The Withdrawal of the Boulder Letter

Phillip Goldstein is the co-founder of Bulldog Investors. This post is based on his comment letter to the SEC Division of Investment Management.

I. Any Limitation on Voting Rights of a Shareholder of a CEF Violates Sections 16 and 18 and the ICA.

The May 27, 2020 Statement did not disavow the Boulder Letter’s reasoning or its conclusion that a CEF would violate Section 18(i) of the Investment Company Act of 1940 (the “ICA”) by opting into a state control share statute (“CSS”). The May 27th Statement solicited comments on, among other things, the following point:

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)(l)(E) of the Act, which requires pass-through or mirror voting for certain fund of funds arrangements, or rule 13d-l 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.

As you know, Section l(b) of the ICA requires all of its prov1s10ns to be interpreted “to mitigate and, so far as is feasible, to eliminate (1) ‘[funds that are] organized.. .in the interest of directors, officers, investment advisers… or other affiliated persons… or in the interest of… special classes of their security holders,’ (2) the issuance of ‘securities containing inequitable or discriminatory provisions,’ and (3) the failure of fund boards ‘to protect the preferences and privileges of the holders of their outstanding securities.”‘ To our knowledge, no state statute regulating corporations or other business entities contains a similar interpretive mandate. By faithfully applying that mandate, the Boulder Letter rejected the argument that a CSS “which is intended to disenfranchise certain shareholders, would not be inconsistent with Section l 8(i).”

We believe that this argument is without merit. The plain wording of Section 18(i), in conjunction with Sections 2(a)(36) and 2(a)(42), as described above, clearly prohibits discrimination between or among both shares and shareholders. Any interpretation of Section 18(i) that envisages personal discrimination against an investment company shareholder would be flatly inconsistent with the purposes of Sections 18(i) and 1(b) and the special protection that Congress mandated for investment company shareholders. .. Although discrimination between and among shareholders may be permitted for operating companies … , such discrimination is not permitted for a CEF under Section 18(i). (Emphasis added, footnotes omitted.)

But Section 18(i) does not stand alone. It is the basis for, and must be viewed and interpreted in the context of every provision of the ICA that references voting securities, voting, or elections. Opting into a CSS has significant implications for compliance with other provisions of the ICA. That is because Section 2(a)(42) defines a voting security as “any security presently entitling the owner or holder thereof to vote for the election of directors of a company” so opting into a CSS necessarily means that the number of outstanding voting shares can be less that the number of outstanding shares which would contravene Section 18(i). Some of the most important affected provisions are as follows:

  1. Section 2(a)(3) defining “affiliated persons” with respect to a percentage of an entity’s outstanding voting securities
  2. Section 2(a)(9) defining “control” with respect to a percentage of an entity’s outstanding voting securities
  3. Section 12(d)(l)(A)(i) prohibiting a fund from acquiring more than 3% of another fund’s outstanding voting shares
  4. Section 13(a) prohibiting certain changes in a fund’s investment policy unless authorized by the vote of a majority of its outstanding voting shares
  5. Section 15(a) requiring approval, and permitting termination, of a fund’s investment advisory agreement by the vote of a majority of its outstanding voting shares
  6. Section 16(a) requiring a director of a fund to be elected by the holders of its outstanding voting securities
  7. Sections 18(a)(l)(C)(i) and 18(a)(2)(C) of the ICA requiring, in certain circumstances, that the holders of (presumably all outstanding) senior securities issued by a fund “shall be entitled” to elect directors
  8. Section 32(a)(3) permitting the termination of a fund’s accountant by a vote of a majority of the outstanding voting securities

In addition to violating Section 18(i), any measure that restricts the ability of a shareholder of a fund to vote all of his or her shares in an election for directors is contrary to these sections of the ICA because each of them presumes that every share issued by a CEF can be voted by its holder on any matter that every other holder of the same class of shares can vote her or her shares. Such unlawful measures include a opting into a CSS or including a similar provision in a CEF’s organizing documents. In the context of the entirety of the ICA, no other interpretation of these sections is reasonable.

II. The Withdrawal of the Boulder Letter Was Procedurally Improper.

There are only two possible reasons that the staff would try to put the Boulder Letter genie back in the bottle: (1) The staff succumbed to undue pressure from the Chairman and/or lobbying by the fi.md management industry; (2) The staff has come to believe that there may be circumstances in which it would be in the best interest of investors to limit the ability of a shareholder of a fund to vote all of his or her shares. However, if the latter is the case, a ftmd seeking to limit a shareholder’s ability to vote all of his or her shares should seek exemptive relief based upon the facts and circumstances so that that fund’s investors and the staff can evaluate whether such relief is warranted. Converse.ly, until the staff explains why it believes the Boulder Letter was flawed, the blanket no action relief provided in the May 27th Statement is a procedurally improper invitation to violate the ICA as well as an alarming refusal by the staff of a federal regulatory agency to enforce a statute it has a duty to administer.

III. The ICA Establishes a Fiduciary Duty Floor for Fund Insiders.

In the May 27th Statement, the staff “reminds market participants that any actions taken by a board of a fund, including with regard to control share statutes, should be examined in light of… the board’s fiduciary obligations to the fund…. However, it provides no guidance as to what those fiduciary obligations are or any examples of when it would be a breach of fiduciary duty for a board to cause a fund to opt into a CSS. Instead, it asks readers to comment on the following points:

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)?

Generally, each state establishes its own standard of fiduciary duty for officers and directors of business entities. For example, unlike Delaware’s General Corporation Law, the Delaware Statutory Trust Act expressly permits the fiduciary duties of trustees of a Delaware statutory trust to be restricted or eliminated in the governing instrument. It goes without saying that that is not an option contemplated by the ICA. Indeed, in Brown v. Bullock, 294 F.2d 415 (2d Cir. 1961), the Second Circuit Court of Appeals stated: “It is… unreasonable to suppose that Congress would have wished to permit its purpose to protect investors in all investment companies … to be frustrated if a particular state of incorporation should be satisfied with lower standards of fiduciary responsibility for directors than those prevailing generally.” That is, if a state can water down the fiduciary duties referenced in Section 36 and Section 17(h) of the ICA, that could undermine the effectiveness of those sections. Therefore, the ICA must be deemed to establish a nationwide floor for fiduciary duties that supersedes any more relaxed state law. Absent such a floor, the staffs reminder about fiduciary duty is effectively empty verbiage. Consequently, the staff needs to fill in the blanks so that fund officers, directors, and trustees know what is expected of them when they consider opting into a CSS.

IV. The Proper Fiduciary Duty Floor for Action that Impedes a Shareholder Vote is Set Forth in Blasius Industries, Inc. v. Atlas Corp., 564 A.2D 651 (Del. Ch. 1988).

In Blasius, Chancellor Allen ruled that a Delaware corporation’s board of directors may only take an action “for the sole or primary purpose of thwarting a shareholder vote” if the board has a “compelling justification.” His premise was that while such an action may not be expressly prohibited by statute, “inequitable action does not become permissible simply because it is legally possible.” Former Director Donohue expressed a similar view by framing the question for a board as “not just whether the action is legal under state and federal law, but whether it is truly in the best interests of fund shareholders.” In sum, Blasius holds that in the voting context, absent a compelling justification, a board has a fiduciary duty to permit shareholders to make their own choices, even if the board believes they may be the wrong ones.

Blasius is the gold standard and many states have applied it to determine whether a corporate board breaches its fiduciary duty by taking action primarily intended to thwart the free exercise of the shareholder franchise. However, it is uncertain whether courts in some states that are favored by CEFs like Maryland or Massachusetts would apply Blasius to the same set of facts and circumstances as a Delaware court. Moreover, even in Delaware, Blasius may not be applicable to other business entities like a Delaware statutory trust (which, under the Delaware Statutory Trust Act, may not even require trustees to be elected by shareholders ).

It is indisputable that the ICA cannot be undermined by state law. Consequently, the staff should conclude that a fund board must apply Blasius’ “compelling justification” standard before it takes any action that adversely affects the franchise rights of any shareholder including opting into a CSS or otherwise limiting a shareholder’s ability to vote all of his or her shares. If a board believes it has a compelling justification for taking such action, it should seek exemptive relief.

V. Absent a Compelling Justification, Other Anti-Takeover Measures by Funds are Unlawful.

As explained above, opting into a CSS violates various sections of the ICA including Section 18(i) and, absent a compelling justification, is also a breach of the board’s fiduciary duty. Of course, there are other actions that a board can take to impair the ability of shareholders to effectively exercise their franchise rights. All of them are likely expressly prohibited by the ICA and, even more likely, all of them constitute a breach of fiduciary duty.

For example, the boards of some CEFs have adopted a bylaw that requires that, in order to be elected as a director, a nominee must receive not merely the most votes at a shareholder meeting but a majority (or more) of the votes of holders of the fund’s outstanding shares. Its primary purpose is to make almost certain that in a contested election no nominee will be elected so that the incumbent directors will then “hold over” in their positions. As former Director Donohue observed, “[T]his amounts to an anti­ takeover device that keeps the existing board in place.” A vote requirement that is intended to result an incumbent director continuing to serve despite getting fewer votes than a challenger at a valid shareholder meeting violates Section 18(i) (and Sections 18(a)(l)(C)(i) and 18(a)(2)(C) if senior securities are outstanding), and Section 16. In addition, it clearly constitutes an action taken “for the sole or primary purpose of thwarting a shareholder vote” which, absent a compelling justification, constitutes a breach of fiduciary duty under Blasius.

To illustrate the practical effect of a “majority of outstanding shares” bylaw, consider the 2019 annual shareholder meeting of Neuberger Berman High Yield Strategies Fund held on October 3, 2019. Each nominee proposed by a dissident shareholder received approximately 6.2 million votes vs. approximately 4.0 million votes for each incumbent. Yet, because no nominee received the votes cast by holders of a majority of the fund’s approximately 19.5 million shares outstanding, each incumbent director whose term expired at the meeting continued to serve as a director “until his or her successor is elected and qualified.” This outcome cannot be squared with Section 16(a) or 18(i) or with the board’s fiduciary duty to permit shareholders to elect directors of their choice.

More recently, another CEF that had long required a plurality of the votes cast to elect a nominee as a trustee amended its bylaws to require a nominee to be elected by vote by holders of 60% of the fund’s outstanding shares. The fund was enjoined by an Arizona court from applying the 60% requirement and at the annual meeting, the challenger easily elected its slate of nominees. The decision is reproduced below. Had the 60% requirement been upheld by the court, the incumbent trustees would have retained their positions. Such an outcome would contravene Section 16. Future litigation would likely be unnecessary if the staff makes it clear that it expects fund boards to adhere to the voting and fiduciary duty provisions contained in the ICA and intends to recommend enforcement action if they fail to do so.

VI. Conclusion: The Staff Should (1) Either Reissue the Boulder Letter or Provide Reasons to Disavow it, and (2) Provide Guidance on Other Anti-Takeover Measures

The Boulder Letter’s unqualified conclusion that voting discrimination between and among shareholders of a fund is impermissible seems irrefutable. However, if the staff believes that that conclusion is no longer correct, it should explain its reasoning. Otherwise, the Boulder Letter should be reissued. In addition, the staff should remind fund boards that they have a fiduciary duty to avoid taking any action that, absent a compelling justification, impairs the effectiveness of a shareholder vote.

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