United States: Defending Maryland Closed-End Funds

Last Updated: January 6 2017
Article by Scott R. Wilson

Closed-end funds trading at a discount to net asset value sometimes are the subject of attack by activist stockholders. Activist focus on short-term gains can be at the expense of the long-term strategy preferred by many retail stockholders. In 2016, several closed-end funds were the subject of campaigns by activist stockholders and corresponding demands that boards of directors liquidate or open-end their funds. This post discusses options available to boards of directors of closed-end funds formed as Maryland corporations. This post is tailored to closed-end funds registered under the Investment Company Act of 1940 (the "'40 Act") and, accordingly, does not address similar options that may be useful to operating companies (e.g., the Maryland Business Combination Act).

Director Duties in Response to Fund Activists

Pursuant to Section 2-405.1(c) of the Maryland General Corporation Law ("MGCL"), a director of a Maryland corporation is required to act: in good faith; in a manner the director reasonably believes to be in the best interests of the corporation; and with the care that an ordinarily prudent person in a like position would use under similar circumstances. This standard of conduct applies to all acts of a director and irrespective of activist stockholder actions. But when considering an activist's demands to liquidate or open-end a Maryland closed-end fund, a board of directors should also take note of the following:

  • Just Say No – The standard of conduct does not require that a director "accept, recommend or respond on behalf of the corporation to any proposal" by a person seeking to acquire control of the corporation.
  • Maximize Value – While directors have a general duty to obtain the best value for stockholders in a change of control or sales transaction, a director of a Maryland corporation is not required to act solely because a proposed action would result in a reduction of the current discount to net asset value or otherwise increase the trading price of the stock of the corporation.
  • Statutory Business Judgment Rule – In Maryland, a director's actions are presumed to satisfy the applicable standard of conduct by statute.
  • No Higher Standard of Review – Unlike Delaware, in Maryland, a director's actions "relating to or affecting an acquisition or a potential acquisition of control of a corporation may not be subject to a higher duty or greater scrutiny than is applied to any other act of a director." This is commonly recognized as a statutory abrogation of the well-known Unocal standard articulated by the Delaware courts.

Defensive Measures

Activist stockholders in closed-end funds frequently seek to arbitrage pricing displacements for short-term gain. To obtain the time necessary to demonstrate the effectiveness of the long-term strategy, a board of directors should consider the following defensive options:

1. Classification of the Board of Directors

While the charters of many Maryland closed-end funds establish classified boards, a Maryland closed-end fund board that is not classified should consider the unique ability in Maryland to classify directors – at any time – without stockholder action. Section 3-803 of the MGCL allows a Maryland closed-end fund with a class of equity securities registered under the Securities Exchange Act of 1934 and at least three independent directors to self-classify directors into three classes without a stockholder vote and notwithstanding a charter or bylaw provision to the contrary. Additionally, the board of directors may then designate existing directors into those three classes prior to the next annual meeting such that only one-third of the current board of directors will stand for election at such meeting. As a collateral benefit, directors of a classified board may only be removed for cause (unless the charter provides to the contrary).

2. Opt-In to Section 3-804(c) Requiring That Directors Fill All Board Vacancies

If the board of directors has not already done so, it should consider opting into Section 3-804(c) of the MGCL, if available. Section 3-804(c) provides that a Maryland corporation with a class of equity securities registered under the Securities Exchange Act of 1934 and at least three independent directors may, by opting into this Section of the MGCL (which can be accomplished by resolution of the board), require that all vacancies be filled by the board of directors. Consequently, an activist would need to succeed in removing the entire board of directors to fill any openings on the board. Additionally, when paired with a classified board, directors so elected to fill vacancies will serve for the remainder of the term of the vacancies and not merely until the next annual meeting of stockholders.

3. Opt-In to Control Share Acquisition Act

The Maryland Control Share Acquisition Act (MGCL § 3-701 et seq., the "MCSAA") provides that "control shares" of a corporation acquired in a "control share acquisition" have no voting rights except to the extent approved by a vote of two-thirds of the votes eligible to be cast on the matter. A control share acquisition occurs when a stockholder, directly or indirectly, acquires outstanding stock in excess of one of three thresholds, beginning at 10 percent. While operating companies are subject to this statute unless they chose to opt-out, a Maryland closed-end fund registered under the '40 Act must opt-in to the MCSAA.

While the permissible use of the MCSAA by closed-end funds has been recognized by at least one federal district court, the Securities and Exchange Commission has taken the position that the MCSAA conflicts with Section 18(i) of the '40 Act. Boulder Total Return Fund, Inc., SEC No-Action Letter (Nov. 15, 2010). Because of the SEC's position, many closed-end funds have been hesitant to opt-in to the MCSAA for fear of turning a dispute with an activist into a potential enforcement action. Nevertheless, under existing law, the MCSAA remains a valid defensive measure that a board of directors should consider.

4. Stockholder Rights Plan

A stockholder rights plan, or poison pill, provides rights to existing stockholders that make hostile acquisitions economically impractical for an acquirer. The goal in enacting such a plan is to deter coercive and abusive tactics by hostile bidders to acquire control of a corporation without paying a full and fair price to all stockholders for all of their shares of stock. In Maryland, a board of directors has the authority to authorize and issue stock, options, and warrants that are necessary to implement various types of poison pills. The MGCL expressly recognizes the validity of stockholder rights plans and directors' discretion to establish them. The same provision also expressly validates "slow hand" provisions of stockholder rights plans that prevent future directors from redeeming or terminating such a plan for a period not to exceed 180 days. In addition, the MGCL expressly provides that the duty of directors does not require them to "redeem any rights under, modify, or render inapplicable, a stockholder rights plan."

5. Other Considerations

  • Quorum for Stockholder Meetings – Generally, the presence in person or by proxy of stockholders holding a majority of all votes entitled to be cast at the meeting constitutes a quorum. To reduce solicitation costs in connection with uncontested elections, however, many Maryland closed-end funds reduce their quorum requirement to one-third of the votes entitled to be cast. In a contested setting, this lower threshold – particularly when paired with a plurality director election standard – may no longer be appropriate.

  • Special Stockholder Meetings –The MGCL provides that, unless varied by a corporation's charter or bylaws, a special meeting must be called upon the request of stockholders with 25 percent of votes entitled to be cast. But Section 3-805 of the MGCL provides that a Maryland corporation with a class of equity securities registered under the Securities Exchange Act of 1934 and at least three independent directors may, by opting into Section 3-805 (which can be done by resolution of the board), provide that a special meeting of stockholders will be called only at the request of stockholders with at least a majority of votes. Notably, absent an express provision in the charter, Maryland currently has no procedure for written consent voting by stockholders other than unanimous written consent.

  • Increase Voting Thresholds for Director Elections – The most common voting standards applicable to elections of directors of closed-end funds are: plurality, majority of votes cast, majority of votes cast in uncontested elections with plurality in contested elections and a majority of all the votes entitled to be cast. Unless the charter or bylaws of a Maryland corporation provide otherwise, a plurality of votes cast at a meeting at which a quorum is present is sufficient to elect a director. Although brokers generally may not vote shares on non-routine matters without instruction from beneficial owners, uncontested elections for companies registered under the '40 Act are considered routine matters. Therefore, the applicable standard in an uncontested election is typically not an obstacle to achieve the requisite vote. Nevertheless, many closed-end funds rationally select a plurality standard to minimize solicitation costs incurred by the fund. In a contested election, however, broker non-votes soar as many brokers will not receive instructions from beneficial owners. Accordingly, while a plurality standard increases the likelihood that an activist will prevail in a contested election, any higher standard increases the likelihood that the election will fail. A board of directors will need to balance these considerations. Many will rationally conclude that a change in board composition of a closed-end fund is as fundamental as a decision to merge or dissolve the corporation and, therefore, a majority of the votes entitled to be cast should be required to elect an activist's slate and unseat the incumbent board.

  • Director Qualification Bylaws - Director qualification bylaws can present another hurdle to an activist seeking to nominate directors. Section 2-403(a) of the MGCL provides that "[e]ach director of a corporation shall have the qualifications required by the charter or bylaws of the corporation." The board may amend the bylaws of the corporation and require that future directors of the corporation meet specific qualifications to be permitted to serve as a director.

Be Prepared

There are numerous other considerations that will confront a board of directors responding to an activist stockholder. The board of directors will place itself in a better position to succeed if it starts to prepare before the filing of a Schedule 13D, receipt of Rule 14a-8 proposals or submission of stockholder nominees. In addition to business decisions that may reduce the discount to net asset value, and to make a fund less attractive to activists, the board of directors should analyze the fund's charter and bylaws, review advance notice bylaws, and consider director and officer liability limits and indemnification rights. Successfully defending a closed end fund is a dynamic process and preparation is important, but there is no one-size-fits-all approach to corporate governance. Each individual Maryland closed-end fund should consult its own officers, stockholders, legal advisors and accountants as to its particular circumstances before making any decision. But start early.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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