On May 27, 2020, the Staff (the Staff) of the Division of Investment Management (the Division) of the U.S. Securities and Exchange Commission (the SEC) issued a Staff Statement (the Staff Statement)¹ reversing course on a decade-old interpretive position that has effectively prevented business development companies (BDCs) and registered closed-end funds (CEFs) regulated under the Investment Company Act of 1940 (the 1940 Act) from utilizing a powerful statutory anti-takeover mechanism known as the “control share statute” (Control Share Statute), which has long been available to companies not subject to the 1940 Act. The Staff Statement could enhance the ability of BDCs and CEFs (the Funds) to defend against hostile takeover attempts by the activist shareholders who frequently target them for arbitrage opportunities.

Background

Control Share Statutes function by preventing persons who acquire a specified percentage of a company’s voting power (e.g., 10%, 33 1/3%, or 50%) from voting the shares acquired in excess of that percentage, unless the company’s disinterested stockholders vote to restore the acquirer’s voting rights, typically by a majority or two thirds vote.

Maryland and Massachusetts² (though not Delaware), where many Funds are organized, have adopted Control Share Statutes. BDCs organized under Maryland law are subject to the Maryland Control Share Acquisition Act (the MCSAA) by default and must opt out to avoid coverage, while CEFs organized under Maryland law must affirmatively opt in to coverage.³

Division Staff formerly took the position that a Fund utilizing a Control Share Statute would be “inconsistent with the fundamental requirements of Section 18(i) of the Investment Company Act that every share of stock issued by [a Fund] be voting stock and have equal voting rights with every other outstanding voting stock.”⁴ The position taken by the Staff at that time was inconsistent with the one federal court decision that discussed the interplay between a Control Share Statute and Section 18 of the 1940 Act,⁵ and was critiqued by industry practitioners for a variety of reasons – most notably that Section 18 of the 1940 Act concerns the voting power of the shares themselves, while Control Share Statutes restrict the voting power of the person acquiring them.

The Staff Statement

Recently, SEC Chairman Jay Clayton instructed the Division to continue reviewing “whether prior staff statements and staff documents should be modified, rescinded or supplemented in light of market or other developments,”⁶ and the Investment Company Institute submitted a report to the SEC recommending that the SEC withdraw the Boulder letter and issue guidance clarifying that closed-end funds and BDCs can employ Control Share Statutes and other common takeover defenses.⁷ The Investment Company Institute noted in its report that, targeted by professional activists, a significant portion of the closed-end fund market is at risk of liquidation or conversion to open-end structures. Only 494 traditional exchange-listed closed-end funds were in operation at year-end 2019, a 25% decline from year-end 2007.

Likely as a result of Chairman Clayton’s directive and industry commentary, the Staff Statement now withdraws the Boulder letter, allowing Funds to take advantage of Control Share Statutes, as long as the Fund board’s decision to become subject to a Control Share Statute is 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 Statement cautions 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.”

The Investment Company Institute applauded the Staff Statement, commenting that:

ICI is truly grateful the SEC staff took this important step to further protect closed-end fund shareholders from growing attacks by activist private funds. This action helps repair a regulatory imbalance that has prevented closed-end funds from using common takeover defenses that other entities can deploy when besieged by corporate raiders.

Withdrawing the Boulder letter is a commonsense decision that is consistent with the Investment Company Act of 1940’s goals of protecting fund shareholders from outsiders that own large amounts of the closed-end fund’s shares. Furthermore, closed-end funds are critical investment vehicles that can help realize the SEC’s goal of providing retail investors with exposure to various asset classes, including the private markets. We believe today’s action will help bolster this important segment of the regulated fund industry and protect the interests of millions of fund shareholders. We look forward [to] further discussions with the staff on whether additional Commission action is warranted in this area.

The Staff Statement also requests feedback on several questions relating to the impact of Control Share Statutes and other related matters, in order to determine whether additional SEC action involving this matter is warranted. Specifically, the Staff requested input, backed by data where feasible, on the following questions:

• What are the practical and functional impacts on closed-end funds, their management, and their shareholders when funds opt-in and trigger control share statutes?  How are those impacts affected by the availability of other defensive measures?  Relatedly, in what circumstances would the availability of other defensive measures affect a fund’s decision to opt-in to and trigger a control share statute?
• What considerations would a fund’s board take into account in determining whether to opt-in to and trigger a control share statute, particularly with regard to benefits to shareholders and compliance with the board’s fiduciary duty?  Under what specific facts and circumstances would a board decide to opt-in to and trigger a control share statute (or decline to do so)? 
• Apart from 18(i), which turns on the meaning of “equal voting rights,” please explain whether the ability to opt-in to and trigger a control share statute would have a practical or functional impact on a fund’s compliance with other provisions of the federal securities laws, such as  section 12(d)(1)(E) of the 1940 Act, which requires pass-through or mirror voting for certain fund of funds arrangements, or rule 13d-1 under the Securities Exchange Act of 1934, which places a limitation on the ability of certain shareholders from voting based on the size of their holding.  If relevant, please provide an analysis of any practical or functional differences between how the principle of equal voting rights may apply in those different regulatory contexts.
• Should the staff recommend that the Commission address the ability of a closed-end fund to opt-in and trigger a control share statute in accordance with section 18(i)?

Commentary

The option to become subject to a Control Share Statute should be considered carefully by Fund boards. In weighing this option, Boards should consider their legal duties under federal and state law, the Fund’s business strategy, the presence or history of any activists in the Fund's and other Funds' shares, the views of Fund shareholders, other takeover defenses available to the Fund, and the advice of the Fund’s officers.

For Funds that do not attract activist attention, there may not be as much utility in a Control Share Statute. Additionally, Control Shares Statutes like the MCSAA permit a person proposing to acquire more than 10% of the Company’s voting power (even a person who has not yet acquired shares) to compel a special meeting of stockholders to consider whether the holder (or would-be holder) should have voting rights. For companies not regulated under the 1940 Act, the cost and distraction of permitting an acquiring person an open forum has been thought to outweigh any advantage gained by restricting the acquiring person’s voting power through a Control Share Statute. On the other hand, Funds regulated under the 1940 Act may find Control Share Statutes to be beneficial, since existing Staff interpretive positions could restrict Funds from adopting other defensive measures, such as poison pill plans, to defend against activist attacks.⁸ The costs of permitting a special stockholder meeting may in some cases be outweighed by the advantage of limiting an acquiring person’s voting rights, for example where a Fund is faced with a possible forced liquidation. In certain other cases, Funds may consider becoming subject to a Control Share Act on a proactive basis, since the election to become subject to a Control Share Act may only be effective with respect to shares acquired after the board action effecting the change. Some Funds have already taken Board action to become subject to the MCSAA.⁹

Boards of Funds organized under the laws of a state without a Control Share Statute may consider redomesticating to a state with a Control Share Statute, or, alternatively, adopting share ownership and voting restrictions similar to those contained in a Control Share Statute directly into the governing documents of the Fund.¹⁰

We recommend that Funds and their boards consult with experienced counsel to analyze the costs and benefits of becoming subject to a Control Share Statute or taking similar defensive measures, and to ensure compliance with Staff guidance and other law in so doing.

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