Closed-end funds (“CEF”) have a plethora of advantages that are attractive to individual investors looking for yield and the monthly distributions typically provided. The most current and brightest draw is the prevalence of funds with a discount to NAV, which allows investors to buy shares at less than what they are worth. A CEF also eliminates the “run on the fund” risk faced by open-end mutual funds – which provides access to less liquid and more complex asset classes – and can provide retail investors with affordable sources of leverage which would normally be unavailable to them, subsequently upping the potential yield. When compounded over time, these benefits become extremely attractive for retirees in particular, and it is common for them to be largely dependent on CEFs for monthly income.
Q4 2020 hedge fund letters, conferences and more
An Overlooked Loophole In The 1940 Act
However, a commonly overlooked loophole in the 1940 Act has been providing institutions and activist hedge funds with a means of exploiting these closed-end funds and violating the spirit of the law, often to the detriment of the individual investors. The loophole allows activists to avoid the 3% ownership limit rule in the 1940 Act, essentially creating leeway to buy up much larger stakes and exert greater control. By combining multiple corporate vehicles—each with 3% ownership—activist investors build up a significant voting bloc, synthetically acquiring large ownership of a CEF at a discount below NAV. The activists then leverage this built-up ownership, which can range anywhere from 8% to 25% of the fund, to force a shareholder vote and, usually, a subsequent liquidity event. If a full liquidation is forced, the activists walk out having pocketed a short-term share price increase, and individual investors and retirees are left without a way to receive regular income they relied on.
The case of Bulldog Investors against the Western Asset Variable Rate Strategic Fund (GFY) is a perfect recent example. As a means of strongarming GFY into offering a large tender or buy back, Bulldog refused to approve a new management agreement with new owner Franklin Templeton Investments. Bulldog—having purchased its majority stake through several different corporate vehicles that all belonged to one master firm—pressured GFY to accommodate their demands. In recognizing how uneconomical the fund had become, Western was forced to close down the fund and return money to all investors, even those who wanted to remain invested. While a liquidation was not pursued from the onset, the inevitable shuttering meant Bulldog pocketed a sizeable profit, and individual investors lost their monthly income, which some had relied on for over 15 years.
Activist Takes Nuveen's Closed-End Funds To Court
Another prominent activist recently took five Nuveen funds to court over Nuveen’s adaptation in October of by-laws allowing voting restrictions on holders who go above 10% after the adaptation date. The adaptation was in the interest of Nuveen protecting itself from activist efforts, and said activist had at the time held at least 9.9% of five Nuveen closed-end funds. Ironically, the activist sued on the grounds that the adaptation violated the “equal voting right” concept of the 1940 Act.
A question might arise: is this behavior legal? One could assert that it might not be. It can be argued that using multiple entities technically dodges the plain language of the 3% rule and violates Section 48(a) of the 1940 Investment Company Act, which prohibits performing indirectly what may not be done directly. Furthermore, accumulation of a substantial set of up to 3% positions by multiple funds—under common control of one investment adviser—technically violates the "undue influence" control that Congress intended to curtail and prevent.
The 3% Rule
The legislative history in 1940 and the amendments in 1970 that make up Section 12(d)(1) in today's 3% rule in were clearly done with an eye to stopping shareholder votes that would negatively affect a fund, such as forced buy backs and liquidations. The SEC made note of this debate in the adaptation of Fund of Funds Arrangements made in November 2020 (Rule 12d1-4). It used the key term "undue influence" 143 times in the final rule and 64 times in the proposed rule. However, as it relates to closed-end funds, specifically, it deemed the discussion as "beyond the scope" of this particular rulemaking, leaving CEF managers, investors, retirees and the wider markets to fend for themselves if they want any level of protection.
The future of CEFs and the security of millions of investors remain threatened as long as other menacing hedge funds and their institutional investors, sometimes coming from abroad, continue to take advantage of this loophole. Countless retirees, in particular, rely on CEFs for regular income, and if the SEC and Congress do not act, activists will continue accumulating sizeable stakes, forcing the funds to either shrink or liquidate entirely. The long-term individual investors on Main Street will be the ones who unfortunately pay price while the CEF industry suffers in general. Our nation’s retirees deserve better and the SEC must do more to address the loophole and put an end to the vulnerability these investors face as hedge fund aggressions escalate.
