United States: SEC Staff Indicates the Maryland Control Share Acquisition Act Conflicts with the Investment Company Act

An SEC staff position casts doubt on the continued use by closed-end funds of anti-takeover tactics that restrict voting rights of large stockholders. In Boulder Total Return Fund, Inc., the staff of the Securities and Exchange Commission (the "Staff") asserts that the Maryland Control Share Acquisition Act (the "Control Share Act")¹ is inconsistent with the voting rights requirements of the Investment Company Act of 1940 (the "1940 Act").² The Control Share Act provides that a holder of ten percent or more³ of a corporation's voting stock has "no voting rights with respect to" such stock unless two-thirds of the stock held by "disinterested" stockholders is voted in favor of restoring such rights.⁴ The Control Share Act and comparable laws in other states have been used by closed-end funds as an anti-takeover device. The Boulder interpretive letter is the Staff's first formal attempt to limit the use of this type of anti-takeover tactic.⁵

In Boulder, the Staff sets forth its objections to the Control Share Act first by examining the legislative history and stated purpose of the 1940 Act's key voting rights provisions in Section 18(i). The Staff draws parallels between the Control Share Act and voting rights abuses that Section 18(i) was designed to eliminate. The Staff then asserts that the Control Share Act is inconsistent with two suffrage requirements set forth in Section 18(i): (1) that every share of stock be "voting stock"; and (2) that each share of stock have "equal voting rights" with all other outstanding voting stock.

Staff Interpretation of Section 18(i) Legislative History: The Purpose of Section 18(i) and the 1940 Act Generally

In Boulder, the Staff takes the view that Section 18(i) was designed to combat entrenchment of management and voting rights abuses. Quoting from the SEC's report to the Senate in 1940, the Staff suggests that Section 18(i) was conceived to limit "various devices of control" by management intended to deny stockholders "any real participation in the management of their companies." In particular, the Staff points to abusive practices that placed voting control "in a small group of stockholders ... typically by means of special classes of stock with differential voting rights[.]"

The Staff also cites to the Declaration of Policy contained in Section 1(b) of the 1940 Act.⁶ The Declaration of Policy requires that the 1940 Act be interpreted to mitigate certain enumerated abuses. These abuses include the operation of investment companies for the benefit of insiders and the issuance of securities that contain inequitable or discriminatory provisions.⁷ The Staff states that stockholder voting is a fundamental component of Congress's response to such abuses and key to the "equitable operation" of funds.

Staff Position that Opting into the Control Share Act is Inconsistent with the "Voting Stock" Requirement of Section 18(i)

After framing the intent and purpose of Section 18(i), the Staff asserts that the Control Share Act is inconsistent with this section. Section 18(i) provides that each share of stock issued must be a "voting stock". The Staff interprets "voting stock" to be any security that confers a present right to vote for the election of directors.⁸ Because the Control Share Act would restrict a control stockholder's ability to vote for directors, the Staff asserts that such control stockholder would not possess a "voting stock". The Staff rejects the suggestion that a voluntary acquisition of a control share should be subject to the same lessened scrutiny as other voluntary actions that trigger voting restrictions.⁹ The Staff asserts that this argument ignores the difference between a voluntary surrender of voting rights and losing such rights due to action by an investment company.

Staff Position that Opting into the Control Share Act Conflicts with Equal Voting Rights Requirement of Section 18(i)

The Staff next argues that opting into the Control Share Act is inconsistent with the equal voting rights requirement of Section 18(i). This requirement mandates that each share of stock has "equal voting rights" with all other outstanding shares of stock. Pointing to the abuses enumerated in Section 1(b), the Staff interprets "equal voting rights" to proscribe conduct that is inequitable or discriminatory with regard to the voting preferences and privileges of holders.¹⁰ Under the Staff's theory, the stock of a fund that opted into the Control Share Act would discriminate against persons who acquire control shares.

Finally, the Staff rejects three common arguments in favor of the Control Share Act. First, the Staff asserts that, while the SEC has in the past criticized "any rigid interpretation"¹¹ of Section 18(i), any flexibility should be limited to differences in voting rights that flow "logically from the differences between" share classes or that are required by state law. The Staff asserts that neither of those two circumstances applies with respect to the Control Share Act. Second, the Staff dismisses the contention that the "equal voting rights"

requirement is satisfied when voting rights are equal at the time stock is issued, noting that this interpretation could result in the creation of stock that loses voting rights shortly after issuance. Finally, the Staff rejects the argument that the Control Share Act does not affect the equal voting rights of the stock itself and instead affects only the voting rights of certain stockholders. The Staff states that this is "flatly inconsistent" with the purposes of Section 1(b) and Section 18(i) and that the wording of Section 18(i) applies to both the stock and stockholders of an investment company.

Impact of Guidance on Closed-End Funds

The Boulder letter represents the Staff's first formal position on the Control Share Act and, as such, is likely to generate both discussion and criticism.¹² The Staff has not indicated whether enforcement of this view of Section 18(i) voting rights will become a priority.

Furthermore, it is unclear how courts would view Boulder. While courts typically grant interpretive letters a degree of deference, the letters are non-binding and depend heavily on discrete sets of facts.¹³ However, boards of closed-end funds that have opted into the Control Share Act or similar statutes, or have incorporated analogous provisions into their organizational documents, should consider this new guidance carefully.

Footnotes

1. Md. Code Ann., Corps. & Ass'ns §§ 3-701 et seq.

2. Boulder Total Return Fund, Inc., SEC No-Action Letter (November 15, 2010). The letter states that the fund was considering whether to opt into the Control Share Act. The letter requests, on behalf of the fund and its two investment advisers, Boulder Investment Advisers, LLC and Stewart West Indies Trading Company, Ltd., the Staff's view on whether opting in would be consistent with the requirements of Section 18(i) of the 1940 Act. The Staff concludes that the "the wording of, and purposes underlying, Section 18(i) and the Investment Company Act generally" support the view that the Control Share Act is inconsistent with Section 18(i).

3. Control Share Act § 3-701(d)(1)(i)-(iii). The Control Share Act also affects voting rights at thresholds greater than ten percent. The current specified control thresholds 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. For example, a ten percent stockholder could regain voting rights with respect to that ten percent through a disinterested stockholder vote. A subsequent purchase of more than one-third of that company's voting stock would lead to a bar on voting rights for stock in excess of the ten percent previously approved.

Operating companies are, by default, subject to the Control Share Act. Closed-end funds are not subject to the Control Share Act but may elect to opt into the Control Share Act.

4. "Interested shares" are excluded from the two-thirds vote. "Interested shares" are shares that are held by the control stockholder, any officer of the company, or any employee of the company who is also a director.

5. The letter does not extend to other anti-takeover strategies. For example, the Staff points out that the courts have found that a shareholder rights plan, or "poison pill" plan, if adopted by a closed-end fund, does not violate Section 18 of the 1940 Act. See e.g., Neuberger Berman Real Estate Income Fund Inc. V. Lola Brown Trust No. 1B, 342 F. Supp 2d 371 (D. Md. 2004). Prior to the Boulder letter, the Staff had, on occasion, provided guidance on the Control Share Act informally through the comment process on closed-end fund registration statements.

6. 1940 Act Section 1(b).

7. 1940 Act Section 1(b)(2).

8. "Voting Stock" is not defined in the 1940 Act. The Staff notes that the definition of "security" in Section 2(a)(36) includes "stock" and combines that with the definition of "voting security" in Section 2(a)(42): "any security presently entitling the owner or holder thereof to vote for the election of directors of a company."

9. Boulder provides the following examples of voluntary actions that may trigger voting restrictions: the granting of proxies or the purchase of securities subject to reporting requirements under Schedule 13D and Rule 13d-1 under the Securities Exchange Act of 1934.

10. 1940 Act Section 1(b)(2).

11. See e.g., In the Matter of Solvay American Corporation, 27 S.E.C. 971, 973 (1948).

12. In Boulder, the Staff noted "the absence of published Commission or Staff guidance or settled case law."

13. See New York City Employees' Retirement Sys. v. SEC, 45 F.3d 7, 12-13 (2d Cir. 1995) (finding that interpretive letters are not entitled to the same level of deference as either rule-making orders or formal policy statements).

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