Closed-end investment companies registered under the Investment Company Act of 1940, as amended (the "1940 Act"), have proven to be a product sought by many investors, especially individuals.[1] Despite their appeal to long-term investors, closed-end funds have been subjected to persistent attack over many years by arbitrageurs and some stockholder activists with very different objectives from long-term investors.
Many closed-end investment companies are formed as Maryland corporations and we have advised many closed-end funds on matters of Maryland law in responding to stockholder activism. We have observed, as have others, that the motivations of these activist stockholders vary. Some activists are arbitrageurs attempting to make a short-term profit in funds trading at a discount to net asset value by purchasing shares at the discount and then exerting pressure on the fund to open-end, liquidate or take other actions to eliminate the discount. Other activists apparently have different motives, such as obtaining control of a fund in order to replace the existing adviser with a new adviser, perhaps one affiliated with the activist stockholder.
In light of these developments, and in response to the withdrawal by the Staff of the Division of Investment Management of the Securities and Exchange Commission of a no-action letter issued in 2010, in which the Staff expressed the view at that time that it would be "inconsistent" with Section 18(i) of the 1940 Act for a closed-end investment company to be subject to the Maryland Control Share Acquisition Act (the "Control Share Act"), many closed-end investment companies elected to be subject to the Control Share Act.[2] Nevertheless, given the continued proliferation of activist attacks, we recommend that boards of closed-end funds formed as Maryland corporations periodically evaluate various other corporate governance options available under Maryland law with a view to positioning each fund to defend its corporate existence against arbitrageurs and other stockholder activists with short-term investment horizons seeking to destroy it. All of the provisions discussed below may be implemented by the board of directors without stockholder action under Maryland law, though the charter and bylaws should be reviewed for any potential issues in this regard.
1. Stockholder Rights Plan
A stockholder rights plan, sometimes referred to as a "poison pill," generally provides for a distribution to the common stockholders of rights which (a) in the event of an acquisition of more than a certain percentage (generally 10% to 20%) of the common stock, become rights to purchase additional shares of common stock at a significant discount (the "flip-in" feature) and (b) in the event of a squeeze out transaction, become rights to purchase the acquiring person's equity at a significant discount (the "flip-over" feature). Importantly, these rights are not exercisable by the acquiring person. Because, in general, only the board of directors is given the power to redeem the rights or amend the plan, a potential bidder is encouraged to negotiate with the board rather than to attempt a tender offer or other stock accumulation that may trigger the distribution of the rights.[3]
The Maryland General Corporation Law (the "MGCL") specifically authorizes the board of directors of a Maryland corporation, "in its sole discretion", to (a) set the terms and conditions of rights, options, or warrants under a stockholder rights plan and (b) issue rights, options, or warrants under a stockholder rights plan to designated persons or classes of persons. Those options, rights or warrants "may, in the sole discretion", of the board of directors include any limitation, restriction or condition that (i) precludes, limits, invalidates, or voids the exercise, transfer, or receipt of the rights, options, or warrants by designated persons or classes of persons in specified circumstances or (ii) limits for a period not to exceed 180 days the power of a future director, as defined in the stockholder rights plan, to vote for the redemption, modification, or termination of the rights, options, or warrants. The latter provision, known as a "slow hand" provision, prevents new directors elected in a proxy contest, which bidders often run in tandem with tender offers, from voting to change or end a stockholder rights plan for 180 days after election. In addition, in Neuberger Berman Real Estate Income Fund v. Lola Brown Trust, 485 F. Supp. 2d 631 (D. Md. 2007), the Court noted that the adoption of several successive rights agreements lasting individually less than 120 days but in aggregate more than 120 days did not violate the 1940 Act.[4]
2. Classified Board of Directors; Subtitle 8 Opt-In
Classified boards are a long-time feature of corporate governance found in a number of public companies, and are very common in the listed closed-end fund sector in our experience. Classified boards also enhance continuity and stability in the board's development and execution of corporate strategies and contribute to board effectiveness by helping to attract and retain individuals willing to commit the time necessary to understand the fund, especially prospective independent directors who may be asked to serve on the audit committee or other board committees. In addition, a classified board will slow down an unfriendly attempt to take control of the board of a fund, as the insurgents must generally win two consecutive annual elections to take control. Moreover, under the MGCL, unless the charter provides otherwise, a director on a classified board may be removed only for cause. The MGCL provides different mechanisms by which a board may be classified, including amendment of the bylaws and election by the board, on behalf of the fund, to classify the board under Title 3, Subtitle 8 of the MGCL ("Subtitle 8"), notwithstanding any contrary provision in the charter or bylaws.
3. Additional Subtitle 8 Provisions Relating to Directors
Subtitle 8 permits a Maryland corporation with a class of equity securities registered under the Securities Exchange Act of 1934, as amended, and at least three independent directors to elect, by provision in its charter or bylaws or by resolution of its board of directors and notwithstanding any contrary provision in the charter or bylaws, to be subject to the additional provisions described below.
- Fixing Number of Directors and Filling Vacancies. The power to fix the number of directors and the power to fill vacancies on the board are often – but not always – conferred on the board in the charter and the bylaws. If so, and if the board has the exclusive power to amend the bylaws (as is permitted in Maryland but not in Delaware with respect to corporations), then no further action in this regard is necessary. However, if the charter gives to stockholders the power to fix the number of directors or to fill vacancies, or if these powers are given to the board in the bylaws but the stockholders have the concurrent power to amend the bylaws, then the board may want to elect for the fund to opt in to provisions of Subtitle 8 conferring on the board the exclusive powers to set the number of directors and to fill vacancies. Moreover, electing to be subject to the Subtitle 8 provisions relating to filling vacancies has an added benefit for classified boards: Any director elected to fill a vacancy under Subtitle 8 will hold office for the full remainder of the term of the class of directors to which he or she was elected, instead of holding office only until the next annual meeting of stockholders.
- Removal of Directors. Under the MGCL, the stockholders may remove any director, with or without cause (unless, as noted above, the director is a member of a classified board), by the affirmative vote of a majority of all the votes entitled to be cast generally in the election of directors. However, the charter may increase this percentage. Some charters of closed-end funds provide for a supermajority vote to remove directors, but others do not. If there is not already a supermajority vote required in the charter, the board of directors may want to consider electing on behalf of the fund to be subject to the applicable provision of Subtitle 8 increasing the vote required to remove a director to two-thirds of all the votes entitled to be cast generally in the election of directors.
4. Director Qualification Bylaws
The MGCL provides: "Each director and each nominee for director of a corporation shall have the qualifications required by the charter or bylaws of the corporation." Carefully drafted director qualification bylaws can aid in ensuring that directors have the requisite background and expertise to act in the best interests of the fund and not of any one stockholder or group of stockholders.
5. Increased Voting Requirement for Election of Directors
The MGCL provides: "Unless the charter or bylaws of a corporation provide otherwise, a plurality of all the votes cast at a meeting at which a quorum is present is sufficient to elect a director." Historically, most bylaws of publicly traded companies provided that directors are elected by a plurality of all votes cast in the election. Increasing the required vote to elect directors to a majority of all the votes entitled to be cast can be an effective defense against a slate of nominees proposed by a dissident with a large position in a fund. Many closed-end funds have included such a provision in their bylaws. However, a majority standard (whether a majority of votes entitled to be cast or a variant of majority of votes cast) for the election of directors may make it more difficult to defend against a withhold-the-vote campaign as to incumbent directors (and any non-incumbent management nominees), even in an otherwise uncontested election. Under the MGCL, however, if directors are not elected, the incumbent directors hold over until their successors are elected and qualify.
6. Supermajority Board Vote Requirements
The MGCL provides that the board acts by the vote of a majority of directors present at a meeting at which there is a quorum, unless "the charter or bylaws of the corporation require a greater proportion . . . ." To limit the power of a classified board of directors in which the insurgents have won two successive elections, the charter or bylaws may provide for a vote requirement in excess of two-thirds of the number of directors in order to approve various actions (e.g., election and removal of officers, appointment of committees, authorization of dividends or other distributions, appointment of the adviser, recommendation of extraordinary corporate action to the stockholders).
7. Advance Notice of Stockholder Proposals
The MGCL specifically authorizes the charter or bylaws of a Maryland corporation to require stockholders to provide advance notice of nominations for directors and other proposals for business. Advance notice bylaw provisions have proven to be an effective means of permitting a fund and its stockholders sufficient time and information to evaluate stockholder nominations and proposals. Typically included in advance notice provisions are requirements for submission of various information about the proponent and the proposed nominee or other business. The bylaws of most of our closed-end fund clients have advance notice provisions. Closed-end funds that do not have broad advance notice bylaw provisions may want to consider adopting them and closed-end funds with existing advance notice bylaw provisions may want to consider updating and further enhancing them.
8. Conduct of Stockholders Meetings
As stockholders' meetings involving contested nominations or proposals are common, it is important for the chair of the meeting to have the necessary and appropriate powers to conduct the meeting. We have developed bylaw provisions authorizing the chair to establish procedures for the conduct of the meeting and to take various actions in his or her discretion. In particular, we suggest that boards consider giving the chair of the meeting the explicit power to recess or adjourn the meeting to a later time. It is also important that the bylaw provision on inspectors be both comprehensive in its coverage and specific in its direction to the inspector.
9. Request Requirement for Calling Special Stockholders' Meeting; Subtitle 8 Opt-In
The MGCL requires the secretary of a Maryland corporation to call a special meeting of stockholders upon the request of the holders of shares entitled to cast at least 25% of the votes entitled to be cast at the meeting. However, the MGCL permits this 25% requirement to be increased to as high as a majority in the charter or bylaws. The bylaws of most of our closed-end fund clients permit a special meeting of stockholders to be called by the board of directors or specified officers or upon the request of holders of shares entitled to cast at least a majority of all the votes entitled to be cast at the meeting. If the board does not have the sole control of the bylaws, the board may want to elect for the fund to opt in to a provision of Subtitle 8 raising the requirement for stockholders to call a special meeting of stockholders to a majority of all the votes entitled to be cast at such meeting. This provision will allow a fund to avoid the time, cost and distraction of holding a special meeting if it is not clear that the requesting stockholders will be able to attain a quorum.
10. Procedures for Stockholder-Requested Special Meetings
The MGCL expressly provides that the board of a Maryland corporation has the sole power to establish procedures for a stockholder-requested special meeting, including (a) the record date for the request, (b) the record date for the meeting and (c) the date, time and place of the meeting. We have developed a form of bylaw that establishes requirements for the stockholders' written request (e.g., record date for the request, purpose of the meeting, names and addresses of requesting stockholders) and other procedures for calling and holding a stockholder-requested special meeting (e.g., date, time, place, record date, costs of notice, inspectors of election).
11. Indemnification/Advance for Expenses
Maryland has a very broad director and officer indemnification and advance-of-expenses statute. It is common practice for the bylaws of a Maryland corporation to require it to provide its directors and officers with the maximum indemnification and advance of expenses possible under Maryland law, subject, in the case of investment companies, to the limitations of the 1940 Act. A broad indemnification and expense advance provision aids directors in taking action in the best interests of the fund in opposing hostile takeovers by reducing the possibility that a director will personally have to pay an adverse judgment and by absorbing the director's cost of defending litigation challenging board actions. We recommend reviewing a closed-end fund's charter and bylaws to determine whether the provisions relating to indemnification and advance of expenses are current and, if not, what actions may be taken to obtain the broadest indemnification and advance of expenses available under Maryland law.[5] We have also developed a Maryland-specific form of indemnification agreement that provides additional protection for directors and officers.
12. Exclusive Board Control of Bylaws
As indicated above, Maryland law permits the board to be given the exclusive power to amend, alter and repeal the bylaws. Board control of the bylaws is critical to the adoption and maintenance of many of the measures discussed above and is common in Maryland-incorporated funds.
13. Other Measures
Each closed-end fund is a unique vehicle with its own investment objective, adviser and other characteristics. The circumstances and challenges facing funds change. We have developed other fund- and situation-specific measures, designed to protect the existence of closed-end funds, for consideration in particular circumstances.
The MGCL 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).
In connection with each of the possible actions described above, we advise directors to consider and be familiar with among other matters:
- their legal duties,
- their business strategy for the fund,
- the presence and prior history of any activists in the fund's shares or the shares of other funds with similar investment objectives and the activists' apparent investment strategies,
- the views of the fund's stockholders, especially long-term stockholders,
- the views of management, and
- any other factors or information that the directors consider relevant.
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 at any time to discuss these or other matters.
Jim Hanks
Michael Leber
Hirsh Ament
Footnotes
[1] Most of the provisions discussed in this memorandum operate in the same manner for Maryland corporations that are closed-end investment companies that have elected to be treated as business development companies under the 1940 Act. This memo focuses on funds with common stock listed on a national securities exchange, as non-listed closed-end funds do not generally present the same opportunities for accumulation of shares by activists and, accordingly, may have different governance profiles.
[2] We have previously written on the Control Share Act and do not discuss its application further in this memorandum. The Control Share Act, like any other governance provision, should be opted into only after careful deliberation by a fully-informed and well-advised board.
[3] A registered closed-end fund incorporated in Maryland may also opt in to the Maryland Business Combination Act by board action alone. Nevertheless, opting in to the Business Combination Act is unlikely to be particularly helpful to closed-end funds, as we are not aware of any attackers of closed-end funds subsequently seeking to engage in any of the squeeze-out and other self-dealing transactions defined as a "business combination" in the Act.
[4] Section 18(d) of the 1940 Act prohibits the issuance by a registered management investment company of warrants or subscription rights with a term of more than 120 days.
[5] Modern closed-end fund charters typically include a director and officer liability exculpation provision that limits liability for money damages to the maximum extent permitted by Maryland law, subject to the 1940 Act. This provision must be in the charter and may not be added by amendment of the bylaws. Under the MGCL, amending the charter to include exculpation to the maximum extent permitted by Maryland law requires a vote of the stockholders.