On April 8, the Securities and Exchange Commission adopted rule and form amendments to modify the registration, communications, and offering processes for business development companies and other closed-end funds under the Securities Act of 1933. Among other things, the amendments are expected to facilitate CEFs’ ability to offer their shares to the public. On May 27, the staff of the SEC’s Division of Investment Management issued a statement withdrawing a previous letter that interpreted Section 18(i) of the Investment Company Act of 1940 as pre-empting the ability of CEFs to opt into state law control share acquisition statutes.
Control share statutes typically enable a company to prevent or restrict certain changes in control by altering or removing voting rights when a person acquires, directly or indirectly, the ownership of, or the power to direct the vote of, control shares as defined in the specific control share statute. The IM statement replaces the withdrawn letter with no-action relief if a CEF opts-in to and triggers a control share statute as long as the CEF board’s decision to do so was taken with reasonable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.
The CEF offering reforms and the IM statement may create incentives that will reverse the decline in the number of listed CEFs over the past nine years. In particular, CEFs may become increasingly attractive to sponsors as it becomes faster, simpler, and less expensive for a CEF to issue its shares, and as a CEF is no longer automatically precluded from relying upon a control share statute. However, these developments create their own set of challenges for CEF boards. We examine some of the challenges created and how a CEF board may wish to respond to these challenges.
The amendments to the registration process are intended to allow CEFs to offer and sell securities “off the shelf” more quickly and efficiently in response to market opportunities.
The SEC’s amendments will permit CEFs to file short-form registration statements on Form N-2. While a CEF can file a short-form registration statement to register a shelf offering, other types of offerings will also be eligible for short-form registration statement filings. In general, a CEF that has timely filed its periodic reports, has been registered under the 1940 Act for at least 12 months operating history, and has a public float of at least $75 million will be eligible to file a short-form registration statement.
In addition, CEFs that qualify as well-known seasoned issuers (WKSIs)—a CEF that is current and timely in its reporting and generally has at least $700 million in public float—will be able to file automatic shelf registration statements. A WKSI can register unspecified amounts of different types or classes of securities, and the automatic shelf registration statement and any amendments to the registration statement will be effective immediately upon filing.
The SEC intends for WKSI CEFs to avail themselves of the flexibility to take advantage of market windows, structure terms of securities on a real-time basis to accommodate investor demand, and determine or change the plan of distribution in response to changing market conditions.
How do these reforms affect a CEF board?
A good place to begin the analysis is by examining Section 23(b) of the 1940 Act. That section generally prohibits a CEF from selling its shares at a price below its net asset value per share unless it conducts a rights offering. However, a majority of listed CEFs—both equity and fixed income—generally trade in the secondary market at a discount to their NAV. Because an offering at or above NAV would fail if investors could purchase shares in the secondary market at a discount to NAV, and because the offering reforms do not contemplate rights offerings, a typical CEF that would seek to take advantage of the offering reforms would presumably do so during narrow windows of opportunity when its shares are trading at a premium to its NAV.
That, in turn, takes us to the CEF’s valuation policies. Valuation of fund assets has been a larger area of focus for open-end funds (mutual funds) than for CEFs, but a CEF that does not wish to run afoul of Section 23(b) must ensure that its assets are accurately valued. This can pose a challenge because CEFs, unlike mutual funds, do not have limits on the amount of net assets that can be invested in illiquid investments. Although there is not a direct correlation between the liquidity of an investment and the manner of its valuation for purposes of the U.S. generally accepted accounting principles fair value hierarchy, CEFs tend to invest a far higher percentage of their assets in securities and other assets that are valued using Level 2 or Level 3 inputs than do mutual funds. Because the SEC views investments valued using Level 2 or Level 3 inputs as investments that would be valued in good faith by a fund’s board, a board of a CEF that wishes to engage in shelf offerings during instances in which its shares are trading at a premium to NAV will need to satisfy itself that its valuation policies utilize proper methodologies for valuing these investments, and that the methodologies are being properly applied.
Another area of focus for a CEF board will be a CEF’s policies and procedures governing its filings and advertising. The SEC amendments will permit CEFs to use many new and expanded forms of communication, including:
- “tombstone ads,” or advertisements publishing factual information about the CEF or the offering;
- free-writing prospectuses;
- communications without risk of violating the gun-jumping provisions until 30 days prior to filing a registration statement; and
- publication and dissemination of regularly released factual and forward-looking information, including around the time of a registered offering.
Recall that Rule 38a–1 under the 1940 Act requires fund boards to adopt written policies and procedures reasonably designed to prevent the fund from violating federal securities laws. The SEC release adopting Rule 38a-1 noted that compliance policies and procedures should address the accuracy of disclosures made to investors, clients and regulators. Given the scope of changes to type and manner of permitted communications, as well as the liability associated with those communications, a CEF board should actively engage with the CEF’s investment adviser, underwriter, and other service providers. The board should aim to assure itself that personnel at these providers understand the import of these changes as they pertain to the CEF, and that changes to the CEF’s compliance procedures designed to take advantage of the SEC’s communication reforms continue to be reasonably designed to prevent the fund from violating federal securities laws.
Control Share Statutes
As noted above, IM will no longer recommend enforcement action against a CEF under Section 18(i) of the 1940 Act for opting-in to and triggering a control share statute if the decision to do so by the CEF’s board “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.” The IM statement cautioned market participants “that any actions taken by a board of a fund, including with regard to control share statutes, should be examined in light of (1) the board’s fiduciary obligations to the fund, (2) applicable federal and state law provisions, and (3) the particular facts and circumstances surrounding the board’s action.” (emphasis added)
The IM statement then specifically requested feedback from market participants regarding certain issues, including:
- What considerations would a fund’s board take into account in determining whether to opt-in to and trigger a control share statute, particularly with regard to benefits to shareholders and compliance with the board’s fiduciary duty? Under what specific facts and circumstances would a board decide to opt-in to and trigger a control share statute (or decline to do so)?
- Apart from Section 18(i), which turns on the meaning of “equal voting rights,” explain whether the ability to opt-in to and trigger a control share statute would have a practical or functional impact on a fund’s compliance with other provisions of the federal securities laws, such as Section 12(d)(1)(E) of the 1940 Act, which requires pass-through or mirror voting for certain fund-of-funds arrangements, or Rule 13d-1 under the Securities Exchange Act of 1934, which limits the ability of certain shareholders to vote based on the size of their holding.
- Should IM recommend that the SEC address the ability of a CEF to opt-in and trigger a control share statute in accordance with Section 18(i)?
The IM statement did not specifically seek comment on the possible impact of a CEF opting into a control share statute on any premium or discount from its NAV. While one request does focus on considerations that a CEF’s board would take into account in determining whether to opt-in to and trigger a control share statute, particularly with regard to benefits to shareholders and compliance with the board’s fiduciary duty, it is curious that a factor that is as important to listed CEF shareholders as premium or discount to NAV is not explicitly recognized.
Notwithstanding the SEC’s failure to do so, it seems prudent for boards to consider factors such as fund performance and actions that fund management has taken, or proposes to take, to mitigate or eliminate persistent discounts to NAV, in determining whether to invoke a control share statute. Given that independent board members face a conflict between their pecuniary interest in continuing to collect payments for service as board members and their fiduciary obligations to shareholders, a fully developed record that recognizes the conflict and that shows that the board took steps to mitigate the conflict (such as seeking the advice of disinterested experts) should help to protect the board’s decision in the event that it is later challenged.
In 1998, the SEC proposed far-reaching reforms of the securities offering process for operating companies, which was called the Aircraft Carrier. Eventually, most aspects of the Aircraft Carrier release foundered, and while the SEC adopted significant reforms in 2005, CEFs were left behind. To our knowledge, no one has used any nautical terminology to describe the disclosure reforms that the SEC adopted for CEFs. Nonetheless, these reforms are quite significant and will extend many of the 2005 reforms to CEFs. It is reasonable to predict that these offering reforms, together with the staff’s recent determination to withdraw its prior position prohibiting CEFs from opting into state anti-takeover statutes, will increase the attractiveness of CEFs to investment advisers. However, these reforms may create a new set of challenges for CEF boards—challenges which may not be obvious at first blush but can be traps from the unwary board member.
Ethan Corey has spent 22 years as an investment management lawyer and has deep knowledge and expertise in distribution issues (including FINRA rules) as well as 1940 Act and Advisers Act issues. Before joining Practus, Ethan was a senior vice president and associate general counsel at MFS Investment Management in Boston, where he oversaw global regulatory initiatives and supervised the MFS Legal Department's Distribution, Regulatory and Corporate Group. He also served as counsel at Dechert LLP and senior counsel at the Division of Investment Management at the SEC.
 Securities Offering Reform for Closed-End Investment Companies, Investment Company Act Rel. No. 33836 (Apr. 8, 2020), 85 FR 33290 (June 1, 2020) (Adopting Release).
 Control Share Acquisition Statements, Staff Statement, Division of Investment Management (May 27, 2020) (https://www.sec.gov/investment/control-share-acquisition-statutes) (visited Aug. 7, 2020).
 See id., at n. 15.
 An illiquid investment is defined in Rule 22e-4 under the 1940 Act as an “investment that cannot be sold or disposed of in seven calendar days or less without the sale or disposition significantly changing the market value of the investment.”
 Good Faith Determinations of Fair Value, Investment Company Act Rel. No. 33845 (Apr. 21, 2020), 85 FR 28734, 28755 (May 13, 2020) . Level 1 inputs are “quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can assess at the measurement date.” Level 2 inputs are “inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.’’ Level 3 inputs are “unobservable inputs for the asset and liability.” Id., at n. 209.
 “Free writing prospectuses” are written communications (other than statutory prospectuses) that constitute offers to sell or solicitations of offers to buy securities.
 The “gun-jumping provisions” in the Securities Act restrict the types of offering communications that issuers or other parties subject to the Securities Act’s provisions may use in connection with a registered public offering. The gun-jumping provisions were intended to make the statutorily mandated prospectus the primary means for investors to obtain information regarding a registered securities offering. Adopting Release, supra note 1, 85 FR at 33306.
 Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act Rel. No. 26299 (Dec. 17, 2003), 68 FR 74714, 74716 (Dec. 24, 2003).
 We examine this development in more detail in our Legal Insight: SEC Staff Withdraws Prior No-Action Letter on Control Share Acquisition Statutes, Requests Feedback on Control Share Statutes and Closed-End Funds.