Closed-End Funds Oppose Activism With False Arguments

Previous articles described the conflict between institutional investors in closed-end funds and the managers of those funds. Discount reduction measures can benefit shareholders, but they reduce the managers' fees and profits. So far this year at least eight funds have had stockholders voting to request such measures, so now the Directors of those funds -- who may also serve as Board members at dozens of other funds sponsored by the same manager -- face a tough choice. They can ignore the vote, and face a proxy fight next year for their Board seats or a proposal to remove the manager -- as has been threatened at the Singapore Fund (SGF). Or they can do what the institutions want, to the manager's detriment. Not only could this injure working relations at all the other funds with the same manager and Directors, but because a manager/sponsor selects the initial Directors when a fund is first organized, any decision that favors fund owners over managers has an odor of ingratitude about it.

So it becomes the job of the fund's attorneys to concoct plausible justifications when a Board disregards a shareholder vote, and to invent new twists in the law that will protect incumbent Directors from challengers. The arguments against discount reduction proposals are quite familiar to those few investors who actually read proxy materials in order to decide how to vote. Lawyers model their drafts on documents that other lawyers have already written, so various funds tend to use similar arguments, complete with the same logical fallacies. Here are two of the most common:

1) "We Must Protect the Fund from Those Who Would Destroy It."

A closed-end fund is basically just an incorporated securities "port-folio" - something that holds papers. It's a bundle of abstract rights and claims, not a living being, and it has neither a heartbeat nor a soul. People buy shares in them in hope of profit, of receiving future rewards that may be worth the wait.

But corporate law is inherently dehumanizing; practitioners learn to value the welfare of abstract entities above that of their fellow human beings. Their appeals for proxy votes appear to make the existence of the entity superior to the interests of those who own it. At the Korea Equity Fund (KEF), for example, where a proxy fight is shaping up in advance of the August 24 meeting, the Board's latest "fight letter" calls for a "no" vote on proposals to buy back shares (now trading at 10% below net asset value) because that "could lead to the Fund's liquidation or merger" -- as if that was necessarily a bad thing.
KEF, like many CEFs, has taken counsel from Venable, LLP, of Baltimore. This law firm's May 12, 2010 online memo "Protecting Closed-End Investment Companies under Maryland Law" explains their approach. The authors treat any attempt by shareholders to reduce a fund's market discount as if it were tantamount to an attack on corporate existence, as if the fund were a pathetic, helpless kitten crying for protection against the nasty, evil arbitrageurs and activists who would seek to destroy it. The memo recommends, for instance, that funds:

"[I]nclude in the charter a provision explicitly stating, if consistent with the fund's investment objectives, that the fund is designed as a long-term investment vehicle and authorizing and directing the board of directors to take any and all lawful action to protect the existence of the fund against any efforts that would be likely to result in the termination or significant reduction in the size of the fund." (p. 7 of 8)

What the Venable folks are really proposing here is the Roach Motel approach to investing: Money checks in, but it can never check out. They proceed to list eleven ways for incumbents to rig the rules against challengers, all aimed at preventing fund owners from laying their hands on their own investments. Counsel appear to be trying so hard to believe in their own fantasies as to obscure their reading the text of the law, because their explanation of the legal duties of fund directors describes things that are not actually there. It is important, they say:

"[T]o emphasize to directors of closed-end funds their statutory obligation to act with a reasonable belief that their actions are in "the best interests of the corporation" as a continuing entity rather than in the interest of any particular stockholder or group of stockholders. " (p. 2 of 8)

In fact, as explained in an earlier article, the official commentary to the Model Act on which the Maryland law is based says:

"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."

That stuff about a "continuing entity" just isn't there. It's not the law. If it were, a corporation could never merge or be dissolved, since that would extinguish its existence as an entity. And the lawyers at the Venable firm are smart enough to know that. Unfortunately, they also know who signs the checks that pay their invoices, and have shaded their interpretation of the law accordingly. Their plea to "Protect the Fund ... etc." might better be translated as:

"We must protect the manager's fee from those who would seek to reduce it."

2) Do discount reduction plans hurt "long-term" shareholders?

Boards and managers often claim to have their investors' "long-term" interests at heart. At FGI, for example, one reason given for not buying back shares at net asset value was that: "Given the Fund’s long-term investment focus, the Board believes strongly in providing Shareholders with a solid investment program that produces a competitive investment record." But aside from the buzzwords, the "long-term" vs. "short-term" argument is a semantic subterfuge, based on a confusion of meanings. Consider an investor who now owns fund shares purchased bought ten years ago -- a "long-term holder" by just about any definition. Suppose that the market price for those shares used to be only 90% of net asset value. But now, when the fund offers to buy back shares for 100% of NAV, our long-term investor accepts and is cashed out. Isn't it obvious that they benefited from the buy-back offer, since they received a higher price for their shares?

"Not so" says Fund Counsel (an attorney who specializes in resisting shareholder proxy proposals.) "You just don't understand. Your friend isn't a long-term investor in the fund any more. They stopped being a "long-term holder" as soon as they sold the stock and took advantage of the tender offer that eliminated the discount."

Gwailo wonders: "You mean -- reducing the discount gives more money to those who choose to sell, but that doesn't help "long-term holders", because a seller, by your definition, isn't a "long-term holder" no matter how long they owned the shares?"

"Exactly," says Fund Counsel. "My job is to protect the real long-term investors, the ones who aren't concerned about discounts because they never, ever sell. And now, if you'll excuse me, I have to go check the unclaimed property registry and see if anything exciting happened in probate court yesterday." [exits stage right]
Gwailo (thinking): "So the real long-term investors -- the ones Fund Counsel is protecting -- are the folks who put their money into closed-end fund shares and never take it out. 'In -- but never out.' Now - where have I heard that before?"

2A) "Discount reduction plans just benefit 'short-term' hedge fund activists and arbitrageurs."

Absurdity reigns when a proxy fight letter from a fund managed by the investment arm of a global bank with extensive trading operations attacks activist challengers as "a group of hedge funds seeking short-term gain" -- especially because that bank had just been tagged by the IRS for its role in facilitating the illegal concealment of offshore accounts. Few mourned when the CEF in question, UBS' Investment Grade Municipal Income, was liquidated earlier this year "in the best interests of the Fund."

Short-term holders, be they "activists" or "arbitrageurs", generally bought their shares from disappointed long-term investors who needed liquidity more than some theoretical claim on the fund's net asset value. "Quick profits" for short-term holders simply compensate them for making a market for those long-term sellers who could not wait for the fund to reform itself.

2B) "Discounts are good, because you can buy assets for pennies on the dollar."

TY used to use this truly inane variant to justify 15% discounts. But anyone at all who has the money can buy when shares trade at a discount, but those who sell at a discount are those who already own shares. The ongoing loss of value due to trading discounts weighs entirely on the current owners who, for whatever reason, are obliged to sell, even though the corporate entity is supposed to be managed for their benefit.

More on the proxy fight at Korea Equity Fund

At KEF, a past client of our friends at Venable, LLP, institutions own 59% of the stock, led by City of London (25%) and Lazard (19.5%), while Phil Goldstein's Bulldog Investments holds an additional 7.2%. The proxy card includes CitLon's proposal to convert KEF to an interval fund, which, as usual, is opposed by the Board and the adviser, Nomura Asset Management. Bulldog recently filed form PRE14A seeking proxies for two additional proposals: a §15(a) vote to terminate Nomura's management contract and an immediate self-tender for half the outstanding shares. Goldstein has also announced his candidacy for the Board (possibly to prevent trash votes from counting towards a quorum), while KEF claims that he hasn't given the Board the info that's required by its bylaws. Stay tuned. - Kimchi, anyone?


Disclosure: Long SGF, KEF, FGI