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Massachusetts Case Exemplifies The Perils Of Defensive Bylaws In Closed-End Funds

A Massachusetts Superior Court decision in March 2021 reaffirms the significant contractual, state law, and federal law protections over fund shareholder voting rights.  Trustees and fund managers should take heed and proceed cautiously when implementing defensive measures intended to preclude shareholders from exercising those rights.  A version of this article was published by Law360.

05/26/21

Background

In anticipation of a potentially contested trustee election, the board of trustees of four closed-end funds managed by Eaton Vance enacted two defensive bylaws.  The first new bylaw provided that, in a contested election, a trustee may be removed only by vote of a majority of all outstanding shares (the “majority-of-all-outstanding bylaw”); previously a trustee could be removed by a plurality of shares participating in the vote.  The second new bylaw provided that a shareholder controlling more than 10% of the voting power cannot vote unless a majority of the other shareholders agree to permit it to (the “control share bylaw”).  Because of the historically low voter turnout in closed-end fund elections, the new bylaws made it exceedingly difficult to unseat a trustee even with significant shareholder backing.  A current trustee who does not receive enough votes for reelection, but whose replacement also does not receive enough votes under the new voting threshold, would remain on the board as a holdover.

After the new bylaws were implemented, but before they were disclosed to shareholders, Saba Capital Management—an investment adviser and a large shareholder in the funds at issue—nominated three new trustees in connection with one of the fund’s annual meeting.  Following the meeting, the board and adviser contended that the new nominees had not received sufficient votes under the new voting threshold, resulting in litigation between the parties in the Massachusetts Superior Court.

In March of this year, Judge Salinger ruled that Saba’s claims could proceed on multiple theories that may be relevant to trustees and advisors operating under similar circumstances.  [1]

Contractual Protections May Preclude Defensive Measures

Trustees and advisors should be aware that a fund’s declaration of trust may provide contractual protections over shareholder voting rights that may preclude a board from implementing certain defensive measures.  Taking such actions anyway may give rise to breach of contract claims by shareholders.

In the Eaton Vance case, the court held that an investment company’s declaration of trust is “a contract between the trustees of the trust and the shareholders that defines the rights of the trust’s shareholders.”  Because the declaration of trust at issue provided that “[s]hareholders shall have the power to vote” in elections and that “[e]ach whole [s]hare shall be entitled to one vote,” the control share bylaw, which expressly limited the right of large shareholders to vote absent special approval, was impermissible.  Likewise, the majority-of-all-outstanding bylaw was impermissible because the new voting threshold was allegedly unachievable in light of historically low voter turnout, and thus “deprive[d] shareholders of the power to remove a trustee.”  [2]

These findings were supported not only by contractual law in Massachusetts, but also public policy.  The court noted that Massachusetts courts have long held that the “[t]he ability to nominate and elect different trustees is a crucial means for shareholders to prevent the entrenchment of poorly performing trustees.”

Fiduciary Duties May Preclude Defensive Measures Under The Circumstances

A fund board may also be precluded from implementing defensive measures by its fiduciary duties owed to shareholders if the actions are motivated more by entrenchment than legitimate interests of the fund and its shareholders.  In such a scenario, trustees should be aware that the business judgment rule may not apply to protect their discretionary actions, leaving trustees to defend their conduct on the merits (and potentially subjecting them to personal liability).

In the Eaton Vance case, the court held that Massachusetts law does not permit trustees to “act solely or primarily out of a desire to perpetuate themselves in office,” and that Saba had sufficiently “alleged facts that, if proved, would [show] that the Trustees did not act in good faith to further the best interests of the Trusts, but instead were trying to prevent Saba from voting them out solely to entrench themselves, protect their positions and the money they make off of it, and protect the [a]dviser from losing its profitable position managing the Trusts.”  Crediting these allegations, the court found “bad faith” conduct that precluded the application of the business judgment rule.

The Investment Company Act May Require Rescission Of Impermissible Bylaws

Similar to the claims above, trustees should be aware that the Investment Company Act of 1940 (the “ICA”) may also preclude the use of defensive bylaws if the bylaws conflict with an ICA provision, including Section 18(i), which provides that “every share of stock . . . shall be voting stock and have equal voting rights.”  To challenge such bylaws, shareholders may utilize Section 47(b), which creates a private right of action for investors to seek rescission of a contract that violates a provision of the ICA.  [3]

In the Eaton Vance case, the court found that the control share bylaw is a contract between the funds at issue and shareholders, and that its terms violated Section 18(i)’s requirement that all shares have “equal voting rights.”  Given that the control share bylaw eliminated Saba’s voting rights absent special permission (which, as discussed above, is effectively impossible to obtain), the bylaw ran afoul of Section 18(i).  The court reached this conclusion despite recent signals by the SEC that it has softened on the use of control share bylaws by closed-end funds.  [4]  The ruling is a reminder that the SEC’s position, by its own admission, has “no legal force or effect,” and courts will continue to apply Section 18(i) based on the particular defensive measures and board conduct at issue.  [5]

Advisers May Be Held Liable For A Board’s Defensive Measures

An adviser may face secondary liability in connection with a board’s defensive measures if the adviser is alleged to have directly participated in formulating and implementing the actions giving rise to primary liability.  However, allegations of mere awareness or tangential support will not be enough to keep an adviser in a lawsuit.

In the Eaton Vance case, the court dismissed claims for tortious interference and aiding and abetting against the adviser because Saba had not sufficiently alleged that it had “instigated, participated in, or helped to bring about the bylaw amendments” or otherwise had an “improper purpose or motive.”  Allegations that the adviser had been “fully aware of the contents and purposes of the bylaws,” as well as “conclusory allegations” that the adviser had “induced or caused the [t]rustees to breach the Declarations of Trust,” were not enough.

Nonetheless, claims against advisers may well be supported by allegations in circumstances where an adviser is clearly the driving force behind the defensive measures.  Given an adviser’s inherent financial interest in maintaining its position, the pleading bar does not appear high.  Indeed, in Eaton Vance, the fund made allegations that the adviser itself had initiated the bylaw “review” process that had resulted in the defensive measures, which were drafted by the adviser’s counsel (these allegations were not addressed in the court’s recent ruling).  Additional facts relating to these allegations may emerge in subsequent litigation, potentially permitting the court to reevaluate its ruling.

Shareholders May Pursue Claims Directly Without Making A Demand On The Board

Trustees should be aware that they may not be entitled to receive a pre-litigation demand in disputes involving shareholder voting rights, even in states like Massachusetts that have universal demand statutes.

In Eaton Vance, the court held that the claims at issue were not derivative, and did not require a demand, in light of Massachusetts precedent holding that “[w]here a shareholder seeks relief for harm caused by alleged breach of a duty ‘owed directly to them’ . . . the shareholder may bring an individual claim directly on their own behalf.”  Accordingly, it appears that nearly all voting rights disputes, as well as potentially other types of claims brought by shareholders, will fall within this category of direct claims in Massachusetts, and trustees will not have the opportunity to review the claims pre-litigation nor be afforded deference in deciding whether to pursue them.  This procedural risk calls for even more diligence on the part of trustees before implementing defensive measures that may give rise to litigation (both in consideration of their own personal liability as well as the potential expense and distraction to the fund).

Considerations Regarding The Use Of Defensive Bylaws By Closed-End Funds

In light of the Eaton Vance ruling and other recent cases involving defensive bylaws, [6] trustees should think carefully about whether the risks and uncertainties of defensive measures are outweighed by the benefits to fund shareholders.  Trustees risk personal liability for breach of fiduciary duty claims, and the affected funds risk the expense and distraction of a time-consuming public litigation.  On the other hand, the typical justifications for defensive bylaws (advanced by advisers) do not always withstand scrutiny.  For example, in the Eaton Vance case, the adviser argued that shareholder activism is “contrary to the interests of the majority of shareholders who invest in closed-end funds for the long-term returns.”  Namely, that shareholder activists often seek “tender offers (which can substantially shrink the size of the fund), liquidation of the fund (which would cause the fund to cease existing altogether), or the conversion of the fund into an open-end fund (which would change the fundamental structure and nature of the fund).”  Each of those ends, however, is aimed at reducing a closed-end fund’s discount to NAV and increasing the value of its shares for shareholders.  For example, many long-term shareholders in the funds at issue invested while the discount to NAV was smaller.  As the discount grew, those investors were robbed of the full appreciation of the value of the fund’s portfolio.  Indeed, this appears to be the basis for Saba’s engagement with the board (in addition to arguments relating to investment underperformance supported by benchmark comparisons).  Advisers routinely choose to alter, liquidate and merge funds for a broad array of reasons, and almost always obtain board support to do so.  Indeed, it is by no means unusual within the industry; hundreds of funds are liquidated and merged each year at their adviser’s whim.

Boards should consider closely whether shareholders seeking meaningful action to improve a fund’s performance or NAV discount are entitled to that relief before assuming a defensive posture.  Boards serve the interests of fund shareholders, not the adviser.  The Eaton Vance case is a reminder that the law will hold trustees to account in that regard.  Depending on the circumstances, trustees may do well to push harder on a fund’s advisor than discontent shareholders in order to avoid litigation and obtain an optimal result for the fund.

Footnotes

[1]           See Eaton Vance Senior Income Trust v. Saba Capital Master Fund, Ltd., 2021 WL 1422031 (Mass. Super. Ct. Mar. 31, 2021).

[2]           The court rejected arguments by Eaton Vance that voting rights “attach to shares, not shareholders,” noting that “[s]hares do not vote themselves” and that “by purchasing shares of the [funds], each shareholder obtains a right to vote.”  Holding otherwise would “strip the right to participate in [fund] decision making from the shareholders and give it to a disembodied share.”

[3]          See Oxford Univ. Bank v. Lansuppe Feeder, LLC, 933 F.3d 99 (2d Cir. 2019).

[4]          The SEC recently retracted its so-called Boulder No-Action Letter, 2010 WL 4630835, which previously stated an opinion that the use of control share bylaws would by inconsistent with Section 18(i) of the ICA.

[5]           Moreover, the risk of SEC review remains.  The SEC has made clear that it will continue to evaluate whether a particular fund board’s decision to implement a control share bylaw was “taken with reasonable care on a basis consistent with other applicable duties and laws and the duty to the fund and its shareholders generally.”

[6]          For example, a trial court similarly sided with shareholders in Saba Capital C E F Opportunities 1 Ltd v. Voya Prime Rate Trust, 2020 WL 5087054 (Ariz. Super. Ct. June 26, 2020).