Players and Scorecards. In Part I we saw how mediocre performance and a persistent trading discount at the Swiss Helvetia closed-end fund inspired a shareholder proxy proposal that would ask the Board to adopt an "interval fund" structure. If it were implemented, SWZ would periodically offer to buy back a certain percentage of outstanding shares at prices close to net asset value from those shareholders who choose to tender them. (Oversubscribed offers would be pro-rated.)
Interval funds have been around since 1993, when the SEC adopted Rule 23c-3 as a way to increase liquidity for investors within the closed-end format and to combat the problem of discounts. The Investment Management Division recommended the interval rule in its report Protecting Investors: A Half Century of Investment Company Regulation, (1992) because:
Closed-end securities often trade at a discount to net asset value in the secondary market, a situation that has adverse consequences for both investors and sponsors.
The report indicated that "country" funds (of which SWZ is one), with "somewhat liquid" portfolios, might appropriately use the interval fund structure.
Interests in Conflict. What's good for the investors can be bad for the fund manager. The effective remedies for CEF discounts generally involve transferring assets out of the fund and over to shareholders, cashing them out in whole or in part. If Mr. Market will only offer $86 for a packet of shares in various Swiss companies while they are bundled up inside SWZ, but Monsieur Marché in Geneva & Herr Markt in Zurich will pay $100 worth of Swiss francs for those same shares once unbundled, then economic logic suggests that it is quite inefficient for SWZ to hang on to the bundle. But SWZ's manager, Hottinger Capital ("HCC", an arm of the Swiss private banking business run by the Hottinger family since 1786) was paid $3,144,000 last year for managing SWZ, a fee based on the fund's net assets that is not affected by the -13.8% discount at which SWZ shares currently trade. A share buyback would reduce assets under management, and since the manager's own costs are relatively scale-invariant, this would be a direct hit to the Hottinger bottom line.
Cast of Characters: Meet the Hottingers
- Baron Henri Hottinger Age 75 Director Emeritus of SWZ, as well as its former Chairman and CEO. His hereditary title as a Bonapartist aristocrat dates from 1810, when Napoleon ennobled Jean Conrad Hottinguer, a cotton merchant turned banker. Earlier, during his exile in the US at the time of the revolutionary Reign of Terror, JC had married the daughter of a Newport, Rhode Island, ship owner and slave trader. A few years later, JC and friends came close to starting a war between France and the United States by demanding enormous bribes from the fledgling administration of President John Adams in the so-called "XYZ affair." He survived Napoleon's defeat and fall through an exquisitely timed switch of loyalty to the restored Bourbon King Louis XVIII. The current Baron is quite respectable by contrast.
- Paul Hottinguer Age 67 Brother of the Baron. "Interested" Director of SWZ since 1989, as well as its former Chairman and CEO.
- Frederic Hottinger Age 48 Son of the Baron. Board Chair of HCC, SWZ's manager/adviser, since 1994.
- Rodolphe Hottinger Age 53 Son of the Baron. President of SWZ from 1997 thru 2009 and CEO of HCC, 1994 - 2009.
SWZ Reacts to the Interval Proposal. The "SWZ No-Action letter" file, online at the SEC, shows that the response to the interval fund proposal was framed from the start as a matter of legalistic defense to be managed by lawyers, rather than being an investment management policy issue or a subject for business negotiation. There may have been a conscious decision early on, or it may simply have happened by default. In any event, Fund Counsel controlled all communications regarding the proposal, opposed it with a barrage of sophistic arguments, and stage-managed a Board of Directors meeting that aimed to pre-empt any vote by SWZ's shareholders.
Cast of Characters: Meet Fund Counsel
- Stuart H. Coleman Age 55 Co-Managing Partner of Strook & Strook & Lavin, a leading Wall Street law firm. Counsel to SWZ and many other investment company clients.
Thinking Like a Lawyer. There is something about the legal mindset that leads attorneys to choose particular strategies and arguments. The first thing an experienced attorney looks for when a legal battle begins is some procedural defect in the opponent's position, some way to obtain a victory regardless of the actual merits of the underlying claim. "Aha", Fund Counsel must have thought while composing his January 8th response to the proposal (.pdf pp. 22-23), "Mr. Baer hasn't proved he owns $2,000 worth of shares in SWZ" (the threshhold for a shareholder proxy proposal under SEC Rule 14a-8). "His letter from E-Trade says he owns stock in the Swiss Helvetica Fund, not the Swiss Helvetia Fund. It's a good thing that I studied pettifogging back in law school." ["Pettifogger, noun - "Someone who quibbles over trivia and raises petty, annoying objections." Orig. "A deeply contemptuous term for a certain class of lawyers."]
When procedure fails, experienced lawyers resort to substance. On January 22 Fund Counsel wrote again (.pdf pp. 26-28), asking that the interval fund proposal be withdrawn "or revised, if possible" and presenting three single-spaced pages of objections "in order to avoid unnecessary costs to the Fund and its stockholders". [SWZ spent $466,374 on "professional fees" in 2009, in addition to fees for administration, custody, accounting and transfer agent services. The amount paid to the Stroock firm is not shown separately, but $132,552 is shown as going to another law firm that represents the independent directors.]
Objection! The proposal is illegal! It requires the Board to do something it cannot lawfully do. It would breach fiduciary duty (i.e. the legal obligation to act in a trustworthy manner) if the Board went forward with an interval fund plan, because the Board might conclude that the a plan is not in "the best interests of the Fund". [Translation: "Even if we wanted to, we couldn't, because you're telling us we have to, and we might not want to."]
Oops! This won't work, because the proposal only "asks" the Board to act and doesn't "require" it. Fund Counsel can save face by telling the SEC that he was helping "clarify" the proposal, instead of admitting that he read it wrong. [.pdf, p. 6] Now think, Fund Counsel, think! There must be some other clever way to keep this from coming to a shareholder vote. "Perhaps we can convince the SEC that a vote is useless -- is 'moot' -- because the Board has already been asked to act and has decided not to. Aha! Let's have a special telephone meeting, and pretend as if the shareholders had voted for the resolution, even though they shouldn't. Let's tell the Board about everything wrong with interval funds, and explain why it's not 'in the best interest of the Fund or of its shareholders.' Then we'll ask the SEC for permission to leave this proposal off the proxy. We'll say that the request has already been 'implemented' -- the Board was asked to do something and decided not to." That's it! Roll 'em!
Cast of Characters: Meet the Chairman of the Board
- Samuel B. Witt III, Esq. Age 74 Retired attorney, Director of SWZ since 1987 and Board Chair since 2006. Described in the current proxy as having been "General Counsel of the International and U.S. Businesses of a Fortune 100 public company", which Google shows was the R.J. Reynolds Tobacco Company, later RJR Nabisco. Sam "Smokey" Witt's name appears a number of times in various online document troves in connection with tobacco litigation. The proxy also lists several public service endeavors, but somehow omits his current Trusteeship of the Confederate Memorial Literary Society, d/b/a the Museum of the Confederacy, to which Sam and his wife donated $102,000 last year.
The Board Plays 'Let's Pretend". The minutes of the virtual meeting on February 25 (.pdf at pp. 35-39) show Chairman Witt turning the meeting over to Fund Counsel, for a rather one-sided presentation with no one -- even a lone devil's advocate -- tasked with raising alternate views. Fund Counsel:
Referred the directors to correspondence with Mr. Baer .... detailed several deficiencies .... said the proposal would unlawfully place constraints on the Board's fiduciary duties .... impermissibly strip the Board of its discretion .... recited the regulatory provisions under which the Board could exclude Mr. Baer's proposal .... noted that stockholders could not compel the Board to propose the adoption of an interval fund structure .... discussed Mr. Baer's history of activism .... referred the Directors to memoranda .... reminded the Directors .... noted that adoption ... could be viewed as a protracted liquidation .... described the risks .... also noted ... increase expense ratio .... said the claim (of reduced discount) was not borne out by empirical evidence ....
The "empirical evidence" was described in a subsequent letter to the SEC [.pdf, p. 6] as "materials prepared by an independent third party financial services firm engaged by the fund". But "independent" does not equal "impartial" or "competent". The minutes indicate that this mystery firm was actually UBS (nee Union Bank of Switzerland), fellow gnomes to the Zurich-based Hottingers. The materials themselves unfortunately are not part of the public record, and we do not know whether the Board was told (a) that several other CEF's sponsored by UBS' asset management arm had recently battled activist proposals to reduce discounts, (b) that Fund Counsel's group at Stroock represented UBS Securities as well as "several registered, closed-end alternative investment funds sponsored by UBS Financial Services, Inc.", or (c) that UBS had been the dealer-manager for SWZ's May 24, 2007 dilutive rights offering, where 8 million new shares were sold far below net asset value, thus increasing SWZ's assets by $130 million (and fattening HCC's fees) while knocking net asset value per share down by about 7%. Nor do we know whether the UBS gnomes looked at any of the academic literature on CEF repurchases, such as:
"We investigate the price performance of closed-end funds that announce share-repurchase programs. Closed-end funds experience positive average stock-price reactions to the announcements. The long-run buy-and-hold abnormal returns of repurchasing funds over the subsequent three years are significantly higher than a nonrepurchasing control sample matched by size, type, investment style and geographic diversification." Akhigbe, Kim & Madura, The Financial Review 42 (2007) 537--555
"Closed-end fund self-tender offers can create value for shareholders in three ways: 1) The self-tender offer itself (by immediately eliminating discount on tendered shares), 2) permanent discount effects, and/or 3) increase in NAV effect. The first avenue to value creation, through the self-tender offer itself, will be studied more rigorously later in this paper and is found to create shareholder value. However, the other two claims are not strongly supported by the evidence. " Gray, Two Essays on Self-Tender Offers (May, 2008)
Part 3 will look further at the flawed logic and legalistic mindset that shaped the Board's notion of the "best interests of the Fund and its shareholders." The Directors, though intelligent, successful and independent individuals, did not behave like watchdogs, nor were they like lapdogs. Instead, they were puppy dogs.
Disclosure: Author holds a long position in SWZ