit courts created a need to consolidate into a single point of view, Cellupica said.
SCOTUS has been reluctant to create such openings in the past, but there is no telling how it will rule in this case, he said.
“We believe this should be resolved in a way that does not recognize a private right of action,” Cellupica said. “That would be very harmful for funds and fund shareholders and open an avenue for shareholders to challenge all sorts of contracts.”
The Supreme Court is expected to issue a ruling on the issue by June, 2026.
