Alert December 01, 2009

Director of SEC Division of Investment Management Speaks at Independent Directors Council Conference

The Director of the SEC’s Division of Investment Management, Andrew J. Donohue, spoke at the November Independent Directors Council Investment Company Directors Conference.  His speech examined issues regarding (1) recapture arrangements included in expense limitations implemented by mutual fund advisers; (2) managed distribution plans for closed-end funds; (3) fund mergers; (4) fulcrum fees; and (5) the use of certain anti‑takeover tactics by closed-end funds.  A brief overview of Mr. Donohue’s remarks with respect to each of these topics follows. 

Expense Recapture.  Mr. Donohue discussed the practice of “expense recapture” as a part of undertakings by advisers to limit the expenses of funds they manage.  Under an expense recapture, once fund expenses fall below the level of the expense limitation, the fund’s adviser becomes entitled to be reimbursed by the fund for the fees it waived and the expenses it paid in maintaining the expense limitation, with the amount of reimbursement determined  by the extent to which the fund’s expenses fall below the expense limitation threshold.  Mr. Donohue cautioned that the SEC staff has taken the position that when an adviser increases an expense limitation after the initial year of a fund’s operations, the adviser may only recapture waived fees in accordance with the original recapture arrangements with the fund.  “A subsequent increase in the expense cap does not create an opportunity for the adviser to recapture waived fees from a previous period that are below the higher cap,” he observed.

Mergers.  Mr. Donohue cautioned fund directors to be vigilant when reviewing merger proposals.  He cited a number of considerations in the closed-end fund context, focusing on issues related to the existence of any discounts for the funds involved in a merger.  More broadly, he referenced issues such as a merger’s impact on investment strategy, post-merger expense levels and tax consequences.  He also called attention to the accounting survivor analysis that determines the performance record of the surviving entity: “In some cases, it appears to Division staff that a newer fund or the fund that was chosen to be the accounting survivor had only a few months of operations, had net assets that were much smaller than the target, and that the shareholders were affiliated with the adviser. In contrast, the fund that was being merged away had a significantly longer track record, much more assets and its shareholder base was not made up of affiliated entities. However, due to market declines, particularly those experienced in 2008, the merged away fund's performance was very poor.”  

Fulcrum Fees.  Mr. Donohue emphasized that fund directors should understand the calculation and ramifications of a fulcrum fee before approving such an arrangement.  He noted that “a fulcrum fee is a performance based fee that an adviser charges a fund when the adviser achieves a return above a certain benchmark”, indicating that such an arrangement can be beneficial to the extent it aligns the adviser’s and shareholders’ interests.  Rule 205-2 under the Investment Advisers Act of 1940 requires the incentive portion of a fulcrum fee be calculated using the fund’s average net assets over a rolling performance measurement period.  However, Rule 205-2 also provides the fund with the option either to apply the rate to the average net assets over the rolling measurement period or to apply the rate to current level average net assets, i.e., the “most recent sub-period” which represents the period between payments. “Once the fund has selected which option to apply it must be applied consistently”, said Donohue.  He observed that many fulcrum fee structures opt to pay the adviser with the base portion of the fee being calculated on current level net assets, as permitted by the rule.  He then cautioned that “[w]hat advisers sometimes fail to realize, however, is that when the base fee is calculated on current level net assets, the adviser runs the risk of having to reimburse the fund when there is a significant decline in assets coupled with poor performance.”  He explained that the SEC staff had seen certain structures attempting to limit an adviser’s downside risk by implementing a “floor total fee.”  He indicated that “[t]he problem with this approach, however, is that a floor only limits the downside without proportionally limiting the adviser’s upside.  As such, a floor is not permissible because the incentive adjustments must be symmetrical — hence the term ‘fulcrum.’”

Managed Distribution Plans.  Mr. Donohue emphasized the importance of adequate disclosure regarding distributions for closed-end funds that maintain managed distribution plans designed to provide a predictable distribution rate.  He emphasized that investors should receive disclosures that enable them to understand such a strategy involves the risk that they will receive returns of capital.  He also noted the importance of explaining any discrepancies between disclosures in the explanatory notices that accompany distributions as required by Rule 19a-1 and other fund disclosures about distributions, e.g., those on fund websites.  He also urged that funds make an effort to ensure that Rule 19a-1 notices regarding distributions reach the beneficial holders of fund shares, not just the financial intermediaries that hold fund shares of record on their behalf.

Closed-End Fund Anti-Takeover Measures.  Mr. Donohue discussed certain tactics that closed-end funds employ to discourage takeovers.  Mr. Donohue acknowledged that certain tactics and strategies in this regard may be in the interest of a fund’s long-term investors, but appeared generally skeptical of the appropriateness of the various anti-takeover measures he discussed.

Mr. Donohue first addressed the adoption of a “shareholder rights agreement”, commonly referred to as a “poison pill.”  Mr. Donohue called into question whether the use of poison pills was consistent with Section 18 of the Investment Company Act of 1940 (the “1940 Act”), particularly whether a poison pill constitutes a “ratable” issuance that would fit within Section 18(d)’s parameters for the issuance of warrants.  If a poison pill were not a ratable security, he observed that a fund would not be able to comply with the terms of Section 23(b) of the 1940 Act governing the sale of closed-end fund shares at less than net asset value.  Second, Mr. Donohue discussed reliance on state law provisions that restrict the voting rights of a person deemed to own “control shares” of a closed-end fund, i.e., shares owned in excess of a designated proportion of outstanding shares such as 10%.  In his view, restrictions on a shareholder’s ability to vote shares based on the number of shares owned was “likely inconsistent” with Section 18(i) of the 1940 Act.  In conjunction with his remarks on poison pills and shareholder rights agreements, Mr. Donohue noted that a federal district court in Maryland has held that a closed-end fund's serial use of poison pills was valid and consistent with the 1940 Act, and that a dissident shareholder's ability under the Maryland control shares statute to vote its control shares was capped at the number of shares the shareholder held at the time that the fund opted into that statute.

Mr. Donohue expressed doubt about the appropriateness of three other tactics related to director elections, also typically having their basis in a fund’s by-laws.  In the first, directors use their ability to change the date of shareholder meetings to postpone annual meetings, thereby delaying an insurgent shareholders ability to exercise its voting power to elect new directors.  In the second, a fund adopts a requirement that director elections be by an affirmative vote of a majority of outstanding shares so that when neither incumbents nor insurgents receive the required vote, the incumbents hold over under the law of the fund’s state of organization.  In the third, a fund board adopts a requirement that directors must have certain qualifications, while exempting existing directors.  Closing his remarks on the topic of anti-takeover measures, Mr. Donohue advised a board considering whether to adopt such various measures that “[t]he question you must always ask yourself is not just whether the action is legal under state and federal law, but whether it is truly in the best interests of fund shareholders.”