On May 27, the Staff of the Division of Investment Management of the Securities and Exchange Commission withdrew a no-action letter (the "Boulder No-Action Letter"),1 issued in 2010, in which the Staff had expressed the view that it would be inconsistent with Section 18(i) of the Investment Company Act of 1940, as amended (the "1940 Act"), for a closed-end investment company to be subject to the provisions of the Maryland Control Share Acquisition Act (the "Control Share Act"). In withdrawing the Boulder No-Action Letter, the Staff explained that it "would not recommend enforcement action to the Commission against a closed-end fund under Section 18(i) of the [1940] Act for opting in to and triggering a control share statute if the decision to do so by the board of the fund was taken with reasonable care on a basis consistent with other applicable duties and laws and the duty to the fund and its shareholders generally." The Staff added that "any actions taken by a board of a fund, including with regard to control share statutes, should be examined in light of (1) the board's fiduciary obligations to the fund, (2) applicable federal and state law provisions, and (3) the particular facts and circumstances surrounding the board's action."2
In light of this reversal, boards of closed-end funds formed as Maryland corporations may wish to consider opting in to the Control Share Act in order to better defend their corporate existence and business strategy against arbitrageurs, short-term investors and other stockholder activists pursuing economic strategies of their own that are not aligned with (and may be adverse to) the applicable fund's goals. In addition, boards of new registered closed-end funds may want to consider whether to opt in to the Control Share Act at the inception of the fund.
A registered closed-end fund incorporated in Maryland3 may opt in, by board resolution, to the Control Share Act.4 Generally, the Control Share Act provides that the holder of "control shares" of a Maryland corporation "acquired in a control share acquisition" may not exercise voting rights with respect to the control shares, except to the extent approved by a vote of two-thirds of all the votes entitled to be cast on the matter, not including votes entitled to be cast by the person who has made or proposes to make a control share acquisition (the "acquiring person") or by officers or employee-directors of the corporation. Control shares are voting shares of stock that, if aggregated with all other shares of stock (i) owned by the acquiring person or (ii) as to which the acquiring person is able to exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the acquiring person to exercise voting power in electing directors within one of the following ranges of voting power: (a) one-tenth or more but less than one-third, (b) one-third or more but less than a majority or (c) a majority or more of all voting power.
An acquiring person may compel the board of directors of the corporation to call a special meeting of stockholders to be held within 50 days of the request to consider voting rights for the shares, subject to satisfying certain conditions, including an undertaking by the acquiring person to pay the expenses of the meeting. In addition, the corporation may submit the issue of voting rights for an acquiring person for consideration at a meeting of stockholders.
The Control Share Act does not apply (a) to shares acquired in a merger, consolidation or share exchange if the corporation is a party to the transaction or (b) to acquisitions approved or exempted by the charter or bylaws of the corporation.
If voting rights are not approved at the meeting or if the acquiring person does not deliver an acquiring person statement as required by the statute, then the corporation may redeem for fair value any or all of the control shares, except those for which voting rights have previously been approved. If voting rights for control shares are approved at a stockholders meeting and the acquiring person becomes entitled to vote a majority of all voting power, all other stockholders may exercise appraisal rights at "fair value," which may not be less than the highest price per share paid by the acquiring person in the control share acquisition. The corporation's right to redeem shares and the stockholders' power to exercise appraisal rights may be subject to certain limitations imposed by the 1940 Act.
Since enactment of the Control Share Act in 1989, it has been conventional wisdom among takeover defense lawyers that, apart from the context of closed-end funds, the disadvantage of permitting an acquiring person to compel a special meeting to make its case to the stockholders outweighs the advantage of lowering the acquiring person's voting power. However, many closed-end funds have historically traded at persistent discounts to their net asset values per share, making them frequent targets of short-term activists that engage in proxy contests for board control or termination of the investment advisory agreement under the 1940 Act, which may result in destruction of the fund. Due to certain 1940 Act requirements, there are concerns regarding the power of closed-end funds to adopt stockholder rights plans and other defenses against attacks. Thus, the potential disadvantage of holding a special meeting compelled pursuant to the Control Share Act may be outweighed by the advantage of limiting the exercise of voting rights by the activist, unless it can obtain approval by two-thirds of all the disinterested votes entitled to be cast on the matter. This is particularly true if the fund is faced with hostile activity that could ultimately result in its liquidation.
The Maryland General Corporation Law requires each director to act (a) in good faith, (b) with a reasonable belief that his or her action is in the best interests of the corporation and (c) with the care of an ordinarily prudent person in a like position under similar circumstances. These statutory duties are legally enforceable against the directors. By contrast, stockholders have no such duties; they can and do act in what they believe is in their own best interests, without any duty to the corporation or other stockholders.
In taking any action, a director may rely on information, opinions, reports or statements prepared or presented by officers or other employees reasonably believed to be reliable and competent; by lawyers and other experts within their competence; or by a duly authorized committee of the board if the director believes the committee merits confidence. In addition, Maryland, unlike Delaware, does not provide for varying judicial standards when evaluating director actions (i.e., no Unocal enhanced scrutiny test or Weinberger entire fairness test).
Consistent with the Staff's recent guidance, as a board determines whether to opt in to the Control Share Act, we advise directors to consider, among other matters:
- their legal duties under both federal and Maryland law,
- the business strategy for the fund,
- the presence and prior history of any activists in the fund's and other funds' shares and the activists' apparent investment strategies,
- the views of its stockholders, especially long-term stockholders,
- other takeover defenses available to the fund, and
- the advice of management.
In weighing these and other considerations, directors should gather as much material information as possible, seek the views of experts, deliberate carefully, meet as often as seems appropriate, avoid undue haste, listen to the views of others and take whatever time they feel they need to reach a decision that each director reasonably believes is in the fund's best interests.
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As always, our colleagues and we are available to discuss these or other matters of Maryland law.
Jim Hanks
Michael Leber
Hirsh Ament
Gabe Steele
Dan Mendelsohn
This memorandum is provided for information purposes only and is not intended to provide legal advice. Such advice may be provided only after engagement for advice and analysis of specific facts and circumstances and consideration of issues that may not be addressed in this document.
[1] This letter was issued at the request of Boulder Total Return Fund, Inc.
[2] We note that the Staff's revised position is consistent with the interpretation Venable has taken for many years. See James J. Hanks, Jr., Control Share Acquisition Statutes, Section 18(i) and Closed-End Funds, The Investment Lawyer, May 2011.
[3] Maryland is one of approximately 25 states, not including Delaware, that has a control share statute.
[4] A closed-end investment company that elects to be regulated as a business development company under the 1940 Act is not generally exempt and is subject to the Control Share Act, unless it opts out, typically by a provision in its Bylaws. Prior to the withdrawal of the Boulder No-Action Letter, the Staff was requiring business development companies to opt out of the Control Share Act by a provision in its Bylaws. Presumably, this will no longer be the case.