Can Shareholder Votes Change Anything at Closed-End Funds?

Our last post posed three questions:

Why are proxy vote totals at closed-end funds so much smaller than the number of shares outstanding? Who is voting for discount reduction plans and against management? Do shareholder votes really matter at all?

1) Stockholder meetings at funds are usually pretty dull affairs -- if anyone from the outside even shows up at all. Most retail investors don't want to spend afternoons pouring through obtuse proxy disclosures or marking ballots to re-elect Directors who run unopposed. "Corporate Democracy" is ordinarily about as meaningful as "Peoples Republic" or "Dear Leader" -- it describes elections that have no practical effect, but survive only as ritual, vestigial reminders of the 19th century evolution of business corporations away from their origins as public bodies specially chartered by the State. The Investment Company Institute (a trade lobby) estimates that beneficial owners of CEF shares held in "street name" brokerage accounts only return proxy cards 31% of the time, and asserts that funds must be able to count uninstructed "broker non-votes" (a/k/a "trash votes") in uncontested elections if the hope to reach the attendance quorum that is required for holding annual meetings.

2) Individual stockholders may not vote, but institutions do. Holders of large share blocks can take the time to analyze performance and issues, and subscribe to proxy recommendation services such as Riskmetrics or Glass, Lewis. Conventional wisdom may still parrot the ICI line that individuals own 98% of all closed-end fund shares [a false generalization from just two CEF sponsors that focus on muni bond funds], but in fact the world of closed-end funds has been shifting from individual to institutional ownership.

Consider the eight funds where proposals for tender offers or interval plans recently won shareholder approval despite management objections. An online aggregation service that tallies up the 13F schedules that institutions must file each quarter shows the following ownership patterns. (Holdings data as of 3/31/10).

Ticker	% Owned by Institutions	Top 3 holders	% top 3 own	Discount 7/9/10
FGF	38.5%	Karpus, Lazard, Relative Value	19%	-7.8%
FGI	44.4%	Karpus, Lazard, RiverNorth	26%	-6.6%
SWZ	35.8%	1607, Lazard, Shufro Rose	27%	-14.2%
SGF	43.2%	City of London, Lazard, 1607	36%	-12.4%
APF	56.2%	1607, City of London, Lazard	28%	-12.3%
MAY	41.8%	City of London, Lazard, 1607	39%	-12.5%
EEA	26.8%	1607, Karpus, Gramercy	20%	-13.2%
GF	51.1%	Lazard, 1607, Karpus	42%	-11.4%

Click to enlarge

But even gentle giants can be pushed too far. We know from the SWZ fund website that 1607 and Lazard supported the interval fund proposal there:

Of the Fund's shares that voted "FOR" Proposal 3, over 80% (7,873,871 out of 9,703,826) were voted by two institutional investors. Other than shares voted by those two investors, only 6% of the Fund's shares were voted "FOR" Proposal 3. ["And other than that, Mrs. Lincoln, how was the play?"]

Other funds also tried to spin down their annual meeting results by emphasizing the number of abstentions and trash votes -- sorry, "uninstructed broker non-votes", the sort that are shut out when proposals are contested. At both FGF and FGI, abstentions and non-votes accounted for 49% of the outstanding shares. SGF counted 39.3% in favor of the interval plan and only 9.4% against, which implies that just over half abstained or didn't respond. APF and MAY echoed this theme. It looks like fund managers and crony directors have found a way to rationalize their continued opposition to discount reduction in spite of the vote results. Like defeated politicians, they console themselves with the belief that: "The activist minority may have won this time, but somewhere out there is a Silent Majority who quietly support me." Quietly indeed, since "silent majority" has long been taken as a polite reference to the dead.

3) So what? These votes were only advisory. Most CEF's are incorporated in Maryland, the state that won a "race to the bottom" by enacting management-friendly laws for investment companies. In Maryland, for example, all corporate business and affairs are managed under the direction of the Board, unless the charter or bylaws give that power to the stockholders -- which they never do. In Maryland, company bylaws which rule the governance of the enterprise can be amended by a vote of the shareholders, unless the bylaws say that only the Board can amend them -- which is always the case. As a result, just about every resolution that comes up for a shareholder vote is merely "precatory": like little Oliver Twist, CEF shareholders must wave their empty gruel cups at the fund Directors while politely asking: "Please... may I have some more?"

3A) So why not elect new Directors? It can be done, but it's not easy. Maryland lets funds have "staggered" boards (e.g. 3 year terms for Directors, with only 1/3 elected each year), so challengers need to win proxy fights two years running in order to gain a majority. "Winning", says Maryland, only requires a simple plurality of votes cast, unless the bylaws (which only the Board can change) provide otherwise. Some funds have decided that winning requires a majority of all the outstanding shares (difficult at the best of times, and almost impossible when there's a contest) and Maryland conveniently lets incumbents hold on to their seats if an election fails and no successors are selected.

The result is the sad parody of democracy we find at the DWS/Deutsche Bank group. In 2008, the incumbent directors of their GCS fund lost to a Western Investment slate by 35% to 65%, but they stayed in office because the challengers did not get an absolute majority. A similar farce played out at DHG last May, where the fund's mealy-mouthed press release said only that: "a quorum was present but none of the Class III Director nominees received a sufficient number of votes to be elected as a Director. Therefore... each of the four incumbents will continue to serve..." In fact, these directors lost by a margin of 43% to 57%, but they still clung to control. These four incumbents also failed the "majority of all shares" test for re-election at three other DWS/DB funds, but they continue to "hold over" there as well.

Even challengers who receive enough support may be snared by other legal traps. Perhaps they did not provide advance notice of candidacy within some narrow time window set by the bylaws (as amended by the Board.) Perhaps they failed a proctological examination: here's a small part (about 1/3rd) of the disclosure requirements for new Board candidates at DWS' DRP fund:

(H) any other derivative positions held of record or beneficially by the Shareholder and any Shareholder Associated Person and whether and the extent to which any hedging or other transaction or series of transactions has been entered into by or on behalf of, or any other agreement, arrangement or understanding has been made, the effect or intent of which is to mitigate or otherwise manage benefit, loss or risk of share price changes or to increase or decrease the voting power of, such Shareholder or any Shareholder Associated Person with respect to the Corporation’s securities; (iv) set forth, as to the Shareholder giving the notice Shareholder Notice and any Shareholder Associated Person covered by clauses (ii) or (iii) of this paragraph (2) of this Section 9.11, (A) the name and address of such Shareholder, as they appear on the Corporation’s stock ledger and current name and address, if different, and of such Shareholder Associated Person and (B) any other information relating to such Shareholder and Shareholder Associated Person, if any, that would be required to be disclosed in a proxy statement or other filings required to be made in connection with solicitations of proxies for, as applicable, the proposal and/or for the election of directors in a contested election pursuant to Regulation 14A (or any successor provision) under the 1934 Act and the rules and regulations thereunder; and (v) set forth, to the extent known by the Shareholder giving the notice Shareholder Notice, the name and address of any other Shareholder or beneficial owner of shares of the Corporation’s stock supporting the nominee for election or reelection as a director or the proposal of other business on the date of such Shareholder’s notice... the applicable Shareholder Notice; (vi) with respect to each nominee for election or reelection as a director, be accompanied by a completed and signed questionnaire, representation and agreement required by Section 9.12 of these Bylaws; (vii) set forth any material interest of the Shareholder providing the Shareholder Notice, or any Shareholder Associated Person, in the matter proposed (other than as a Shareholder of the Corporation); and (viii) include a representation that the Shareholder or an authorized representative thereof intends to appear in person at the meeting to act on the matter(s) proposed. With respect to the nomination of an individual for election or reelection as a director pursuant to Section 9.11(a)(1)(iii), the Corporation may require the proposed nominee to furnish such other information as may reasonably be required by the Corporation to determine the eligibility of such proposed nominee to serve an in independent director of the Corporation or that could be material to a reasonable Shareholder’s understanding of the independence, or lack thereof, of such nominee. If a nominee fails to provide such written information within five Business Days, the information requested may be deemed by the Board of Directors not to have been provided in accordance with this Section 9.11. (See Exhibit 3.1 Form 8-K 4/17/09)

Or perhaps a Board has gerrymandered the qualifications for membership so challengers need not apply, as Deutsche's GF did a few years ago when it refused to count the votes for Phil Goldstein on the ground that he wasn't "German" enough. [The Horst Wessel Lied plays faintly in the background.]

Such tactics may be self-limiting. Most fund sponsors care about their reputations, even if only as a device to attract new business, and most members of the social strata from which fund directors are selected would prefer avoid the regions that Dante reserved for gilded hypocrites. Still, effective proxy fights for Board representation aren't cheap, and cef activism is plagued by the problem of "free riders". An activist challenger bears all the cost of a proxy fight, and getting reimbursement is a gamble, yet all shareholders benefit when discounts shrink and share values rise. The activist bakes the cake, but everyone gets to eat.

3B) One other type of shareholder vote has a binding, though negative effect. Investment companies may be chartered by states, but they are subject to Federal regulation by the SEC under the Investment Company Act of 1940. Under §15(a)(3) of the ICA, fund management contracts can be terminated on 60 day notice by "a vote of a majority of the outstanding voting securities", defined as: >50% of the outstanding shares or a 2/3rds vote at a meeting where >50% are represented, whichever is less. This means that 1/3 of the shares (2/3rds of 50%) can potentially remove a fund's manager -- and with it, the reason for resisting discount reduction measures that would reduce fees. No brains means no headache.

We do not know of any CEF where a §15(a)(3) resolution has won, although in some cases the threat has spurred managers to compromise, open-end or liquidate the fund. §15(a)(3) is a kind of "nuclear option", that wipes out the management contract while also disrupting regular operations and multiplying risks. So it seems quite significant that City of London, a major investor owning @25% of the Singapore Fund (SGF), recently put the fund on notice that a failure to act in response to the recent shareholder vote would lead City of London to consider proposing a §15(a) resolution. The message, which was released to the press weeks ago but was little noticed until now, went on to strike a tone of ironic reassurance:

Do not feel singled out. While many closed end funds are advised and managed in the best interests of their stockholders, The Singapore Fund is just one of those which currently are not. It is City of London’s intention to consider placing similar resolutions on future proxy statements of other deeply discounted funds where we hold significant positions and whose Boards are similarly unresponsive to stockholder mandates to narrow those discounts.

Disclosure: Long all except MAY and EEA