Investment Company Act of 1940 — Section 18(i)
RESPONSE OF THE OFFICE OF CHIEF COUNSEL
Our Ref. No. 2009911617
Your letter dated November 12, 2010 requests guidance concerning the interpretation of Section 18(i) of the Investment Company Act of 1940 (the “Investment Company Act”) in connection with the consideration by the Boulder Total Return Fund, Inc. (the “Fund”) of whether to opt in to the provisions of the Maryland Control Share Acquisition Act (the “MCSAA”).1 The Fund is a diversified, closed-end management investment company organized as a Maryland corporation and registered with the Securities and Exchange Commission (the “SEC” or the “Commission”) under the Investment Company Act. The Fund’s common shares are registered under Section 12(b) of the Securities Exchange Act of 1934 (the “Exchange Act”).
The issue of whether a closed-end fund (“CEF”) that opts in to the provisions of the MCSAA acts in a manner consistent with Section 18(i) of the Investment Company Act has been the subject of vigorous public debate. In considering the issues discussed in this letter, we have benefited from many memoranda and other commentary produced by practitioners and industry participants that advance non-frivolous arguments reaching opposite conclusions.2 Our analysis addresses many of these arguments in addition to those discussed in your letter.
We appreciate that directors of CEFs such as the Fund often must perform a difficult balancing function when faced with the prospect of a takeover attempt.3 We are aware that such directors have increasingly considered whether opting in to state control share statutes may be an appropriate response to this problem.4 Many funds, shareholders, directors, and members of the investment management bar have raised concerns — in the absence of published Commission or Staff guidance or settled case law — regarding whether such action would be consistent with the Investment Company Act.5 We therefore welcome this opportunity to provide the requested guidance.
As discussed further below, we believe that the use of the MCSAA by the Fund to restrict the ability of certain shareholders to vote “control shares” (as defined and discussed below) would be inconsistent with the fundamental requirements of Section 18(i) of the Investment Company Act that every share of stock issued by the Fund be voting stock and have equal voting rights with every other outstanding voting stock. This conclusion is consistent with the wording of, and purposes underlying, Section 18(i) specifically and the Investment Company Act generally. Such a tactic would discriminate against certain shareholders by denying important voting rights and would contribute to the entrenchment of management. Although use of the MCSAA in this manner may be permitted for operating companies under state law, we believe that the Investment Company Act, with its unique regulatory approach, demands a different result for investment companies.
The Maryland legislature adopted the MCSAA in 1989 as an anti-takeover measure.6 Section 3-702(a)(1) of the MCSAA provides as follows:
Holders of control shares of the corporation acquired in a control share acquisition have no voting rights with respect to control shares except to the extent approved by the stockholders at a meeting . . . by the affirmative vote of two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares.
The provisions of the MCSAA seek to compel prospective acquirers to deal directly with a corporation’s management, rather than obtaining significant voting power through market purchases of such corporation’s shares.7 In general, a control share acquisition under the MCSAA occurs when a person obtains, directly or indirectly, ownership of, or the power to direct the exercise of voting power with respect to, issued and outstanding “control shares” as that term is defined in the MCSAA.8 Control shares are generally shares of stock that would equal or exceed specified percentages9 of the corporation’s total voting power if aggregated with all other shares of stock of the corporation owned by a person or in respect of which such person is entitled to exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy).10 Once holders of control shares lose their voting rights with respect to such control shares pursuant to MCSAA § 3-702(a)(1), such holders may not vote their control shares unless and until the corporation’s stockholders vote to approve the restoration of the voting rights associated with the shares by an affirmative vote of two-thirds of the votes entitled to be cast at a special meeting called for such purpose, excluding all “interested shares.”11
An acquiring person seeking a stockholder vote on the issue of whether voting rights should be restored to control shares that the acquiring person has already acquired, or an acquiring person seeking such a vote to prevent the loss of voting rights with respect to control shares that the acquiring person intends to acquire, must execute an “acquiring person statement” containing mandatory disclosures and representations in accordance with MCSAA § 3-703.12 At the time of delivery of such statement, the acquiring person must also formally request that the corporation call a special meeting and must provide a written undertaking to pay the general expenses incurred by the corporation in connection with such special meeting.13 The corporation may also require any acquiring person requesting a special meeting to provide a surety bond to support the acquiring person’s obligation to pay the corporation’s expenses.14
The MCSAA applies only to certain Maryland corporations, and is not applicable to registered open-end management investment companies.15 CEFs are excluded from the provisions of the MCSAA by default,16 but may elect to opt in to such provisions.
Section 18(i) of the Investment Company Act states, in pertinent part, as follows:
[e]xcept as . . . otherwise required by law,17 every share of stock hereafter issued by a registered management company… shall be a voting stock and have equal voting rights with every other outstanding voting stock . . .
For the reasons discussed below, we believe that if the Fund opts in to the MCSAA, its actions would be inconsistent with the wording of, and purposes underlying, Section 18(i).
Congress adopted Section 18(i) to address the use of “various devices of control” by investment company insiders that were intended to effectively deny public shareholders “any real participation in the management of their companies.”18 In drafting the Investment Company Act, Congress drew in part from findings detailed in the Commission’s Report to Congress on Investment Trusts and Investment Companies (the “Trust Study”).19 The Trust Study outlined a number of practices by which management maintained control of a fund by holding shares of stock with superior voting rights.20 These practices often included placing voting control “in a small group of stockholders . . . sometimes having relatively little investment in the corporation,” typically by means of special classes of stock with differential voting rights21 or through the issuance to fund managers of unpaid option warrants as compensation for management services.22 Congress emphasized that such arrangements (and others with similar effect) were particularly insidious in the investment company context due to the highly liquid nature of investment company assets and concomitant temptations associated with insider control:
… control of such funds offers manifold opportunities for exploitation by the unscrupulous management of some companies. These assets can and have been easily misappropriated and diverted by such types of managements, and have been employed to foster their personal interests rather than the interests of public security holders.23
Section 18(i) addresses these concerns by ensuring that each investment company shareholder has a vote proportionate to his or her stock holdings “like a mutual savings bank — one class of stock, no conflicts, [and] everybody has a pari passu share in the voice of the management.”24 Section 18(i) helps to prevent entrenchment of insider control by affording universal suffrage to investment company shareholders.
Our interpretation of Section 18(i) is reinforced by Section 1(b) of the Investment Company Act, which requires that the provisions of the Act be interpreted “to mitigate and, so far as is feasible, to eliminate” certain enumerated abuses. As relevant to Section 18(i), these abuses include the organization, operation and management of investment companies in the interest of insiders25 and the issuance of securities that contain inequitable or discriminatory provisions, or that fail to protect the preferences and privileges of the holders of an investment company’s outstanding securities.26
When Congress adopted the Investment Company Act, it focused on the protection of the rights of investment company shareholders and imposed on investment companies a unique governance system that seeks to reduce the conflicts of interest that are inherent in the investment company form.27 This governance system relies heavily on shareholders’ ability to exercise voting rights that serve as a check on investment company insiders.28 Specifically, the Investment Company Act requires shareholder approval of investment company management — that is, shareholder approval of investment company directors and any investment adviser.29 These voting rights are fundamental to the equitable operation of investment companies,30 and exist in addition to voting rights that are provided under applicable state law.
Section 18(i) requires that every share of stock issued by an investment company be “voting stock.” Although the term “voting stock” is not defined in the Investment Company Act, Section 2(a)(42) of the Act defines “voting security” as “any security presently entitling the owner or holder thereof to vote for the election of directors . . .” Because the definition of “security” under Section 2(a)(36) includes “any stock,” the term “voting stock” may be properly interpreted with reference to the definition of “voting security” provided in Section 2(a)(42). Under Section 18(i), therefore, every share of stock issued by an investment company must presently entitle the owner or holder to vote such share of stock for the election of directors.31 Nullifying the voting rights of an acquiring person with respect to control shares as contemplated by the MCSAA would be inconsistent with Section 18(i) because such acquiring person would no longer presently be entitled to vote such shares for the election of directors — which is, of course, precisely the aim of the MCSAA. Our position gives practical effect to Section 18(i)’s suffrage guarantee.
Some commentators argue that the acquisition of control shares by an acquiring person is a voluntary action that should be treated similarly to other voluntary shareholder actions that may restrict the voting of shares, such as the granting of proxies. This view ignores the fact that the Investment Company Act proscribes actions by investment companies — not shareholders — and underestimates the profound difference between surrendering voting rights freely and without coercion, on the one hand, and losing them by virtue of fund provisions or actions, on the other.32
Congruent to the voting stock analysis, we believe that opting in to the MCSAA by a CEF would be inconsistent with the requirement in Section 18(i) that every share of stock issued by an investment company have “equal voting rights” with every other outstanding voting stock. Although the Investment Company Act does not define the term “equal voting rights” for purposes of Section 18(i), the Commission proclaimed in 1948 that this term must be interpreted with reference to the admonition in Section 1(b)(3) against securities containing inequitable or discriminatory provisions or that fail to protect the preferences and privileges of stockholders.33 The securities of a CEF using the MCSAA would contain such provisions by discriminating against any person who acquires control shares or whose investment objectives and capacity for investment make it likely that such person may acquire control shares (thereby favoring shareholders whose circumstances make such an acquisition highly unlikely). Furthermore, such securities would contain provisions that fail to protect an essential privilege of share ownership — the right to vote one’s shares. Employing the MCSAA as a device to nullify the voting rights of holders of control shares with respect to such shares, while not identical to the pre-Investment Company Act management practice of holding shares of stock with superior voting rights or to the other tactics discussed in Part II.A above,34 would invite the same entrenchment of insiders and enable the same abuses that Congress sought to debar by enacting Section 18(i).35
In Solvay, the Commission acknowledged “the possibility of varying interpretations of what constitutes ‘equal voting rights’”36 and suggested that “in certain cases an inflexible adherence to any rigid interpretation could produce grave distortions of the apparent intent of Congress to require a reasonably equitable distribution of voting power consistent with the applicable provisions pertaining to the different classes of stock.”37 We believe that the circumstances of Solvay are crucial to understanding the meaning and scope of these statements. The Commission noted that some degree of flexibility may be warranted when interpreting the term “equal voting rights” in multi-class CEFs because Congress settled upon the equal voting rights mandate of Section 18(i) before it contemplated permitting CEFs to issue senior securities, and did not revisit the meaning of “equal voting rights” in the context of the newly sanctioned multi-class CEFs.38 While an interpretation of “equal voting rights” may prove excessively rigid if it were to prevent a fund from affording appropriately differentiated rights to different classes of stock (such as those in Solvay), we believe that the Commission’s concern as expressed in Solvay is limited primarily to that context.
Indeed, we have provided no-action assurances in a number of other instances also involving differential voting rights as between separate classes of stock.39 In each of these letters, our position was supported by the fact that the differences in voting rights followed logically from the differences between the share classes. Furthermore, in some cases, such differences were required under state law in order to protect the interests of a class.40 In this respect, Solvay and the various no-action letters are readily distinguishable from the application of the MCSAA to a single class of CEF shares.41
We are aware of the contention that the “equal voting rights” requirement might be satisfied merely by ensuring that the characteristics of the security — including any contingent disenfranchisements — are identical when issued. We believe that this view ignores the plain meaning of the words “equal voting rights,” the intent of Section 18(i), and the mandate to interpret Section 18(i) with reference to Section 1(b). If it is to provide meaningful protection against unfair discrimination, the equal voting rights requirement in Section 18(i) must prescribe more than equal voting rights at the point of issuance — any alternate reading would invite undue stockholder disenfranchisement and management entrenchment. For example, if we were to adopt the “equal-when-issued” standard, a CEF would be able to issue shares that lose their voting rights shortly after issuance or upon the failure of a shareholder to vote in favor of certain management recommendations. We believe that such outcomes would be unreasonable, and would be inconsistent with the wording of, and purposes underlying, Section 18(i).
You refer in your letter to the argument that the disability triggered by a control share acquisition under the MCSAA is intended to attach personally to the holder of the control shares, and not to the shares themselves. By this reasoning, the MCSAA, which is intended to disenfranchise certain shareholders, would not be inconsistent with Section 18(i), which is intended — under this view — to prevent only the disabling of individual shares.42 Some commentators may contend further that the recent amendment to MCSAA § 3-702(a)(1) (the “2010 Amendment”) buttresses this position by replacing the reference to control shares in that section (“Control shares of the corporation acquired in a control share acquisition have no voting rights . . .”) with a reference to holders of control shares (“Holders of control shares of the corporation acquired in a control share acquisition have no voting rights with respect to control shares . . .”).43
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,44 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, as discussed in Parts II.A and B above.45 Although discrimination between and among shareholders may be permitted for operating companies that use the MCSAA, such discrimination is not permitted for a CEF under Section 18(i).
We believe that the Fund, by opting in to the MCSAA, would be acting in a manner inconsistent with Section 18(i) of the Investment Company Act.46 This conclusion is supported by the wording of, and purposes underlying, Section 18(i) specifically and the Investment Company Act generally.47
Kyle R. Ahlgren
1 Md. Code Ann., Corps. & Ass’ns §§ 3-701 et seq. As of the date of this letter, 26 states have control share acquisition statutes in effect: Arizona, Florida, Hawaii, Idaho, Indiana, Kansas, Louisiana, Maryland, Massachusetts, Minnesota, Mississippi, Missouri, Nebraska, Nevada, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, South Dakota, Tennessee, Utah, Virginia, Wisconsin and Wyoming. Ariz. Rev. Stat. Ann. §§ 10-2721 to -2727 (2010); Fla. Stat. § 607.0902 (2010); Haw. Rev. Stat. § 414E-2 (2010); Idaho Code Ann. §§ 30-1601 to -1614 (2010); Ind. Code Ann. §§ 23-1-42-1 to -11 (2010) (“Indiana Act”); Kan. Stat. Ann. §§ 17-1286 to -1299 (2010); La. Rev. Stat. Ann. §§ 12:135 to :140.2 (2010); Md. Code Ann., Corps. & Ass’ns §§ 3-701 to -710 (2010); Mass. Ann. Laws ch. 110D, §§ 1-8 (2010); Minn. Stat. § 302A.671 (2010); Miss. Code Ann. §§ 79-27-1 to 79-27-11 (2010); Mo. Rev. Stat. §§ 351.015, 351.407 (2010); Neb. Rev. Stat § 21-2451 (2010); Nev. Rev. Stat. §§ 78.3780-3792 (2010); N.C. Gen. Stat. §§ 55-9A-01 to -09, 75E-2 (2010); Ohio Rev. Code Ann. §§ 1701.01(Y)-(Z), 1701.831 (2010); Okla. Stat. tit. 18, §§ 1145-1155 (2009); Or. Rev. Stat. §§ 60.801-816 (2010); 15 Pa. Cons. Stat. §§ 2561-2568 (2010); S.C. Code Ann. §§ 35-2-101 to -111 (2009); S.D. Codified Laws §§47-33-8 to -16 (2010); Tenn. Code Ann. §§ 48-103-301 to -312 (2010); Utah Code Ann. §§ 61-6-1 to -12 (2010); Va. Code Ann. §§ 13.1-728.1 to -728.9 (2010); Wis. Stat. § 180.1150 (2010); Wyo. Stat. Ann. §§ 17-18-301 to -309 (2010). Michigan repealed its control share acquisition statue in 2008. Mich. Comp. Laws Serv. §§ 450.1790-1799 (2010), repealed by 2008 Mich. Pub. Acts 402. While we address only the MCSAA in this letter, our analysis may be applicable to other state control share statutes.
2 Publicly available examples of such materials include: James J. Hanks, et al., Protecting Closed-End Investment Companies Under Maryland Law, Venable LLP Clients and Friends Memorandum (May 12, 2010); James J. Hanks, et al., Maryland Law: Continuing Support for Investment Companies, Investment Lawyer (Sep. 2004); and Arthur D. Lipson, Letter to Fellow Shareholders (July 15, 2010).
3 See Andrew J. Donohue, Director, Division of Investment Management, Securities and Exchange Commission, Keynote Address at the Independent Directors Council, Investment Company Directors Conference, Amelia Island, Florida (Nov. 12, 2009) (transcript available at: http://www.sec.gov/news/speech/2009/spch111209ajd.htm#P23_6532):
Some funds employ a variety of tactics to thwart takeover attempts. To be fair, it must be acknowledged that a fund’s proposed response to certain challenges, particularly in the closed-end space, may have a salutary purpose, such as to defend against arbitrageurs attempting to make a short-term profit in funds trading at a discount to net asset value potentially at the expense of long-term investors. In this situation, the interests of arbitrageurs may conflict with the interests of long-term fund investors and the funds must perform a difficult balancing act. In reacting to these challenges, fund boards must be prudent in their responses in order to fulfill their fiduciary duty to the fund and its shareholders.
4 When we have learned that a CEF has opted in to the MCSAA or proposes to do so, we have alerted the CEF (either directly or through counsel) that such action or proposed action would be inconsistent with the provisions of Section 18(i) of the Investment Company Act. Similarly, the Office of Disclosure and Review of the Division of Investment Management has consistently taken this view when reviewing the registration statements of CEFs filed on Form N-2.
5 We note that in Neuberger Berman Real Estate Income Fund Inc. v. Lola Brown Trust No. 1B, 342 F. Supp. 2d 371 (D. Md. 2004), the court held that the adoption of a particular shareholder rights plan (or “poison pill”) by a CEF did not violate Section 18(d) of the Investment Company Act. The court did not reach the issue of whether a CEF would violate Section 18(i) of the Act by opting in to the MCSAA.
6 Control share statutes such as the MCSAA represent merely one species of anti-takeover statute enacted by many states in response to the U.S. Supreme Court’s decision in Edgar v. MITE Corp., 457 U.S. 624 (1982), which struck down the Illinois Business Takeover Act on Commerce Clause grounds. These so-called “second generation” statutes were designed to address the Edgar Court’s concerns and to anticipate other prospective legal challenges. See generally Donald C. Langevoort, Comment, The Supreme Court and the Politics of Corporate Takeovers: A Comment on CTS Corp. v. Dynamics Corp. of America, 101 Harv. L. Rev. 96 (1987); Note, The Constitutionality of Second Generation Takeover Statutes, 73 Va. L. Rev. 203 (1987).
7 See Maryland Department of Legislative Reference, Senate Judicial Proceedings Committee, Bill Analysis for House Bill 179 (1989) (the “1989 Bill Analysis”). According to the 1989 Bill Analysis, it was the view of the special committee recommending the bill that the MCSAA was “necessary to protect Maryland corporations and their stockholders in view of the growth in hostile takeover activity.” 1989 Bill Analysis at 2. The 1989 Bill Analysis makes clear that the “intent of [the statute] is not to prevent hostile takeovers, but to encourage the raider to negotiate with the target corporation’s board of directors.” Id. As discussed in Part II.E below, the MCSAA was last amended in July 2010.
8 MCSAA § 3-701(e)(1).
9 MCSAA § 3-701(d)(1). The current control share thresholds in the MCSAA are: (1) one-tenth or more, but less than one-third; (2) one-third or more, but less than a majority; and (3) a majority or more of all voting power. MCSAA § 3-701(d)(1)(i)-(iii).
10 While the MCSAA excludes from the control share calculation voting power exercised by virtue of a revocable proxy, many control share statutes lack such an exclusion (see, e.g., Indiana Act Section 23-1-42-2), effectively rendering impossible a successful shareholder proxy fight. See Bernard S. Black, Shareholder Passivity Reexamined, 89 Mich. L. Rev. 520, 557 (1990).
11 “Interested shares” include all shares in respect of which the acquiring person, an officer of the corporation, or an employee of the corporation who is also a director of the corporation, is entitled to exercise or direct the exercise of voting power in the election of directors. MCSAA § 3-701(g).
12 In general, an acquiring person statement must: (i) identify the acquiring person and each other member of any group of which such acquiring person is part for purposes of determining control shares; (ii) specify the intentions of such person (and if applicable, such group); and (iii) certify that such person and/or group has the legal right and financial capacity to consummate the control share acquisition. MCSAA §§ 3-703 and 3-705.
13 MCSAA § 3-704(a). Expenses incurred by the corporation specifically attributable to opposing the restoration of voting rights associated with control shares or supporting the default nullification of such rights with respect to prospective control shares are excluded from the acquiring person’s obligation under § 3-704(a).
14 MCSAA § 3-704(b).
15 MCSAA § 3-702(c)(3).
16 MCSAA § 3-702(c)(4). The MCSAA also excludes certain closely held corporations and corporations having fewer than 100 beneficial owners. MCSAA §§ 3-702(c)(1) and (2). Business development companies (“BDCs”) are made subject to the MCSAA by default, but may elect to opt out of its provisions.
17 A general discussion of the extent of the “otherwise required by law” qualification in Section 18(i) is beyond the scope of this letter. A CEF is not required to opt in to the statute’s provisions; the MCSAA is an optional defensive device, and there is no requirement under Maryland law that a CEF avail itself of its protection. Similarly, BDCs may opt out of the MCSAA, and are not required to remain subject to its terms. See supra, note 16, and infra, note 47. The “otherwise required by law” qualification therefore does not affect our analysis.
18 See S. Rep. No. 76-1775, at 7 (1940) (“Senate Report”).
19 Securities and Exchange Commission, Report on Investment Trusts and Investment Companies, pt. 3, ch.4, H.R. Doc. No. 136, 77th Cong., lst Sess. (1940).
20 Id. at 1620-1641.
21 Alfred Jaretzki, Jr., The Investment Company Act of 1940, 26 Wash. U. L. Rev. 303 at 333 (1941) (“Jaretzki”).
22 Trust Study at 1895. Fund managers also secured control for themselves by, among other things: (i) controlling and manipulating proxy machinery; (ii) orchestrating carefully timed seriatim director resignations followed by insider replacement; (iii) issuing fund shares on a partially paid basis and denying voting rights to shares that were not fully paid; (iv) diluting shareholder voting rights by making massive bulk issuances to insiders; (v) creating and manipulating voting trusts; and (vi) executing management contracts with punitive termination provisions. Id. at 1874-1940.
23 See Senate Report at 6. See also Jaretzki at 307 (“The main abuses which developed in the investment company industry were related to the nature of investment companies and their affiliations. The liquidity of their capital assets made more easy their embezzlement or theft or their use for improper purposes.”)(citing Senate Report at 6-8); Securities and Exchange Commission, Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation, at 251 (1992) (“Protecting Investors Study”) (“Investment companies are unique in that they are organized and operated by people whose primary loyalty and pecuniary interest lie outside the enterprise . . . creating great potential for abuse.”) (citation omitted).
24 Investment Trusts and Investment Companies; Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 271 (1940) (statement of Mr. David Schenker, Chief Counsel of the Commission’s Investment Trust Study).
25 Investment Company Act Section 1(b)(2).
26 Investment Company Act Section 1(b)(3).
27 The Commission has described this suffrage-based system as part of “the very essence of the Act.” In re Prudential Ins. Co. of America, 41 S.E.C. 335, 350 (1963), aff’d sub nom. Prudential Ins. Co. of America v. S.E.C., 326 F.2d 383 (3rd Cir. 1964), cert. denied, 377 U.S. 953 (1964).
28 Voting rights are particularly important for CEF shareholders, whose ability to “vote with their feet” is circumscribed by the CEF structure. As noted in the Trust Study, “[i]n closed-end investment companies, where the shareholder does not have the right to compel redemption of his shares at asset value, the investor must dispose of his securities in the open market, and when performance is indifferent these securities may be selling at substantial discounts from their asset values.” Trust Study at 1874.
29 See Investment Company Act Section 15(a) (governing approval of investment advisers to investment companies) and Section 16(a) (governing election of investment company directors). The suffrage provisions of the Investment Company Act also require shareholder approval for, among other things, changes to an investment company’s diversification subclassification (Section 13(a)(1)), policies regarding borrowing money, issuing senior securities, acting as an underwriter, purchasing or selling real estate or commodities and making loans (Section 13(a)(2)), fundamental investment policies (Section 13(a)(3)) or any change in the nature of an investment company’s business so as to cease being an investment company (Section 13(a)(4)).
30 The Commission from time to time has considered whether this reliance on shareholder voting remains the optimal way to protect shareholder interests, largely in view of changes in the investment management industry and evidence that many investors in investment companies (particularly open-end funds) do not choose to participate actively in the voting process. In 1962, at the request of the Commission, the Wharton School of Finance and Commerce of the University of Pennsylvania conducted a study of investment companies (Wharton School of Finance and Commerce, A Study of Mutual Funds, H.R. Rep. No. 2274, 87th Cong., 2d Sess. (1962) (the “Wharton Study”). The Wharton Study linked open-end shareholder passivity in part to the ability of shareholders to redeem their shares at net asset value when dissatisfied with management. In a 1966 report to Congress (Securities and Exchange Commission, Public Policy Implications of Investment Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess. (1966) (the “1966 Report”), the Commission generally endorsed the findings of the Wharton Study, but noted that indications of shareholder dissatisfaction expressed in the voting process may still “play a significant role in influencing the actions of fund managers on many matters of policy.” 1966 Report at 129-30. The 1966 Report further noted that even in the case of open-end funds, redeemability represents an imperfect remedy for dissatisfied shareholders due to sales loads and tax consequences frequently associated with redemption. 1966 Report at 77 and 126. Rather than recommending the elimination of the Investment Company Act’s voting requirements, the Commission recommended and Congress created in 1970 a private right of action whereby shareholders may challenge investment company advisory fees in federal court. See Investment Company Act Section 36(b).
The Commission revisited these issues in 1982 in a release requesting comment as to whether the Commission should propose rules or recommend legislation to enable all or certain types of registered open-end investment companies to be organized and operated without shareholder voting, or without either shareholder voting or boards of directors. Advance Notice and Request for Comment on Mutual Fund Governance, Release No. IC-12888 (Dec. 10, 1982) (the “1982 Open-End Voting Release”). The Commission made clear that these considerations were only appropriate in the open-end fund context (“The Commission does not mean to imply in any way that it contemplates that shareholders of companies other than open-end investment companies could be adequately protected if their ability to elect directors or otherwise exercise voting rights were eliminated. Investors in other types of companies do not have the freedom to redeem their investment at current net asset value. . . . [S]uch investors must sell at a market price which may not, in their opinion, reflect the value their investment might have if the company’s management were different.”). Id. at n. 1. After considering the comments submitted in response to the 1982 Open-End Voting Release, the Commission elected not to alter the shareholder voting and governance requirements applicable to open-end funds.
The Commission recently reiterated the importance of shareholder voting rights with respect to all public issuers, emphasizing that “[a] fundamental tenet of state corporation law is that shareholders have the right to vote their shares to elect directors and to approve or reject major corporate transactions at shareholder meetings.” Securities and Exchange Commission, Concept Release on the U.S. Proxy System, Release Nos. 34-62495; IA-3052; IC-29340 (July 14, 2010).
31 Consistent with the purposes of Section 18(i), we believe that this is a continuous requirement; any other interpretation would render the provision meaningless, as investment companies might, for example, issue stock with voting rights that expire shortly after issuance.
32 Additionally, some commentators contend that a narrow definition of the term “voting stock” may inadvertently implicate a number of accepted practices. For example, CEFs and other investment companies typically limit voting at shareholder meetings to persons who were owners or holders of shares as of a pre-established record date. We generally believe that this practice is not inconsistent with Section 18(i) where its sole purpose is to facilitate the orderly conduct of shareholder meetings and its terms are reasonable and fully disclosed. With respect specifically to CEF shares sold between the record date and the date of a shareholder meeting, we believe that such shares are “voting stock” for purposes of Section 18(i) because the holder of the shares as of the record date (the previous owner) remains entitled to vote such shares at the meeting.
Some commentators also have observed that voting rights are interrupted by Rule 13d-1(e)(2) under the Exchange Act, which generally provides that a person acquiring securities with the intent to change or influence the control of an issuer whose shares are registered under the Exchange Act may neither acquire additional securities of the issuer nor vote or direct the voting of the acquired securities until 10 days after such acquirer files with the Commission on Schedule 13D. We believe that the application of Rule 13d-1(e)(2) to CEF shares registered under the Exchange Act would not cause the CEF to violate Section 18(i) of the Investment Company Act because the voting stock requirement in Section 18(i) does not apply if “otherwise required by law,” and Rule 13d-1(e)(2) qualifies as law.
33 In the Matter of the Solvay American Corporation (“Solvay”), 27 S.E.C. 971, 973 (1948). In Solvay, the Commission granted an order permitting the applicant CEF to issue shares of preferred stock containing certain protective provisions and differential voting rights vis-à-vis the company’s common stock. The company wished to amend its certificate of incorporation to provide for: (1) a supermajority class vote of the preferred shareholders with respect to matters of particular interest to such shareholders; and (2) separate class votes for the election of directors that would exclude preferred shares from voting for the common directors and empower preferred shareholders to elect special directors (representing a majority of directors) when preferred dividends were in arrears for more than two years. Id. at 971-74.
34 See supra, notes 20-23.
35 For an example of a Staff letter articulating a similar concern, see Depositors Investments Trust, SEC Staff No-Action Letter (May 7, 1984) (declining to provide no-action assurance under Section 18(i) of the Investment Company Act to a series investment company that proposed to require its directors to be elected by the shareholders of each series, rather than the shareholders as a whole (“[I]n an investment company with two series, one series having 100,000 shares and the other having three, the vote of two shares in the latter series would have voting power equal to 50,001 shares of the former series. . . . [S]ection 18(i) requires the election of trustees . . . by the shareholders of the entire investment company as a group.”))
36 Solvay at 974.
37 Id. at 975, n. 9.
38 Id. at 973.
39 See, e.g., Drexel Burnham Lambert, Inc. (TARPS), SEC Staff No-Action Letter (June 14, 1989) (providing no-action assurance under Section 18(i) of the Investment Company Act with respect to an arrangement whereby some taxable auction rate preferred stock of a CEF offered at $100,000 per share would be entitled to 100 votes per share, while the common stock offered at $10 per share would be entitled to 1 vote per share) (“Drexel Burnham TARPS”); Allstate Municipal Premium Income Trust, SEC Staff No-Action Letter (July 14, 1989) (providing no-action assurance under Section 18(i) of the Investment Company Act with respect to differential voting rights for holders of preferred and common stock); Zenith Income Fund, Inc., SEC Staff No-Action Letter (Apr. 27, 1988) (providing no-action assurance under Section 18(i) of the Investment Company Act with respect to differential voting rights for holders of preferred and common stock) (“Zenith”); Merrill Lynch Dual Fund, Inc., SEC Staff No-Action Letter (Aug. 14, 1985) (“ML Dual Fund”) (providing no-action assurance under Sections 18(a)(2)(E) and 18(i) of the Investment Company Act with respect to differential voting rights for income shares and capital shares) and Gemini II, Inc., SEC Staff No-Action Letter (Mar. 14, 1985) (providing no-action assurance under Sections 18(a)(2)(E) and 18(i) of the Investment Company Act with respect to differential voting rights for income shares and capital shares). We note further that the staff took many of these positions in reliance upon representations that the requesting entity would obtain an opinion of counsel to the effect that the voting rights constitute “equal voting rights” for purposes of Section 18(i). See, e.g., ML Dual Fund at 1 and Zenith at 1.
40 See, e.g., ML Dual Fund.
41 In Drexel Burnham TARPS, for example, we noted that our position applied “only to closed-end funds that issue two classes of securities which are stock.” Drexel Burnham TARPS at 4.
42 Proponents of this view cite to case law making this distinction under general state corporate law with respect to companies that are not investment companies. See, e.g., Georgia-Pacific Corp. v. Great N. Nekoosa Corp., 728 F. Supp 807 (D. Me. 1990); Harvard Indus., Inc. v. Tyson, 1986 U.S. Dist. LEXIS 17258 (E.D. Mich. 1986); Providence & Worcester Co. v. Baker, 378 A.2d 121 (Del. 1977). As discussed in this Part II.E and at infra, note 45, we believe that the share/shareholder distinction made in these cases does not inform the proper application of Section 18(i) to federally registered investment companies.
43 2010 Laws of Maryland, Ch. 96, H.B. 972 (emphases added). The preamble to this legislation states that the amendments to the MCSAA are for the purpose of “clarifying that certain restrictions on voting rights apply to the holders of certain shares and not to the shares.” Id.
44 As discussed above, Section 18(i) of the Investment Company Act states, in pertinent part: “. . . every share of stock hereafter issued by a registered management company… shall be a voting stock . . .” Because the definition of “security” under Section 2(a)(36) includes “any stock,” the term “voting stock” in Section 18(i) may be properly interpreted with reference to the definition of “voting security.” “Voting security” is defined by Section 2(a)(42) to mean “any security presently entitling the owner or holder thereof to vote for the election of directors of a company” (emphasis added).
45 See Expert Report of Tamar Frankel, Professor of Law, Boston University School of Law, filed with the Federal District Court for the District of Maryland in connection with Neuberger Berman Real Estate Income Fund, Inc. v. Lola Brown Trust No. 1B et al., Civil No. AMD 04-3056 (Mar. 24, 2005) (citations omitted):
Congress determined that the freedom traditionally afforded corporate management under state law to determine and change corporate strategies and business policies is inappropriate for investment companies, and thus determined to regulate investment companies differently. To ensure accountability and transparency, Congress created a comprehensive regulatory structure for investment companies that enhanced fiduciary obligations, enacted reporting requirements, and prohibited the advisers and the companies’ directors from discriminating against shareholders. These goals are in direct conflict with state anti-takeover statutes (or judicial decisions) that permit discrimination and entrenchment tactics in ordinary operating companies. Indeed, the self-dealing and discrimination inherent in state anti-takeover statutes (or state court decisions permitting anti-takeover measures) are precisely what the Investment Company Act was designed to prevent, not enable. . . The SEC, in general, has interpreted the explicit provisions of the [Investment Company Act] as preempting state law provisions that vitiate the [Investment Company Act], especially in the case of shareholders’ voting rights.
46 Some industry participants suggest that any inconsistency between the MCSAA and Section 18(i) of the Investment Company Act would arise not at the time a CEF opts in to the MCSAA, but only upon the actual acquisition of control shares by an acquiring person. For the following three reasons, we believe that the inconsistency between the MCSAA and Section 18(i) would arise at the point a CEF elects to opt in to the MCSAA.
First, the MCSAA defines “acquiring person” as not only a person who makes a control share acquisition, but one who proposes to make such an acquisition. MCSAA § 3-701(b). Substantive provisions of the MCSAA apply to both categories of acquiring persons, and the deterrent effect of the statute is felt from the point of sale onward by all shareholders who are potential acquiring persons.
Second, a CEF that opts in to the MCSAA knowing that it cannot actually apply the statute’s substantive provisions against an acquiring person would take such action in the hope that shareholders are sufficiently misinformed or under-informed that the CEF might nevertheless benefit from the deterrent effect of the MCSAA. Such a tactic would offend shareholder-fund relations and would contravene the purposes of Section 18(i).
Third, Section 47(a) of the Investment Company Act provides that “[a]ny condition, stipulation, or provision binding any person to waive compliance with any provision of this title or with any rule, regulation, or order thereunder shall be void.” We believe that if a CEF opts in to the MCSAA, such CEF would bind its shareholders to waive their rights, under certain circumstances, to compel the CEF to comply with Section 18(i). As a result, the CEF’s election to opt in to the MCSAA would be void under Section 47(a).
47 Your letter asks for our views only with respect to the Fund, which is a CEF. For similar reasons to those discussed above, we believe that it would be inconsistent with Section 18(i) of the Investment Company Act for a BDC organized under Maryland law to fail to opt out of the MCSAA.
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