Governance Protections of the 1940 Act and Abuses Allowed by Annual Meetings

The New York Stock Exchange’s (NYSE) 1920s-era annual shareholder meeting requirement for listed closed-end funds (CEFs) has left open an end-run around the governance protections of the Investment Company Act of 1940 (1940 Act), the landmark law governing mutual funds and other registered investment companies. Recently, the NYSE proposed a rule amendment that would realign its listing standards for CEFs with the governance protections that Congress specifically thought appropriate for investment companies. As it considers whether to permit the NYSE to change its listing rule, the SEC ought to recognize that Congress chose consciously not to mandate annual meetings for CEFs and other investment companies registered under the 1940 Act (either at its inception in 1940 or any time after 1940), which is why no other type of registered fund is subject to such a requirement.

ICI has written a detailed analysis of the issue here, explaining why the NYSE’s rule, which predates the 1940 Act, is unnecessary and in fact facilitates abusive practices. However, we have noted that some well-known academic commentators, in at least one case commissioned by an activist hedge fund that relies on the annual shareholder meeting requirement to take over CEFs, have sought to portray the NYSE rule change as anti-shareholder and poor corporate governance.[1] We respectfully think this academic critique is misinformed and actually encourages hostile practices harmful to retail shareholders and other investors.

Statements from the Congressional Record Regarding an Annual Meeting

When formulating the 1940 Act, lawmakers expressed concerns that a fund shareholder with an outsized minority interest could control the shareholder vote and potentially harm long-term investors in a fund. The risk that a controlling shareholder could pose by electing its own candidates for director—who in turn could change the fund’s investment management contract or investment policies—was considered to be significant for retail shareholders, who generally invested based on a fund’s investment strategy, relied on continuity of the fund’s management, and were less likely to participate in annual meetings. As stated in the Congressional Record:

“[C]ontinuity of management is something for which an investor naturally looks when seeking to invest [their] money…[T]o require annual approval of, or permit the change of, management by a percentage of stockholders may, in our opinion, be bringing about a contrary result, in leaving management the football of a proxy fight to be thrown out by some unscrupulous group having no responsibility to the shareholders in the original sales of the shares. . . . Bear in mind, please, that this investor…has the right to change the management, by [selling their] shares at any time.”[2]

Governance Abuses Occurring Prior to the Adoption of the 1940 Act Are Occurring Once Again

The governance abuses that Congress thought they were eliminating with the 1940 Act are occurring today, facilitated by the NYSE’s legacy annual shareholder meeting requirement for listed CEFs.

I. Historical Harms . . .

After the 1929 stock market crash and the ensuing market dislocations, arbitrageur investors, in particular the Atlas Corporation, embarked on campaigns to acquire control of funds—primarily CEFs—trading at discounts. After electing their slate of board directors, appointing themselves as adviser, or otherwise gaining control of the target fund, the arbitrageurs would typically liquidate the fund and realize a profit differential between the asset value of the underlying portfolio and the market price of the acquired funds’ shares. Where the arbitrageurs did not liquidate the fund, they would change its investment strategy and underlying portfolio substantially —often to make the fund acquire shares of other funds in furtherance of the arbitrageur’s campaign. These fund liquidations and investment changes deprived fund shareholders of the fundamental characteristics of the fund that they had originally purchased and invested in.

As the SEC stated in 1940, such activity

“demonstrated that comparatively rarely does the purchaser of control from a previous sponsor seek control for the purpose of strengthening the position of the investor in the company. The motive, or at least the result, has generally been the utilization of the investment company for the special designs of the purchaser of control, often in disregard of the interests of the investor . . . .”[3]

II.  . . . and Echoes Today

Similar retail investor harms are occurring again, and the activist takeover of the Voya Prime Rate Trust in 2020 is a textbook example. Before 2020, the Voya Prime Rate Trust invested almost exclusively in senior loans and had an investment objective to “provide investors with as high a level of current income as is consistent with the preservation of capital.” In April 2020, an activist firm that held 24.6% of the fund’s outstanding shares  instituted a proxy battle that replaced all eight of the fund’s directors. Of approximately 147 million shares outstanding, 39% voted for the activist’s board slate, 25% voted for the existing board directors, and 34%—presumably mainly retail investors—did not vote, meaning the activist was able to replace directors with only 14% of outstanding shares that it did not otherwise control.

The new board terminated the existing investment adviser and appointed the activist, with shareholder approval, as the new adviser. During that time, the fund engaged in two tender offers. While the activist secured a healthy profit for itself (76% of proceeds from the second tender went to activist shareholders), the tenders resulted in a significant loss in economies of scale for remaining shareholders. Along with the board itself, the fund’s investment restrictions and portfolio allocations were changed. Prior to the activist takeover, the fund held approximately 96% of its assets in senior loans. But afterward, the fund’s portfolio included other CEFs, crypto trusts, private funds, and SPACs—with only 10% remaining in senior loans as of October 2023. Further, as the fund began acquiring other funds and otherwise altering its portfolio, its expenses increased due to management fees it had to pay to those acquired funds, and the fund’s distributions changed from solely income distributions to primarily return of capital distributions. The quantified harms of those actions are explained and visualized here.

Governance Protections of the 1940 Act and the Important Distinction Between Investment Companies and Operating Companies

In light of the potential for the types of harms seen in the Atlas Corporation context in the 1930s and in the Voya Prime Rate Trust context today, Congress enshrined specific governance protections in the 1940 Act in lieu of an annual meeting requirement. These protections reflect an important distinction from operating companies, which are not subject to such requirements and whose shareholders do not have these rights. Such distinctions illustrate the differences between funds and traditional operating companies and exemplify the 1940 Act’s more tailored protections for fund shareholders, which in turn reflects the balance Congress sought in protecting shareholders’ right to vote without allowing retail shareholders’ investment decisions to be overtaken by an outsized minority shareholder. Congress considered the potential abuses an annual meeting requirement could create and instead decided upon an array of protections for retail shareholders, including the following:

• Director Elections – The 1940 Act protects CEF shareholders by preserving their ability to elect directors, who have oversight responsibility for the management of a fund’s affairs and are, among other things, intended to monitor a fund’s potential conflicts of interest. Specifically, Section 16(a) requires a fund to hold a shareholder meeting: (i) to elect the initial board of directors; (ii) to fill all existing vacancies on the board if shareholders have elected less than a majority of the board; and (iii) to fill any director vacancies if shareholders have elected less than two-thirds of the directors holding office. Additionally, Section 18(a)(1)(C) and Section 18(a)(2)(C) provide shareholder voting rights to preferred shareholders to elect directors under specific scenarios.
• Director Independence Requirements – Congress intended for independent directors to be “independent watchdogs” whose role is to be a check on management and represent shareholder interests. For this reason, the 1940 Act requires that independent directors comprise a specified minimum of an investment company’s board and relies on fund boards to represent investors and protect their interests. For example, a majority of a fund’s independent directors must approve: (i) the initial advisory agreement and any renewal; (ii) the initial underwriting agreement and any renewal; (iii) selection of an independent public accountant; (iv) acquisition of securities by a fund from an underwriting syndicate of which the fund’s adviser or certain other affiliates are members; (v) the purchase or sale of securities between investment companies that have the same investment adviser; (vi) mergers or asset acquisitions involving investment companies that have the same investment adviser; (vii) use of an affiliated broker-dealer to effect portfolio transactions on a national securities exchange; and (viii) fidelity bond coverage for the fund.
•  Vote of a Majority of the Outstanding Voting Securities for Specified Governance and Policy Changes – The 1940 Act explicitly requires registered investment companies to obtain shareholder approval by a “vote of a majority of its outstanding voting securities” for specified governance or policy changes. This standard is more stringent than the one that governs most operating companies—in particular, a simple majority vote of shares present at a meeting could not approve a proposal unless the total shares voting in favor also represented a majority of all outstanding voting securities. Matters that require shareholder approval include: (i) a new investment management agreement or a material amendment to an investment management agreement; (ii) a change from closed-end to open-end status, or vice versa; (iii) a change from a diversified company to a non-diversified company; (iv) a change in a policy with respect to borrowing money, issuing senior securities, underwriting securities that other persons issue, purchasing or selling real estate or commodities or making loans to other persons, except in accordance with the recitals of policy contained in the investment company’s registration statement; (v) a deviation from a policy in respect of concentration of investments in any particular industry or fundamental investment policy; and (vi) a change in the nature of the investment company’s business so as to cease to be an investment company.

Misinformed Academic Critique

The argument made by academic commentators to the SEC is that removing the annual meeting requirement would (i) foreclose the possibility of shareholders being able to exit at net asset value (NAV); and (ii) frustrate investors who purchased with the expectation of voting for directors. Those arguments reflect a mistaken view of listed CEFs and a misunderstanding of retail voting patterns and investment behavior.

I. Investors Purchase Shares of CEFs Trading at a Discount

The argument that investors seek to exit their investment at NAV pre-supposes that investors purchased shares with that expectation. Because many investors purchase on the secondary market when CEF shares are trading at a discount, investor activity undercuts that assumption and ignores an inherent feature of a listed CEF—that it may trade at a discount or premium.

Listed CEFs allow retail investors to access less-liquid investments through a retail-focused wrapper that provides the protections inherent in the 1940 Act. Because listed CEFs trade at market price, there is often divergence between that price and the underlying NAV. A listed CEF trading at a share price higher than its NAV is said to be trading at a “premium,” while a listed CEF trading at a share price lower than its NAV is said to be trading at a “discount.”

Listed CEFs may trade at premiums or discounts for a number of reasons, such as market perceptions or investor sentiment. For example, some academics have argued that the discount is representative of neoclassical finance theories and may reflect, in addition to investor sentiment, the uncapitalized expenses and time value that would be required to liquidate a less liquid portfolio and unwind a leveraged position.[4] As another example, a listed CEF trading at a discount may be due to investors having priced in any perceived tax liability resulting from large, unrealized capital gains.

A majority of listed CEFs trade at a discount,[5] demonstrating that such discounts are a feature, not a flaw, of listed CEFs. In many cases, the discount can represent a buying opportunity as investors are able to acquire listed CEF shares or reinvest dividends at a discount to net asset value, which in turn boosts their dividend yield and allows for a potential enhanced total return.[6] The fact that many shareholders buy CEF shares when they are trading at a discount and then reinvest dividends when shares continue to trade at a discount demonstrates that these shareholders buy and hold shares for the yield they offer as opposed to a future opportunity to exit at NAV. The primary entities expecting to exit at NAV are the activist hedge funds seeking short-term profits. And that makes sense, given the short-term profits these activists would stand to lose if the SEC approves the NYSE’s proposal and aligns listed CEF shareholder protections with those Congress intended.

II. Retail Shareholders Are Less Engaged in Governance

In their letter to the SEC, Bebchuk and Jackson argue that removing the annual shareholder meeting will frustrate the expectations of shareholders who bought shares expecting to vote in annual elections.[7] While that statement may make sense from a hypothetical standpoint, the retail voting data simply does not support any such expectation.

It long has been recognized that retail shareholder engagement at annual meetings has been limited.[8] Recent data on proxy voting in contested elections of listed CEF directors shows that retail investors who direct their own vote and do not have an adviser or broker vote for them (i.e., “non-discretionary retail”) often participate in the proxy process at lower rates. While these investors held 59% of the CEF shares involved in these elections, they accounted for only 37% of the votes cast.[9] Also, when non-discretionary retail shareholders did vote in these contests, they leaned heavily toward supporting management—nearly 85% of non-discretionary retail accounts voted in favor of management with over 57% of the total non-discretionary retail ballots being cast in favor of management.

Further, when looking at the Voya Prime Rate Trust takeover, approximately one-third of shareholders didn’t vote. That number is of particular relevance as approximately one-third of outstanding voting shares did not participate in the meetings analyzed by the SEC in the 1930s.[10] Despite all the technological developments in the past 90 years—computers, internet, cell phones— retail investors’ reluctance to vote has not changed. Retail investors buy shares for a fund’s investment strategy, performance, and returns—not because they want to immerse themselves in a fund’s corporate governance matters. The annual meeting requirement does not benefit retail shareholders but rather allows the very same harms to occur that Congress and the SEC analyzed when drafting the 1940 Act.

Conclusion

To the extent anyone can claim annual meetings provide a benefit, it is activist investors operating for their own financial gain. ICI is in the process of conducting a survey of retail shareholders to determine why they buy shares of listed CEFs, and, while the data is preliminary, ICI can affirmatively state that no retail investor responded that they bought shares to get deeply involved in the details of a fund’s corporate governance. With the annual meeting requirement eliminated, activists will find it much harder to prey on CEFs. Investors and stakeholders should ask the SEC to approve the NYSE’s proposed rulemaking.