Speech by SEC Staff:
Keynote Address at the Independent Directors Council Investment Company Directors Conference
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Amelia Island, Florida
November 12, 2009
Thank you for the warm introduction. As many of you are aware, since I began my tenure at the Commission I have expressed a keen interest in understanding the oversight that you — the independent directors — perform in fund governance. To this end, I have participated in more than 30 board meetings of independent directors and deeply appreciate the insight you have shared with me and my colleagues in the Division of Investment Management. This insight has afforded us a greater understanding of the vital role that you perform, which role is fundamental to the efficient operation of funds and the protection of shareholder interests.
In the short time that I have been allotted, I would like to focus my remarks identifying some of the challenges you face and highlighting the necessity for your continued vigilance in the performance of your independent director duties. However, before I continue, now is a good time for me to give the standard disclaimer that my remarks represent my own views and not necessarily the views of the Commission, individual Commissioners or my colleagues on the Commission staff.
Rather than discuss the challenges associated with the usual list of tasks that you regularly perform, such as the annual review and approval of a fund's contract with its investment adviser or the review of transactions with affiliates, instead I would like to address challenges that are perhaps less obvious, but every bit as important. In order to do so, a little background may provide some context so bear with me a few minutes while I set the stage. I will begin with a quote:
"Let me try my hand at a general description of investment trusts and investment companies. Essentially these organizations are large liquid pools of the public's savings entrusted to managements to be invested…. The sales emphasis by promoters of investment companies has been upon the necessity for providing security for old age and for emergencies, and upon the claim that by expert management and diversification of risk, this security can be furnished by these organizations….
In addition, investment companies at present control or are in a position to control or influence various industrial, banking, utility and other enterprises…. Furthermore, these investment trusts and investment companies, because of their very substantial trading in securities on stock exchanges, are a most substantial factor in our securities markets."2
I think we can all agree that the foregoing passage does a very good job of summarizing the current state of the investment company industry. You might be surprised, therefore, to learn that the source is the statement that then-Commissioner Robert E. Healy of the Securities and Exchange Commission made before a Senate subcommittee nearly 70 years ago in support of the enactment of legislation that ultimately became what we now know as the Investment Company Act of 1940 (the "Act").3 At that time the Commission had recently completed a congressionally mandated report detailing fund corporate structures, investment policies and their economic impact, and the roles played by management, affiliates and boards of directors.4 The report, which took four years to complete and spans five volumes, also chronicled "abuses and deficiencies" in the organization and operation of investment trusts and investment companies.5 The report identified a variety of objectionable practices that were rampant in the industry. Examples include share repurchase programs prevalent among closed-end funds that operated for the benefit of affiliates, self-dealing and entrenchment by insiders through various means, such as the creation of multiple share classes in order for insiders with only a nominal economic interest to maintain voting control over funds, and dumping of unmarketable or illiquid securities and other assets into funds by affiliates.
As ultimately adopted, the Act addresses many of the concerns identified in the report. For example, Section 23 of the Act and rules subsequently promulgated thereunder, prescribe the parameters for when a closed-end fund may repurchase shares.6 Section 18 prescribes the capital structure required for funds, and prohibits multiple share classes and restricts the issuance of senior securities except in accordance with strict capital requirements.7 As for self-dealing by insiders, numerous provisions in the Act and accompanying rules impose fiduciary duties on a board to act in the best interests of the fund and shareholders, and restrict the ability of affiliates to transact with a fund to the detriment of its shareholders.8
Given the restraints contained in the Act, one might conclude that the likelihood of a recurrence of the problems that existed in the investment management industry prior to 1940 is slim. Then again, one might be wrong. I do not mean to suggest that the industry is fraught with problems or that investors are at risk. Nonetheless, my Division has observed a variety of situations which confirm that you, the independent directors, must remain vigilant in your oversight of fund management to ensure that funds operate in the best interests of their shareholders.
II. Challenges Independent Directors Face Today
Let me now discuss with you five categories of challenges that exist today that in some respects bear resemblance to challenges that existed in Commissioner Healy's era. Although some of these challenges are perhaps most germane to the management of closed-end funds, open-end funds are not immune, and directors with both types of funds are equally tasked with the obligation to remain steadfast in their oversight responsibilities.
A situation commonly associated with the start-up of a new fund involves the fund adviser's agreement to waive a portion of its fees. In consideration for the waiver, the adviser asks that the fund allow it to recapture the waived fees if the fund's total expenses fall below a benchmark. Hypothetically, let's assume that the adviser agrees, in year one, to cap the fund's expenses at 75 basis points and to waive that portion of the adviser's fee necessary to ensure that the expenses do not exceed this cap. The adviser simultaneously sets up a recapture plan that provides for the adviser to recapture all or a portion of its waived fees within the subsequent three year period if the fund generates sufficient assets. Under this scenario, in order for the adviser to recapture the fees it waived in year one, the fund would have to generate enough assets in the next three years so that the expense ratio falls below 75 basis points. In such event, the adviser could collect or "recapture" the difference between the expense ratio amount that has fallen below 75 basis points and the 75 basis point cap.
Now further assume that in year two the adviser determines that the fund has not attracted as many assets as originally anticipated and calculates that the expense ratio, excluding the effects of the waiver, is at 150 basis points. The adviser then asks the fund to change the expense cap to 160 basis points, recognizing that the adviser will no longer have to waive expenses based on the current asset levels. If the fund approves the higher expense cap, what happens when the adviser subsequently seeks to recapture that portion of its waived fees from year one when the then-existing expense cap was 75 basis points?
It has been the staff's position that in order for advisers to recapture waived fees, the adviser may do so only in accordance with the original recapture plan. In other words, the fund's expense ratio should be below the expense cap upon which the waiver was initially based in order for the adviser to recapture the difference between the lower ratio and the expense cap. A subsequent increase in the expense cap does not create an opportunity for the adviser to recapture waived fees from a previous period that are below the higher cap. In this hypothetical, independent directors should be cautious if an adviser asks the fund to increase the expense cap in order to allow the recapture of fees already waived by the adviser. Absent some extraordinary circumstance which I cannot now imagine, it is difficult to articulate how a board would find such a transaction to be in the best interests of fund investors.
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.
One tactic is the adoption of "shareholder rights agreement" commonly referred to as a "poison pill." Under such an agreement, a fund board declares a dividend of one "right" for each outstanding share of common stock which entitles the holder to purchase from the fund on a "distribution date" additional shares of the fund at a price equal to the par value of such shares (e.g., one penny per share). The distribution date is triggered following the public announcement that a person has acquired a beneficial ownership interest of some percentage (such at 11%) or more of the fund's outstanding shares of common stock. The poison pill further provides that the "rights" of the person who acquired the beneficial shares in excess of the triggering threshold become void, meaning that the acquiring person does not have the ability to participate in the shareholder rights agreement to obtain additional shares at par. The effect of the poison pill is to dilute the acquiring person's interest in the fund.
Another tactic involves a fund's reliance on state law provisions that restrict the voting rights of a person deemed to own "control shares" of a fund. An example of this is in Maryland — the domicile of many closed-end funds. Under the Maryland Control Share Acquisition Act (MCSAA), closed-end funds may opt-in to its provisions and restrict the ability of a shareholder who owns control shares (defined in the statute as greater than 10% of the company) from voting those shares above 10% without two-thirds approval from the other, disinterested shareholders at a special meeting.9
A federal district court in Maryland has held that a closed-end fund's serial use of poison pills was valid and was consistent with provisions in the Act.10 The same court ultimately concluded that a dissident shareholder's ability under the MCSAA to vote its control shares was capped at the number of shares the shareholder held at the time that the fund opted into the MCSAA.11 As such, one might conclude that such actions by a fund, or more particularly its board, may be in the best interests of a fund. In my view, however, I submit that the adoption of a poison pill, or restricting the voting rights of a "dissident" shareholder even where state law authorizes it, may be inconsistent with federal law and not in the best interest of the fund and its shareholders. Let me explain.
Section 1(b) of the Act, referencing the Commission's report to Congress, declares that the national public interest and the interest of investors are adversely affected when, among eight enumerated conditions, investment companies are organized, operated, managed, or their securities are selected in the interests of affiliates, special classes of security holders and others rather than in the interests of all classes of such companies' shareholders.12 This section further declares that the policy and purposes of the Act, in accordance with which the provisions of the Act shall be interpreted, are to mitigate and where feasible to eliminate the enumerated conditions which adversely affect the national public interest and the interest of investors.13
In this context, two provisions in the Act call into question the validity of a close-end fund's use of poison pills. Under Section 18(d), it is generally unlawful for funds to issue any warrant or right to subscribe to or purchase a security issued by the fund except in the form of warrants or rights to subscribe expiring within 120 days after their issuance and issued exclusively and ratably to a class or classes of the fund's security holders.14 Furthermore, under Section 23(b), closed-end funds are prohibited from selling their own common stock at a price below the current net asset value of such stock subject to certain exceptions, including upon the exercise of a warrant issued in accordance with the provisions of Section 18(d).15
In light of the foregoing provisions of the Act, I believe it could be very difficult for fund counsel to advocate for, or fund directors to approve, a fund's use of a poison pill and the restrictions on the voting shares of a dissident shareholder. While Section 18(d) recognizes the ability of a fund to issue warrants for a limited period of time (not to exceed 120 days), importantly, the fund must do so exclusively and ratably to a class or classes of the fund's shareholders. By its very nature, the poison pill excludes from its purview any shareholder who owns shares above a certain percentage. As such, I question whether such device constitutes a "ratable" issuance. Moreover, although Section 23(b) recognizes circumstances where a fund may sell its own shares below net asset value, the exception that allow for such sale requires that it be in conformance with the requirements of Section 18(d). If, as I have questioned, a poison pill does not constitute a ratable distribution, then a fund does not fit within the exception of Section 23(b) for selling its shares at less than net asset value.
Similarly, the use of a state law control share statute to restrict the ability of a shareholder to vote "control shares" in a closed-end fund is likely inconsistent with Section 18(i) of the Act. Under Section 18(i), subject to certain exceptions, every share of stock issued by a fund shall be a voting stock and have equal voting rights with every other outstanding voting stock.16 In my view, a provision which denies a shareholder deemed to possess "control shares" the right to vote those shares constitutes a denial of equal voting rights and may violate the fundamental requirement that every share of fund stock be voting stock.
I raise these points today to highlight for your consideration as directors that these are issues which you must consider carefully when faced with a request by management to adopt a poison pill, to invoke voting restrictions on control shares, or to pursue other strategies that have the effect of entrenching existing management. When considering such options and determining what is in the best interests of the fund and its shareholders, directors should take guidance from Section 1(b) of the Act and should heed that section's declared skepticism of actions that would tend to entrench management if such action is harmful to shareholders.
While I am still on the subject of management entrenchment, three other management strategies bear mention. The first involves delaying a fund's annual meeting. Under NYSE rules, listed companies, including closed-end funds, are required to conduct an annual meeting.17 Moreover, Investment Company Act Section 16(a) requires that, if a fund has a classified board, the term of one class expires each year.18 Nevertheless, some closed-end funds, including those listed on the NYSE, have delayed for many months the holding of an annual meeting and some have changed their by-laws to give the board discretion on when to call a shareholder meeting. If a dissident shareholder has enough shares to elect an insurgent slate of directors, the effect of the delay is to postpone the ability of the shareholder to replace the existing board.
The second tactic is the imposition of a requirement that election of directors requires the affirmative vote of a majority of outstanding shares. For the vast majority of funds, election of a director requires a plurality of the votes cast. For a few funds, however, election of a director requires the affirmative vote of a majority of the outstanding shares. In a contested election, neither incumbents nor insurgents can garner the required vote. However, under Maryland law, incumbents are entitled to hold over until a successor is elected. In my view, this amounts to an anti-takeover device that keeps the existing board in place.
The third tactic, also typically found in a fund's by-laws, relates to director qualifications. Specifically, a fund board will adopt a by-law that mandates certain qualifications for director nominees, but exempts existing directors, including those affiliated with the fund's adviser. Again, this results in additional hurdles for the replacement of existing directors and the entrenchment of existing management.
While the foregoing tactics may be in conformance with state corporate laws and I appreciate why management may favor them, nonetheless you — the independent directors — must still determine whether such actions, if taken, will be in the best interest of the fund and its shareholders. The question you must always ask yourself is not just whether the action is legal under state and federal law, but whether it is truly in the best interests of fund shareholders. This is not an easy task, but one that is critically important. My staff and I are always available if you have questions.
Another area requiring careful consideration by directors is the merger of funds. This year we have witnessed a significant increase in the number of fund mergers. A merger can be beneficial to shareholders for numerous reasons, including if it reduces expenses or results in better performance. However, as a recent Wall Street Journal article notes, some of these mergers appeared to be structured for the sole purpose of merging away a fund with poor performance.19 This raises a variety of considerations. Assume, for example, that a closed-end fund trading at a discount to its net asset value decides to merge with a larger affiliated closed-end fund that is also trading at a discount. From the perspective of the larger fund, the merger would appear in the best interests of the larger fund's shareholders. What about the interests of the shareholders in the smaller fund? Since the fund is trading at a discount, would the interests of the smaller fund's shareholders be better served if the fund liquidated and eliminated the discount? What is the purpose of the merger with the affiliate? Does the affiliate benefit by keeping all of the assets under management to the detriment of the small fund's shareholder interests?
More broadly, other questions arise when funds contemplate a merger. For instance, how does a merger affect the investment strategy of the fund? Will the merger result in higher costs for shareholders of the acquired fund? What are the tax consequences?
Another merger concern involves the accounting treatment that arises from the merger. If a poorly performing fund is merged into another fund, directors must be cognizant of the accounting survivor analysis that determines which fund's performance is carried over to the new entity. In some cases, it appears to Division staff that a newer fund or the fund that was chosen to be the accounting survivor had only a few months of operations, had net assets that were much smaller than the target, and that the shareholders were affiliated with the adviser. In contrast, the fund that was being merged away had a significantly longer track record, much more assets and its shareholder base was not made up of affiliated entities. However, due to market declines, particularly those experienced in 2008, the merged away fund's performance was very poor.
Obviously, each merger transaction has its own particular facts and circumstances. To the extent that you contemplate a merger transaction, you should be asking a lot of questions to make sure that the merger is in fact in the best interests of your fund's shareholders.
The application of fulcrum fees is another area that presents challenges. The application of a fulcrum fee can be tricky and it is important that you understand its calculation and the ramifications before you undertake this arrangement.
In a nutshell, a fulcrum fee is a performance based fee that an adviser charges a fund when the adviser achieves a return above a certain benchmark.20 A benefit of a performance based fee is that it aligns the interest of management with the interests of investors. The fulcrum fee has two components: a base fee which represents the midpoint of the entire fulcrum fee; and an incentive adjustment. These components are tied to or conditioned upon the fund's performance relative to an index benchmark. In practice, the adviser receives the base fee if the fund's performance matches the performance of the index. Applying the incentive adjustment, an additional fee is generally added to the base fee when the fund out-performs its benchmark but is subtracted from the base fee when the fund underperforms the benchmark.
Under Commission Rule 205-2, the incentive portion of the fulcrum fee is always calculated using the fund's average net assets over a rolling performance measurement period.21 However, when establishing a fulcrum fee arrangement, a fund has the option either to apply the rate to the average net assets over the rolling measurement period or to apply the rate to current level average net assets, i.e., the "most recent subperiod" which represents the period between payments. Once the fund has selected which option to apply it must be applied consistently.
Many funds that implement a fulcrum fee structure opt to pay the adviser with the base portion of the fee being calculated on current level net assets as permitted by the rule. What advisers sometimes fail to realize, however, is that when the base fee is calculated on current level net assets, the adviser runs the risk of having to reimburse the fund when there is a significant decline in assets coupled with poor performance. We have observed that some funds, when relying on Rule 205-2, try to implement a floor total fee, which would limit the downside to an adviser by providing it a minimum cash payment and prevent the adviser from ever having to reimburse the fund. The problem with this approach, however, is that a floor only limits the downside without proportionally limiting the adviser's upside. As such, a floor is not permissible because the incentive adjustments must be symmetrical — hence the term "fulcrum."
As with the other challenges discussed today, the implementation of a fulcrum fee requires your careful consideration. In particular, it must be clear to you and the adviser what the fulcrum fee represents, including that the adviser, in addition to incurring a decline or elimination of its fee, may owe the fund money under certain conditions.
"Yield" and Managed Distribution Plans
The last challenge that I would like to discuss with you today involves disclosures associated with a fund's yield or its managed distribution plan. Closed-end funds sometimes tout a high, level dividend or a managed distribution plan to investors. Investors may incorrectly believe that the dividend rate is "yield," i.e., earned income or gain. In fact, the dividend rate often includes a return of capital. As directors, you must make sure that the fund's disclosures explain what the distribution yield represents and what it does not represent and that it is not confused with the fund's actual performance. In particular, if a fund with a managed distribution plan does not earn enough income to sustain a distribution, it must be clear that distributions to investors may be paid from a return of capital which has the effect of depleting the fund's assets. Moreover, in exercising your oversight, you should carefully consider whether managed distribution plans continue to be in the best interests of the fund and its shareholders.
Let me highlight one additional managed distribution plan disclosure issue for your consideration. As you know, funds are required under Rule 19a-1 to provide notice when distributions include a return of capital.22 In reviewing these notices, my staff has found inconsistencies between 19a-1 notices and other information posted on a fund's website. In particular, the 19a-1 notices show the return of capital while other charts on a fund's website show distributions consisting of all income. Funds have indicated to us that the reason for any differences is because the disclosures are prepared under different bases with 19a-1 notices disclosing book values and other disclosures based on tax considerations. However, fund websites do not always include an explanation discussing why the information is inconsistent in different online sections. Accordingly, I suggest that you review your fund's disclosures to make sure that the information is disclosed consistently and, if not, that the reason or reasons for any inconsistencies are adequately explained to investors.
One final point regarding 19a-1 notices is worth mentioning and that is whether investors who hold a beneficial interest in a fund through a financial intermediary, such as a broker-dealer or a bank, actually receive the notice. In practice, we have witnessed funds sending 19a-1 notices to record holders of fund shares and to the Depository Trust Company (DTC). DTC in turn posts copies of these notices on its website.23 Whether a beneficial owner of a fund periodically checks the DTC website for such notices is unknown — all the more reason why funds should make an effort to ensure that all beneficial shareholders receive the notice and should be careful that the information a fund discloses on its own website is clear and consistent.
I appreciate being afforded time today to highlight some of the many, but often less obvious, challenges that you face as independent directors. I wish to underscore the vital role that you perform and to thank you for your continued vigilance on behalf of funds and their investors. If anyone has any questions, please do not hesitate to contact me or my staff and we will be glad to help. Thank you again and enjoy the rest of the conference.