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Part 3: Whose Best Interests?
In Part 1 we saw how SWZ's mediocre performance and persistent discount inspired a shareholder proxy proposal for the upcoming June 16 meeting that asks the Board to adopt an "interval fund" structure. Part 2 looked at the diverging interests of SWZ's shareholders and its manager (an affiliate of the Hottinger family of Swiss private bankers) and described how Fund Counsel tried to block a vote on the proposal by arguing, among other things, that it had already been "implemented" by a Board resolution not to do it. Fortunately, the SEC staff was not impressed with this exercise in Newspeak, so shareholders will be allowed to vote. Because individual investors often toss proxy envelopes into recycle bins without opening them, the votes of the two institutions that together own 25% of SWZ will probably be decisive.
Regardless of the outcome, a case study of the role of SWZ's Directors may prove informative for closed-end fund activists and corporate governance theorists.
1) Who Makes Policy -- the Board, the Manager or the Lawyers?

SWZ's receipt of the interval fund proposal triggered a flurry of lawyering by Fund Counsel, but this was not the only possible response. An experienced attorney like Fund Counsel could no doubt have come up with an equally convincing set of arguments in favor of interval fund status if so instructed by a client who had made a business decision to implement it. Did the Board actually learn of the proposal and tell Fund Counsel to oppose it back in early January, long before the February 25th meeting where the Directors supposedly considered the merits? Or was the policy set by SWZ's President or CEO, both of whom owe their compensation and primary loyalty to the Hottinger-controlled management company that stands to lose fee income if the proposal goes through? Or did Fund Counsel give himself his own marching orders, as the instinctive response by an experienced corporate attorney to any outsider who presumes to tell his client what to do? We can only guess. (FC's correspondence was cc'd to Board Chair Witt, Fund/Adviser CEO Millisits and an attorney at Sullivan & Cromwell.) The second and third alternatives are the most likely, which suggest that the adversarial response was pretty much locked in as Fund policy by the time the issue was presented to the Board.
Cast of Characters: Meet the Officers
  • Alexandre de Takacsy Age 80 Interested Director of SWZ since 1998 and President since 2009. Senior Adviser to the Hottinger Group, and now also President and CEO of HCC, the fund manager.
  • Rudolf Millisits Age 52 Not a Director, but portfolio manager for SWZ since 1996. Became CEO of SWZ and COO of HCC in 2009, having worked at HCC since 1994.
2) The Board Stumbled Over a Hypothetical Shareholder Vote
The stage-managed Director's meeting resulted in a Resolution saying that the interval fund proposal had been considered as a hypothetical:
"(NYSE:A)s if it (i) had been submitted to and approved by the Fund's stockholders at the 2010 Annual Meeting of Stockholders and (ii) did not contain any of the deficiencies discussed at this meeting or otherwise identified by Fund Counsel." (Minutes pp. 4-5)
The stated conclusion was that such a proposal "is not in the best interests of the Fund or its stockholders and is therefore not approved." (emphasis added). But if the stockholders had approved the Proposal -- and for purposes of testing the hypothetical let us assume that they did so unanimously -- then how could the Directors have concluded that something the stockholders all wanted was not in the best interests of those stockholders? How can someone know your best interests better than you do? The Board didn't follow the rules of the game when they played "let's pretend the stockholders approved it": either they didn't understand the hypothetical or they didn't take it seriously.

Meet the Director Who Counsels the Others...

  • Stephen K. West, Esq. Age 81 Independent Director of SWZ since 1995. Senior Counsel at leading Wall Street law firm Sullivan & Cromwell, counsel for the Independent Directors. His term expires in 2012, and SWZ's Nominating Committee charter says that his age (over 80) makes him ineligible for re-election unless the Committee -- on which he sits -- waives the age limit for him again, just as it did last year.
...and Gets It Wrong. According to the meeting minutes, Director West reviewed past discussions of the discount and reminded the Board "that eliminating the Fund's discount was not a fiduciary duty of the Board." (.pdf, p. 37) Perhaps Mr. West was speaking as an "independent" Director, in which case he didn't understand the hypothetical (i.e. can a Director in good faith really ignore a unanimous shareholder vote in favor of a course of corporate action?) Or it may be that Mr. West was providing legal advice in his capacity as counsel to the Independent Directors, which would cast him in the dubious position of a lawyer representing himself as his own client.

3) Does the Phrase "The Best Interests of the Fund" Mean Anything?
Directors of investment companies formed under Maryland law (as most are) must perform their duties:
"(1) In good faith; (2) In a manner they reasonably believe to be in the best interests of the corporation; and (3) With the care that an ordinarily prudent person in a like position would use under similar circumstances." (Maryland Corps. & Assoc. Law §2-405.1(a).)
Sounds nice. What does it mean? Let's say one of the Directors of SWZ has second thoughts, and wants to know "How can I as an independent fund director determine whether a shareholder activist proposal is or is not 'in the best interests' of my fund."?
It Doesn't Mean What It Sounds Like. The Maryland statute is based on §35 (now §8.30) of the Revised Model Business Corporation Act. Sharfman, Understanding Maryland's Business Judgment Rule, 8 Duquesne Business Law Journal 1 (2006). The Official Comment to §8.30(a) of the RMBCA explains:
"The phrase 'best interests of the corporation' is key to an explication of a director's duties. The term 'corporation' is a surrogate for the business enterprise as well as a frame of reference encompassing the shareholder body. In determining the corporation's 'best interests,' the director has wide discretion in deciding how to weigh near-term opportunities versus long-term benefits as well as in making judgments where the interests of various groups within the shareholder body or having other cognizable interests in the enterprise may differ." (vagueness in the original, but emphasis added)
"Oh", says our friend, "So I need to think about what's good for shareholders as well as for SWZ as an entity. But which shareholders? I remember Senior Counsel West telling us that proposals to reduce fund discounts were 'largely made by short term investors who wanted the ability to sell their shares from time to time' even if those proposals were not in the best interests of a fund's long-term investors. That's why our proxy statement told shareholders to vote 'no': 'because the proposal is not in the best interests of the Fund and its long-term stockholders.'"
The 'Long-Term vs. Short-Term' Fallacy. CEF incumbents in proxy fights often try to portray their opponents as corporate raiders, arbitrageurs, hedge funds, "short-term speculators" or "quick buck artists" trying to wreck the fund at the expense of its small, loyal "long-term" investors. It's good propaganda, even though the managers probably have little real understanding of who actually owns fund shares or what their trading patterns look like from year to year. And some holdings run counter to stereotypes. The Lazard firm, for example, professes support for CEF activism, but has held 5% or more of SWZ's outstanding shares continuously since 1998.
People invest to make money. Except for timing the >1 year holding period necessary for favorable tax rates on long term gains, it's better to gain quickly than to gain the same amount slowly. As Professor Angel of Georgetown has noted, the willingness to invest long-term is contingent upon the ability to exit at some point in the future. Otherwise, a closed-end fund becomes the financial equivalent of a Roach Motel [TM], where money checks in but can never check out. The folks with the most to lose from discounts are those "long-term" individual shareholders who may from time to time need some cash -- for tuition, a new home, or retirement. How do "short-term" traders acquire their shares, if not from past long-term holders who had to cash out and took a significant haircut to net asset value?

"True", says our friend, "but Senior Counsel West also told us that SWZ's stock repurchase programs 'were more beneficial to the Fund's stockholders, as the accretion to the Fund's net asset value was distributed in a more equitable fashion.'" (.pdf, p. 37)
"Equitable" is an unusual word to use in describing a plan that takes a lot of money away from selling shareholders in order to give a little bit to continuing holders. In 2007, for example, SWZ's repurchase program added 4 cents to net asset value per share for the folks who didn't have to sell, while paying only 87% of net asset value to those who sold -- an average of $17.42 for shares with a NAV of $20.03.
The key to the "long-term shareholder" fallacy. It's a verbal gimmick that treats anyone who ever sells SWZ as if they didn't exist when it comes to assessing benefits and detriments, because they aren't "long -term" holders any more. This ignores the value lost by those who have to sell at a discount, now or in the future, and overlooks the main benefit of interval fund repurchases -- the immediate gain in value for those who tender shares at net asset value -- because anyone who cashes out isn't in the "long-term investor" category. Many, many folks who own SWZ now may need to cash out in the future, and would rather receive a high price than a low one. But the potential future benefit to these current long-term owners from a switch to interval fund status was never identified, much less quantified, in the Board minutes.
Suppose you are a "long-term" owner of 1000 shares of SWZ, which now trade at $10 with a NAV/sh of $11.83, and are worth $10,000. If the fund repurchases 500 shares at $11.60 and the discount doesn't change otherwise, you would have $10,800 -- $5,800 cash and 500 shares at $10. Suppose the expense ratio after the repurchase increases by as much as 50 basis points. Your portion of this added cost would be about $29 per year. That's a better comparison of gains and losses, but it is hidden by the "long-term shareholder" fallacy.
4) Does the Fund have an interest in its own existence? At the core of modern capitalism is a legal fiction -- that a corporation is a "person" in the eyes of the law. But the analogy to flesh-and-blood humans can be carried too far. Individuals do not pay dividends, trade on exchanges or engage in mergers and acquisitions. We are profoundly disquieted by reports of suicide, yet feel no great shock to learn that Directors of a UBS fund recently recommended a proposal to liquidate and dissolve it as being "in the best interests of the Fund."

As Professors Hu and Westbrook recently explained, the traditional description of the "best interests of the corporation" falsely assumes a unity of interest between the company, its managers and its owners. However:
"Modern finance theory suggests that, in the usual publicly held corporation, serious conflicts exist between the corporation's interest and the shareholders' interests with respect to corporate investment decisions." Abolition of the Corporate Duty to Creditors, 107 Columbia Law Review 1321 (2007)
Furthermore, the mandate to weigh near-term and long-term interests of the various groups with "cognizable interests" in the enterprise:
"[G]ives no clear operational or theoretical guidance for investment decisionmaking. It says to care about the corporation and the shareholder but fails to even acknowledge differences in interest, much less provide a rule for weighing the two interests in case of conflict. Since virtually every investment decision will involve conflict, the silence of the traditional conception means that it provides no guidance regarding how management should behave." (id.)
One should not underestimate the power of false beliefs, especially when presented as the advice of counsel. Directors of SWZ have, in other contexts, firmly supported actions to return value to investors, both in theory and in practice, yet the SWZ Board minutes record only their silent presence while the interval fund proposal was under consideration.

Cast of Characters: Meet the Directors Brealey
  • The Theorist Richard Brealey Age 73 Director of SWZ since 2009, previously on the Board thru 1995. English academic and author of leading corporate finance textbook. Brealey & Myers, Principles of Corporate Finance pp. 23-24 (7th ed. 2003) sets the manager's goal as maximizing the market value of each stockholder's share.
  • The Practical Didier Pineau-Valencienne Age 78 SWZ didier p-vDirector since 1999. Leading French businessman, now with Sagard, a French private equity firm. Former head of electrical equipment maker Schneider, SA. Satirized (in French) as the "Boss Without a Soul" for having told Le Figaro that "employment is the only adjustment variable", and having earlier in his career presided over the dismemberment of engineering firm Creusot-Loire. In 1994 was briefly jailed in Belgium on questionable charges of forgery and embezzlement, but jumped bail and fled the country while undertaking to clear himself of the accusations.

Disclosure: Long SWZ