The Value of Takeover Defenses: Evidence from Exogenous Shocks to Closed-End Mutual Funds

1. The Value of Takeover Defenses: Evidence from Exogenous Shocks to Closed-End Mutual Funds Martijn Cremers, Robert J. Jackson, Jr.* and John Morley Global Corporate Governance Colloquium University of Tokyo June 3, 2017

2. Introduction This paper contributes to longstanding debates over the value effects of takeover defenses. • Although takeover defenses like poison pills may increase managerial slack and agency costs (e.g., Gilson & Kraakman, 1989), they may also serve the socially laudable function of permitting managers to precommit to long-term investments (Lipton, 1984). • While early empirical analysis of the effects of pill adoption on firm value suggested that they were value-reducing (e.g., Jarrell & Ryngaert, 1986), those studies have been roundly (and properly) criticized as endogenous, incorrectly coded, or both (Catan & Kahan, 2016). • To study the effect of pills on value, an exogenous event is needed, Catan & Kahan show. There are some recent event studies in this area. But none on poison pills. (Directly; cf. Cremers & Ferrell, 2014.) • In this study, we present three such exogenous events, albeit in a limited context, to contribute to this debate.

3. What is a “Closed-End Fund”? Unlike the “open-ended” mutual funds you are likely more familiar with, shares in closed-end funds cannot be redeemed for cash simply by presenting the shares to the fund. • Because shares in these funds are relatively illiquid—that is, exchanging shares for cash is harder than for other funds—their shares trade at a discount to the value of the funds’ assets, or “net asset value” (“NAV”). • Previous work has shown that hostile raiders attack closed-end funds in the hope of acquiring enough shares to “open” the fund—that is, require the fund to redeem shares at NAV and liquidate any assets necessary to pay for those share redemptions. (Bradley et al., 2010; Dimson, 1999.) • To protect against this risk, closed-end funds commonly employ two types of antitakeover defenses: staggered board elections and poison pills—that is, the issuance of shares at a discount to non-activist shareholders in order to dilute activist shareholders’ stakes.

4. A Word on CEFs and Staggered Boards Although we’d hoped to find variation among CEFs in staggered-board status, we’ve learned that nearly all funds have staggered elections—or their functional equivalents. • Overall, we find that some 89% of the funds in our sample have staggered boards, in striking contrast to previous work in this area by financial economists (Souther, 2015). • The reason, we think, is the very unique corporate forms that CEFs use. Less than 70% of funds we study stagger in the usual way: through charter amendments to corporate documents. • The rest use two unique corporate-law mechanisms that have not been previously noted in the CEF literature: • Some 10% use indefinite board terms, problematic under Delaware corporate law but permissible in statutory trusts; and • Another 11% use a little-known Maryland statute that gives firms a “shadow” staggered board: directors can stagger at will.

5. Theoretical Value of Takeover Defenses Let’s begin by theorizing—both generally, and then for closed-end funds—why takeover defenses might be valuable (and, thus, valued by shareholders). General Theories Closed-End-Fund Theories • Takeover defenses allow managers to precommit to long-term investment strategies without fear that short-term inefficiencies in share prices will lead to a hostile attack (e.g., Lipton, 1984; Cremers & Sepe, 2014). • Takeover defenses allow shareholders to avoid erroneously interfering with managers’ expert judgments—and the costs that accompany those errors (Goshen & Squire, 2015). • Takeover defenses allow closed-end funds to invest in illiquid assets without fear of having to engage in a “fire sale” of those assets if an activist attempts to “open” the fund. • Relatedly, defenses allow these funds to hold less (unproductive) cash on their balance sheets in order to address the prospect of the fund suddenly being attacked and opened. • Finally, defenses allow closed-end funds to manage the realization of taxable gains more efficiently. These benefits must be balanced against the agency-cost problems that pills might exacerbate.

6. The Investment Company Act Unlike ordinary public companies, closed-end funds are subject to a federal law—the Investment Company Act of 1940—that creates unique questions about the validity of poison pills. • Section 18(d) of the Act says that funds cannot issue rights to purchase shares to investors without doing so “ratably”; pills can be interpreted to (but do not obviously) run afoul of this provision. • Section 18(d) also says that any rights issued by these funds must expire “not later than 120 days after issuance” of the right; this suggests that any pills are time-limited to 120 days, which might significantly limit their effectiveness. • Prior to 2004, practitioners in this area believed (and told their clients via Memoranda) that the tension between these provisions and the pill was not problematic—that is, that pills were legal for closed-end funds.

7. Our Setting From 2004 through 2009, however, a series of three events significantly shaped the market’s perception of the legality of poison pills in closed-end funds. Pills are allowed Pills are illegal October 29, 2004: March 30, 2007: November 12, 2009: In Neuberger v. Horejsi, the U.S. District Court for the District of Maryland, where many funds are incorporated, issues an opinion indicating that the Investment Company Act permits poison pills. More than two years later, the same Maryland district court confirms that “serial” renewals of Neuberger’s poison pill are consistent with the Investment Company Act in a brief order. Andrew J. Donohue, then Director of the SEC’s Division of Investment Management, stuns audiences at a conference in Florida by declaring in a speech that the Commission’s view is that pills violate the Investment Company Act, leading to a chaotic scene. We also have anecdotal evidence that the third event—by far, our cleanest—was important to funds themselves, as dozens of funds immediately adopted staggered boards after Donohue’s speech.

8. Our Data We use two methods to measure closed-end fund returns around each of our four events—controlling carefully for each fund’s “style,” or the type of assets it invests in. • We include all publicly traded closed-end funds and hand-match each fund to the Morningstar database, which allows us to determine its style. We then identify each fund’s stated benchmarks—that is, the indices the fund compares its performance to. • We then compute two measures of fund returns: first, benchmark-adjusted returns (fund return minus benchmark return), and second, abnormal returns, calculated by using the benchmarks in a factor model. • We evaluate fund returns, by style, across all four of our events, using event windows ranging from [0,1] to [0,3]. • We also examine changes in fund discounts to NAV, calculating discount to NAV as price – NAV, such that (more) negative values mean (greater) discounts to NAV.

9. Event Studies and Closed-End Funds Before I show you the event-study results, I should confess that the literature in this area raises serious questions about the validity of this method in the closed-end fund context, which is why we’re going to offer a number of robustness checks. • Lee, Shleifer, and Thaler (1991) argue that closed-end funds are overwhelmingly held by individual investors, and that CEF returns reflect shifts in individual-investor sentiment (although this view is contested, Cherkes, Sagi, and Stanton (2007)). • Pontiff (1997) separately shows that the variance in CEF share prices far exceeds the variance in the pricing of the underlying assets in the fund, suggesting at least a partially behavioral suggestion for price movements. • So we should interpret event-study evidence in this area, such as that on the slides that follows, very cautiously.

10. Results: How Do Share Prices React to These Events? Nevertheless, we show reasonably consistent evidence, across specifications, pricing models, and even in NAV discounts, that investors in closed-end funds, in general, like the poison pill.* * Note that discount to NAV is calculated in percentage terms, i.e., as (price – NAV) divided by NAV, such that discounts are reflected in negative values.

11. Results: How Do Share Prices React to These Events? We also show that these results are especially robust in funds that focus on municipal bonds—consistent with our thesis about the relevance of the liquidity of the underlying assets. * Note that discount to NAV is calculated in percentage terms, i.e., as (price – NAV) divided by NAV, such that discounts are reflected in negative values.

12. Longer-Run Results In an effort to address the questions raised by short-run event studies, we borrow from Bradley et al. (2010) and perform the following analysis on longer-run effects on NAV discounts. These tests leave me skeptical about the value-relevance of the first and second events—and more confident about the importance of the third, cleanest, event.

13. But Wait: Proxy Fights and Value Effects When we evaluate the sample on the basis of firms that have previously had challenges to the management’s strategy, however, we see a very different story.

14. But Wait, Part Two: Activists and Value Effects When we evaluate the sample on the basis of firms that have previously had challenges to the management’s strategy, however, we see a very different story.

15. Conclusion We have several questions about this paper—which, we hope, Emiliano and all of you will help us to answer. • On the one hand, studying closed-end funds is both theoretically and methodologically problematic. On the other, the law of these firms offers a (very) rare methodological opportunity to assess the value implications of takeover defenses. • It is also difficult to know whether these results are in any way generalizable given the unique investor base and corporate structure of these funds. It is not, however, difficult to predict how the various players in the war over pills will deploy the results for their purposes. • Most fundamentally to our enterprise: are these the kinds of results worth pursuing? (Sartre, 1943.) And is our current frame—around the exogenous nature of our events—the right one for the paper?

16. The Value of Takeover Defenses: Evidence from Exogenous Shocks to Closed-End Mutual Funds Martijn Cremers, Robert J. Jackson, Jr.* and John Morley Global Corporate Governance Colloquium University of Tokyo June 3, 2017