File No. 812-13598
Before the
U.S. SECURITIES AND EXCHANGE COMMISSION
----------
In the Matter of Application
of
FLAHERTY & CRUMRINE PREFERRED INCOME FUND INCORPORATED
FLAHERTY & CRUMRINE PREFERRED INCOME OPPORTUNITY FUND INCORPORATED
FLAHERTY & CRUMRINE/CLAYMORE PREFERRED SECURITIES INCOME FUND INCORPORATED
FLAHERTY & CRUMRINE/CLAYMORE TOTAL RETURN FUND INCORPORATED
301 E. Colorado Boulevard
Suite 720
Pasadena, CA 91101
FIRST AMENDED AND RESTATED APPLICATION FOR
AN ORDER PURSUANT TO SECTION 6(c) OF THE
INVESTMENT COMPANY ACT OF 1940 FOR AN EXEMPTION
FROM CERTAIN PROVISIONS OF SECTION 18(a)(l)
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March 23, 2009
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Please direct all communications
regarding this Application to: Copies to:
Donald F. Crumrine Rose F. DiMartino
Chairman Mary C. Carty
Flaherty & Crumrine Incorporated Willkie Farr & Gallagher LLP
301 E. Colorado Boulevard 787 Seventh Avenue
Suite 720 New York, NY 10019-6099
Pasadena, CA 91101 (212) 728-8000
(626) 795-7300
This document contains 48 pages (including exhibits),
which have been numbered sequentially.
UNITED STATES OF AMERICA
BEFORE THE U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------------------------
) First Amended and Restated Application
IN THE MATTER OF ) for an Order pursuant to Section 6(c)
) for an Exemption from Certain
) Provisions of Section 18(a)(l) of the
FLAHERTY & CRUMRINE PREFERRED ) Investment Company Act of 1940, as
INCOME FUND INCORPORATED; FLAHERTY ) amended
& CRUMRINE PREFERRED INCOME )
OPPORTUNITY FUND INCORPORATED; )
FLAHERTY & CRUMRINE/CLAYMORE )
PREFERRED SECURITIES INCOME FUND )
INCORPORATED; and FLAHERTY & )
CRUMRINE/CLAYMORE TOTAL RETURN FUND )
INCORPORATED )
)
301 E. Colorado Boulevard )
Suite 720 )
Pasadena, CA 91101 )
--------------------------------------
Flaherty & Crumrine Preferred Income Fund Incorporated ("PFD"), Flaherty &
Crumrine Preferred Income Opportunity Fund Incorporated ("PFO"), Flaherty &
Crumrine/Claymore Preferred Securities Income Fund Incorporated ("FFC") and
Flaherty & Crumrine/Claymore Total Return Fund Incorporated ("FLC")
(collectively, the "Applicants") hereby apply for an order (the "Order") of the
U.S. Securities and Exchange Commission (the "Commission") pursuant to Section
6(c) of the Investment Company Act of 1940, as amended (the "1940 Act"),
granting an exemption from Section 18(a)(1)(A) of the 1940 Act to the extent
necessary to permit each Applicant, for a period from the date of the Order
until October 31, 2010, the option to refinance all or a portion of its auction
preferred shares ("APS Shares") issued prior to February 1, 2008 that are
outstanding as of the date of the Order (the "Order Date") by issuing or
incurring
2
an equivalent amount of debt (such issuing or incurring to be referred to as
"borrowing" for purposes of this Application) subject to "asset coverage" (as
defined in Section 18(h) of the 1940 Act) of 200% (rather than the asset
coverage of 300% ordinarily applicable to a senior security constituting
indebtedness under Section 18(a)(1)(A) of the 1940 Act). In addition, the
Applicants request that the Order grant an exemption from Section 18(a)(1)(B) of
the 1940 Act so that each Applicant may, in connection with the borrowings
referred to above and to the extent that compliance with Section 18(a)(1)(B) is
not excused in the circumstances by Section 18(g) of the 1940 Act, make
provision to prohibit the declaration of dividends or distributions and the
purchase of its capital stock (including its APS Shares) unless, at the time of
any declaration or purchase, after deducting the amount of such dividend,
distribution or purchase price, it has an asset coverage of at least 200%
(rather than the asset coverage of 300% ordinarily required for such
declarations and purchases under Section 18(a)(1)(B) of the 1940 Act).
Each Applicant's borrowings which are the subject of this exemptive
application would be subject to such Applicant's being able to successfully
increase its current borrowings, for those Applicants which have current
borrowings, by drawing against existing committed borrowing facilities (or
negotiating new agreements with other acceptable counterparties) and, for those
Applicants which do not have current borrowings, negotiating agreements with
acceptable counterparties and approval of such arrangements, as necessary, by
the Applicant's board of directors ("Board"), among other actions. The
Applicants can provide no assurance that if the Commission grants the
3
Order, the Applicants will be able to redeem any or all of their outstanding APS
Shares through borrowing.
For the purposes of the Order, references to the Applicants' refinancings
refer solely to any refinancing of post-Order debt entered into for the purpose
of redeeming APS Shares outstanding at the time Applicants entered into such
post-Order debt. Applicants will comply with the conditions of the Order in
connection with any such refinancings of post-Order debt.
I. THE APPLICANTS
The Applicants are registered under the 1940 Act as closed-end management
investment companies and are advised by Flaherty & Crumrine Incorporated (the
"Adviser" or "Flaherty & Crumrine"). Flaherty & Crumrine Preferred Income Fund
Incorporated (NYSE: PFD). PFD was incorporated as a Maryland corporation on
December 10, 1991, and commenced operations on February 13, 1992 as a
diversified, closed-end management investment company under the 1940 Act. PFD's
investment objective is to provide its common shareholders with high current
income consistent with the preservation of capital. The Fund pursues its
investment objective by investing at least 80% of the Fund's total assets in a
diversified portfolio of preferred securities. Up to 25% of the Fund's total
assets may be invested in securities rated below investment grade (but not below
Ba3 and BB- at the time of purchase), provided the issuer has investment-grade
senior debt outstanding.
Flaherty & Crumrine Preferred Income Opportunity Fund Incorporated (NYSE:
PFO). PFO was incorporated as a Maryland corporation on December 10, 1991, and
4
commenced operations on February 13, 1992 as a diversified, closed-end
management investment company under the 1940 Act. PFO's investment objective is
to provide its common shareholders with high current income consistent with the
preservation of capital. The Fund pursues its investment objective by investing
at least 80% of the Fund's total assets in a diversified portfolio of preferred
securities. Up to 25% of the Fund's total assets may be invested in securities
rated below investment grade (but not below Ba3 and BB- at the time of
purchase), provided the issuer has investment-grade senior debt outstanding.
Flaherty & Crumrine/Claymore Preferred Securities Income Fund Incorporated
(NYSE: FFC). FFC was organized as a Maryland corporation on May 23, 2002, and is
registered under the 1940 Act as a non-diversified, closed-end management
investment company. FFC's investment objective is high current income for
holders of its common stock consistent with preservation of capital. The Fund
pursues its investment objective by investing at least 80% of the Fund's total
assets in a diversified portfolio of preferred securities. Up to 20% of the
Fund's total assets may be invested in securities rated below investment grade
(but not below Ba3 and BB- at the time of purchase), provided the issuer has
investment-grade senior debt outstanding.
Flaherty & Crumrine/Claymore Total Return Fund Incorporated (NYSE: FLC).
FLC was organized as a Maryland corporation on June 23, 2003, and is registered
under the 1940 Act as a diversified, closed-end management investment company.
FLC's primary investment objective is high current income for holders of its
common stock. The Fund's secondary investment objective is capital appreciation.
FLC pursues its
5
investment objectives primarily by investing in a diversified portfolio of
preferred securities and other income-producing securities consisting of various
debt securities. Up to 20% of the Fund's total assets may be invested in
securities rated below investment grade (but not below Ba3 and BB- at the time
of purchase), provided the issuer has investment-grade senior debt outstanding.
Each Applicant has issued and outstanding a class of common shares and a
class of one or more series of APS Shares.
6
II. THE APS SHARES LIQUIDITY ISSUES
THE APPLICANTS' APS SHARES AND USE OF INVESTMENT LEVERAGE
The Applicants issued their APS Shares for purposes of investment leverage
to augment the amount of investment capital available for use in the pursuit of
their investment objectives. Through the use of leverage, the Applicants,
similar to other closed-end funds in the industry, seek to enhance the
investment return available to the holders of their common shares by earning a
rate of portfolio return (which includes the return obtained from securities
that are purchased from the proceeds of APS Share offerings and, for FFC and
FLC, the proceeds of borrowings) that exceeds the dividend rate that the
Applicants pay to the holders of the APS Shares and the interest rates paid by
FFC and FLC to their credit provider, as the case may be. Historically, the
Applicants have generally achieved this goal of enhancing the return to their
common shareholders by leveraging through the issuance of APS Shares, the return
related to which was positive in the context of the amount of dividends paid to
the holders of the APS Shares at a market clearing rate, as described below.
The APS shareholders of FFC and FLC are entitled to receive a stated
liquidation preference amount of $25,000 per share (plus any accumulated but
unpaid dividends) in any liquidation, dissolution or winding up of the relevant
Applicant, before any distribution or payment to holders of the Applicant's
common shares. The APS shareholders of PFD and PFO are entitled to receive a
stated liquidation preference amount of $100,000 per share (plus any accumulated
but unpaid dividends) in any liquidation, dissolution or winding up of the
relevant Applicant, before any distribution or
7
payment to holders of the Applicant's common shares. Dividends declared and
payable on the APS Shares have a similar priority over dividends declared and
payable on the Applicant's common shares. In addition, for each of PFD and PFO,
if the Applicant allocates any net gains or income ineligible for the dividends
received deduction to APS Shares, the Applicant is required to make additional
distributions to APS shareholders or to pay a higher dividend rate in amounts
needed to provide a return, net of tax, equal to the return had such originally
paid distributions been eligible for the dividends received deduction. The APS
Shares are "perpetual" securities and are not subject to mandatory redemption by
an Applicant so long as the Applicant meets certain asset coverage tests
specified in its Articles Supplementary setting forth the rights and preferences
of its APS Shares. Each Applicant is currently in compliance with applicable
asset coverage requirements. The Applicant funds are structured so that APS
Shares are redeemable at the applicable Applicant's option, provided that
certain procedural provisions of the Articles Supplementary are followed.
Under market conditions as they existed prior to February 2008, dividend
rates on the APS Shares for each dividend period (every 49 days for PFD and PFO
and either weekly or every 28 days for series of APS Shares of FFC and FLC) were
set at the market clearing rate determined through an auction process maintained
and administered by unaffiliated broker-dealers that brought together bidders,
who sought to buy APS Shares, and holders of APS Shares, who sought to sell
their APS Shares. Each Applicant's Articles Supplementary provide that, if an
auction fails to clear (because of an imbalance of sell orders over bids), the
dividend payment rate over the next dividend
8
period is set at a specified maximum applicable rate (the "Maximum Rate"),
determined in accordance with the Articles Supplementary, and as disclosed by
each Applicant in its offering documents. Under the Articles Supplementary, the
Maximum Rate is determined by reference to a short-term market interest rate
(i.e., a commercial paper rate). An unsuccessful auction is not a default under
the terms of the Articles Supplementary. In the case of a failed auction and
pursuant to the applicable Articles Supplementary, the relevant Applicant
continues to pay dividends to all holders of APS Shares, but at the specified
Maximum Rate rather than a market clearing rate. The Applicants experienced no
unsuccessful auctions prior to February 2008.
AUCTION FAILURES
Consistent with patterns in the broader market for auction rate securities,
beginning in February 2008 the Applicants have experienced unsuccessful auctions
for their outstanding APS Shares due to an imbalance between buy and sell
orders. As a result, the holders of those APS Shares who desired to sell their
shares at auction have been unable to do so for approximately a year (unless
redeemed through the sale of portfolio securities or redeemed and replaced with
borrowings). During this period where auctions have been unsuccessful,
Applicants have paid the Maximum Rate to holders of their APS Shares.
THE EFFECT OF AUCTION FAILURES
Prior to the failure of the auction market, if investors did not purchase
all of the auction rate securities tendered for sale at an auction, dealers
would enter into the auction
9
and purchase any excess auction rate securities to prevent the auction from
failing. Dealers provided this liquidity using their own balance sheets, even
though they had not entered into any agreements requiring them to do so. In
2008, many financial institutions were required to take substantial write-downs
on investments held on their balance sheets due, in part, to the slowdown of the
real estate market and the sub-prime mortgage crisis. As a result of these
events and other pressures, these financial institutions stopped participating
in auction rate security auctions in February 2008. The failure of a few auction
rate security auctions (including some in which only a few Auction rate
securities were not purchased) had a severe effect on investor sentiment and all
the auction rate security auctions soon thereafter failed. The Applicants
believe that after the first auction rate security auction failures, retail
investors became increasingly concerned that they would not be able to sell
their auction rate securities, and then sought to sell auction rate securities
EN MASSE, exacerbating the imbalance between buyers and sellers and making it
increasingly unlikely that the auction markets could function normally.
The auction markets for auction rate securities of the kind issued by the
Applicants are not currently functioning, and the Applicants believe that such
auction markets are unlikely to return to normalcy in the foreseeable future. If
any financial institution were to enter into an auction for auction rate
securities as dealers had prior to February 2008, the current holders of APS
Shares may well attempt to sell their APS Shares all at once. As there is no
current mechanism (other than the auction process) that provides a financial
institution with the ability to dispose of auction rate securities it acquires,
the Applicants do not believe it is likely that any financial institution will
10
attempt to provide liquidity to the current auction rate securities market. The
Applicants also believe that an established secondary market for auction rate
securities does not exist today that would assure that holders of APS Shares
would receive the liquidation preference of $25,000 or $100,000 per share, as
the case may be (although some financial institutions have offered to repurchase
auction rate securities from their customers, either voluntarily or as part of a
regulatory settlement). In the limited secondary market that has developed for
auction rate securities, auction rate securities have traded at a substantial
discount.(1)
THE HARM TO HOLDERS OF APS SHARES
The Applicants' registration statements disclosed, among other things, the
possibility that the APS Shares might not trade through the auction process and
might be illiquid. The holders of APS Shares may have anticipated liquidity
based on the history of the auction market (prior to February 2008) for various
auction rate securities, including those issued by municipalities and registered
closed-end investment companies, which had previously functioned normally. In
light of this history, it may be reasonable to assume that the holders of
auction rate securities, including the holders of the Applicants' APS Shares,
believed that these securities were highly liquid. In addition, since February
of 2008 it has been reported that many retail investors were advised by their
brokers and financial advisers that auction rate securities were short-term and
highly
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(1) Applicants understand that the relatively limited secondary market trading
that has occurred in auction preferred shares of closed-end funds since the
failure of the auction markets has been conducted at significant discounts.
SEE, E.G., Aaron Pressman, "Auction-Rate Securities: How to Get Unstuck,"
BUSINESS WEEK (June 2, 2008).
11
liquid, were an attractive alternative to other short-term investments because
of their somewhat higher yield, and in many situations the equivalent of
cash.(2)
The Applicants understand that some brokers and financial advisers
recommended that their customers invest their short-term cash balances in
auction rate securities of several different issuers, each with a scheduled
weekly auction on a different day of the week, so that the customers would have
ready access on any business day to a portion of their short-term cash
portfolio. The majority of each Applicant's APS Shares are held of record in
broker "street name" or other nominee accounts, and the Applicants therefore
generally do not have specific knowledge of the identity of the beneficial
owners of their APS Shares.(3)
As the auction process is no longer functioning and no established
secondary market exists that would provide APS shareholders with the liquidation
preference of either $25,000 or $100,000 per share, as the case may be, there is
currently no reliable mechanism for holders of auction rate securities,
including the Applicants' APS
----------
(2) Auction rate securities do not offer daily liquidity, like a money market
fund or a demand deposit account, and consequently ordinarily have provided
a somewhat higher yield.
(3) Other than as indicated later in this Application, the only information
available to the Applicants regarding record or beneficial ownership of the
Applicants' APS Shares is based on filings made on Schedule 13G under the
Securities Act of 1934 by certain entities, as set forth below.
AGGREGATE PERCENTAGE
SHARES SHARES
APPLICANT AS OF REPORTING PERSON OWNED OWNED
--------- ---------- ---------------- --------- ----------
PFD 01/31/2009 UBS AG 31 6.47%
FLC 12/31/2008 Morgan Stanley & Company Incorporated (broker 355 12.7%
dealer)
12/31/2008 Merrill Lynch, Pierce, Fenner & Smith, Incorporated 203 12.8%
PFD 01/31/2009 UBS AG 31 6.47%
PFO 01/30/2009 Bank of America Corporation 213 37%
01/30/2009 Merrill Lynch, Pierce, Fenner & Smith, Inc. 7 1.2%
01/30/2009 Banc of America Securities LLC 206 35.8%
FFC 01/30/2009 Bank of America Corporation 708 17.6%
12
shareholders, to obtain liquidity.(4) The Applicants believe that,
industry-wide, the current lack of liquidity is causing distress for a
substantial number of APS shareholders and creating severe hardship for many
investors. Some holders of these securities have said they will have difficulty
making college tuition payments, or paying their federal and state taxes.(5)
Certain small companies that purchased these securities to manage cash on a
short term basis are unable to pay their bills and may file for bankruptcy as a
result.(6) One specific example of a hardship suffered came to light when
Claymore Securities, Inc., the servicing agent for FFC and FLC, received a
letter from an APS Shareholder which stated that the shareholder had defaulted
on a real estate closing and lost a $50,000 escrow deposit. In addition, it has
been reported that auction rate securities were a popular investment for certain
banks, including some community banks;(7) the Applicants
----------
(4) The Applicants understand that the relatively limited secondary market
trading that has occurred in auction rate preferred stock of closed-end
funds since the failure of the auction markets has been conducted at
significant discounts. SEE Aaron Pressman, "Auction-Rate Securities: How to
Get Unstuck," BUSINESS WEEK (June 2, 2008). The current main secondary
market is secondmarketTM. SEE http://www.secondmarket.com/. The site is run
by Restricted Securities Trading Network, an electronic trading platform,
and began trading auction-rate securities on March 3. SEE "Electronic trade
to start for auction-rate market," February 25, 2009, available at
http://www.reuters.com/article/bondsNews/idUSN2528169320080225. Currently,
the trading volume for auction rate securities is extremely low, trades are
taking place at a significant discount, and the valuation process is
cumbersome. SEE "Illiquid securities to get new market; Firm creating venue
for CDO issues that should boost transparency," PENSIONS AND INVESTMENTS,
November 24, 2008 ("'SecondMarket is offering a solution, but I'll be
surprised if they get a lot of volume. It's too early in the game. If you
look at auction-rate securities, which were supposed to be fairly simple,
it takes 10,000 Excel pages to calculate the value in one issue;'" "the
actual value of the transaction . . . is only a fraction of the notional
amount of the security at face value.").
(5) Jane J. Kim and Shefali Anand, "Trapped by Market Turmoil: Some Fund
Investors Are Locked In as Tax Time Nears," WALL STREET JOURNAL, p. B2
(March 1, 2008).
(6) Rebecca Buckman, "Freeze in Auction-Rate Field Finds Its Way to Silicon
Valley," WALL STREET JOURNAL (March 14, 2008).
(7) Although as stated above, the Applicants generally only have knowledge of
the ownership of the APS Shares through public filings on Schedule 13G,
they have been contacted by one APS Shareholder that is a community bank.
13
are aware of one community bank that holds APS Shares of PFD. Improving
the ability of the Applicants to redeem shares from banks could improve their
balance sheets and could contribute to the overall health of the banking
industry.
In addition, Applicants note that the U.S. is presently in a severe credit
crisis, which has raised continuing concerns regarding the liquidity of the
market. In an environment in which even short-term commercial paper of longer
durations has essentially stopped trading, Applicants are concerned that the
illiquidity of the APS Shares could magnify any harm to individual APS
shareholders resulting from this credit crisis.
LIQUIDITY SOLUTIONS TO DATE FOR FLAHERTY & CRUMRINE CLOSED-END FUNDS
In light of the persistent auction failures, since February 2008 the
Applicants believe they have acted diligently and in the best interests of all
shareholders, redeeming as much of the total amount of APS Shares outstanding as
appropriate and feasible, while diversifying sources of leverage for the benefit
of common shareholders and maintaining appropriate levels of leverage, to the
extent available, at a total cost structure that also benefits common
shareholders. Each Applicant has outstanding APS Shares with a liquidation
preference and, in the case of FFC and FLC, outstanding debt representing more
than one-third of its total assets. As a result, none of the Applicants would be
able to replace its APS Shares entirely with debt financing without the
temporary relief from the 300% asset coverage test, as requested herein.
14
FINANCING ARRANGEMENTS. The table below sets out (i) the number of shares
for each Applicant's APS Shares series that were issued and (ii) were
outstanding as of March 20, 2009, (iii) the number of APS Shares redeemed as of
March 20, 2009, (iv) the aggregate dollar amount of APS Shares redeemed as of
March 20, 2009; and (v) the percentage of the redeemed APS Shares:
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DOLLAR TOTAL
NUMBER OF AMOUNT OF TOTAL PERCENTAGE
APS APS SHARES NUMBER OF OF APS
SHARES REDEEMED APS SHARES SHARES
NUMBER OF REDEEMED AS OF OUTSTANDING REDEEMED
APS SHARES AS OF 03/20/09 AS OF AS OF
APPLICANT ISSUED 03/20/09 ($MILLIONS) 03/20/09(8) 03/20/09
---------------------------------------------- ---------- --------- ----------- ----------- ----------
Flaherty & Crumrine Preferred Income Fund
Incorporated (PFD)(9) 800 352 35.2 448 44%
Flaherty & Crumrine Preferred Income
Opportunity Fund Incorporated (PFO) 700 334 33.4 366 47.7%
Flaherty & Crumrine/Claymore Preferred
Securities Income Fund Incorporated (FFC)
Series M7 3,200 2,658 66.45 542 83%
Series T7 3,200 2,658 66.45 542 83%
Series W7 3,200 2,658 66.45 542 83%
Series TH7 3,200 2,658 66.45 542 83%
Series F7 3,200 2,658 66.45 542 83%
Series T28 2,840 2,359 58.975 481 83%
Series W28 2,840 2,360 58.975 480 83%
Flaherty & Crumrine/Claymore Total Return Fund
Incorporated (FLC)
Series T7 2,570 1,780 44.5 790 69.3%
Series W28 2,570 1,780 44.5 790 69.3%
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(8) Because the majority of each Applicant's APS Shares are held of record in
broker "street name" or other nominee accounts, the Applicants do not have
specific knowledge of the number of beneficial owners of the Applicants'
APS Shares that remain outstanding or the amounts outstanding for any
beneficial owner.
(9) On February 24, 2009, the Board of Directors of PFD announced that PFD will
redeem approximately 100 APS shares, approximately 18% of the outstanding
APS Shares, on April 7, 2009 at a redemption price equal to the liquidation
preference of $100,000 per share, plus the amount of accumulated but unpaid
dividends, for consideration of approximately $10 million. Pursuant to
PFD's Articles Supplementary, these shares were deemed to have been
redeemed on February 24, 2009. The Fund will use currently available cash
to fund this redemption.
16
Since FFC and FLC had both APS Shares and senior securities representing
indebtedness outstanding following the partial APS Shares redemptions, the Funds
were required to and, as of the date of this Application, do comply with the
1940 Act's 300% asset coverage applicable to debt, and the 200% asset coverage
test applicable to preferred stock.
Each Applicant believes that refinancing through the use of borrowings
would be appropriate and, over the longer term would provide additional
investment income net of borrowing costs, and thus would be beneficial to its
common shareholders. The Applicants believe that it is in their best interests,
and in the best interests of their securities holders, to seek to diversify
their leverage sources and to seek to increase leverage flexibility in light of
the uncertain market conditions with respect to outstanding APS Shares, and that
it is in their best interest from time to time, depending on market conditions
and the availability of appropriate alternative forms of leverage, to issue debt
securities or borrow money in order to be able to redeem some or all of the
outstanding APS Shares. In each case in which an Applicant will redeem APS
Shares, the cost of the replacement leverage, over time, is expected to be lower
than the total cost of APS Shares if they remained outstanding, based on the
Maximum Rates applicable to the APS Shares of those funds.
In addition, permitting the Applicants to apply asset coverage of 200% to
all debt incurred, not to exceed, for each Applicant, the aggregate liquidation
preference of such Applicant's APS Shares outstanding as of the Order Date is
anticipated to benefit
17
common shareholders. Historically, the use of leverage has provided a positive
spread between the portfolio return that the Applicants can earn and the cost of
leverage.
ALTERNATE FORMS OF SENIOR SECURITIES THAT ARE EQUITY-BASED. The Applicants
are aware that certain market participants are beginning to develop potential
preferred equity-based instruments to address the liquidity problems posed by
the failure of the auction rate securities markets.(10) However, given the
uncertainty and the current and continuing unsettled state of the securities and
capital markets, it is not possible to predict whether there will be an
equity-based alternative sufficiently viable to allow holders of the auction
rate securities markets to obtain liquidity in the near term. The Applicants
believe that even if such an alternate financing structure is created, it will
take the markets a significant amount of time to implement such an alternative
approach, especially in light of the market's recent experience with the failure
of the auction rate markets -- markets which operated without a major hiccup for
over twenty years. The Applicants continue to consider alternatives and work on
a permanent solution, but in the interim, the Applicants are pursuing immediate
relief for their remaining APS shareholders who have been unable to sell their
APS Shares at auction since February 2008.
SUBSEQUENT DEVELOPMENTS. On August 22, 2008 the Securities and Exchange
Commission's Division of Enforcement announced that a preliminary settlement had
been reached with Merrill Lynch, Pierce, Fenner & Smith, Inc. ("Merrill Lynch")
pursuant to which Merrill Lynch would be required to use its best efforts to
provide liquidity for
18
approximately $1.5 billion worth of auction rate securities purchased through
Merrill Lynch by other business and institutional customers.(11) Merrill was the
lead underwriter for the APS Shares offerings of FFC and FLC shares.(12)
Applicants believe that the settlement would extend to the APS Shares that they
issued that were sold by Merrill Lynch in auctions. According to the preliminary
settlement announcement, Merrill Lynch will not liquidate its own inventory of
particular auction rate shares before it liquidates holdings of its customers in
that security. Therefore, if the Applicants redeem their APS Shares Merrill
Lynch, pursuant to the settlement announcement, would not participate in the
redemption until all of its clients who still own APS Shares and did not
participate in the settlement had their auction rate shares redeemed. However,
if the Applicants redeem all of their outstanding APS Shares, Merrill Lynch
would have its APS Shares redeemed, ultimately.
The Commission entered into similar settlements with Citigroup Global
Markets, Inc. on December 11, 2008, with UBS Securities LLC and UBS Financial
Services, Inc. on December 11, 2008, with Wachovia Securities, LLC and Wachovia
Capital Markets, LLC on August 15, 2008, and with RBC Capital Markets Corp.,
Banc of America
----------
(10) See Eaton Vance Management (pub. avail. June 13, 2008) (no-action relief
granted for the sale of a remarketed preferred stock share coupled with a
liquidity put).
(11) See "SEC Enforcement Division Announces Preliminary Settlement With Merrill
Lynch to Help Auction Rate Securities Investors," Release No. 2008-181,
August 22, 2008., available at
http://www.sec.gov/news/press/2008/2008-181.htm.
(12) Lehman Brothers, Inc. ("Lehman") was lead underwriter for the APS Share
offerings of PFD and PFO. To our knowledge, there was no settlement between
the SEC and Lehman prior to the acquisition of Lehman by Barclays Capital,
and shareholders who held auction preferred shares through Lehman do not
benefit from any settlement.
19
Securities LLC, and Banc of America Investment Services on October 8, 2008. The
Applicants may redeem shares held by the foregoing broker-dealers, or from other
broker-dealers that enter into future settlements with the Commission, as part
of any repurchase that is made in reliance upon the Order.(13)
Applicants believe that, although those settlements make great strides
towards providing liquidity to individual investors, they do not resolve all of
the problems that are facing the owners of the Applicants' APS Shares. First,
the settlements are not universal and do not cover all of the broker-dealers
that brokered the Applicants' APS Shares. As a result, there are investors who
are not covered by the preliminary settlements. Second, the preliminary
settlements do not address the immediate liquidity needs of corporations that do
not qualify as "small businesses." (For example, the settlement does not cover
many smaller community banks that may hold the APS Shares.) Under the terms of
the settlements, those companies would continue to hold illiquid APS Shares.
Applicants believe that relief is still necessary to provide liquidity to those
shareholders. Finally, given the tremendous stresses that are presently placed
upon all markets, Applicants
----------
(13) In general, Section 23(c) of the 1940 Act prohibits a closed-end company,
such as each of the Applicants, from purchasing securities of which it is
the issuer unless the purchase is made on a securities exchange, pursuant
to a tender offer extended to all holders, or pursuant to Commission rule,
regulation or order. Rule 23c-2(a) under the 1940 Act permits a closed-end
company to call or redeem securities of which it is the issuer in
accordance with the terms of those securities, provided that, if less than
all of the outstanding securities of a class or series are to be redeemed,
the call or redemption must be made by lot, on a pro rata basis, or in such
other manner as will not discriminate unfairly against any holder of the
securities of such class or series. The Applicants intend to call or redeem
the entire amount of outstanding APS Shares in accordance with the
requirements of Section 23(c) and Rule 23c-2(a), which would include shares
held by parties to auction-rate settlements with the Commission. If, due to
unforeseen market considerations, the Applicants are initially forced to
call or redeem a portion of their outstanding APS Shares, such a call or
redemption will be done in accordance with Rule 23c-2(a) and may, or may
not, include shares held by parties to auction-rate settlements with the
Commission.
20
believe it is in the public interest to permit the Applicants to redeem their
APS Shares so as to provide the holders of their APS Shares with needed
liquidity.
The Applicants are therefore seeking the Order in order to facilitate
future borrowings by each Applicant without the burden of having to manage to a
very narrow 300% asset coverage margin in extremely difficult market
circumstances.(14) Applicants will seek over the longer term replacement
leverage that complies in full with the asset coverage requirements of Section
18 of the 1940 Act.
REQUESTED RELIEF
Under Section 18(a)(1), any class of senior security that represents an
indebtedness must have, immediately after its issuance or sale, asset coverage
INVESTMENT COMPANY ACT OF 1940 FOR AN EXEMPTION
dividends or distributions on the company's stock or the repurchase of stock
unless the 300% asset coverage is maintained, except that dividends may be
declared upon the company's preferred stock if the indebtedness has asset
coverage of at least 200% at the time of declaration, after deducting the amount
of the dividend. For the reasons stated above, the Applicants request that the
Commission issue a temporary order of exemption permitting each Applicant to
refinance any outstanding APS Shares that were issued prior to February 1, 2008
with the proceeds of borrowings, subject, on a temporary basis, to the 200%
asset coverage requirement that applies to the Applicants' existing APS Shares,
----------
(14) Certain lenders impose the 1940 Act's 300% asset coverage restriction in
their lending documents; however, the Applicants believe that if the
Commission grants the relief requested, the lenders should follow the
Commission's lead in reducing their own asset coverage requirements.
21
rather than the 300% asset coverage requirement that would ordinarily apply to
indebtedness. In addition, the Applicants request a temporary exemption from
Section 18(a)(1)(B) of the 1940 Act so that the Applicants may, in connection
with the refinancings and additional borrowings referred to above and to the
extent that compliance with Section 18(a)(l)(B) is not excused in the
circumstances by Section 18(g) of the 1940 Act,(15) make provision to prohibit
the declaration of dividends or distributions and the purchase of its capital
stock (including its APS Shares) unless, at the time of any declaration or
purchase and after deducting the amount of such dividend, distribution or
purchase price, it meets the 200% asset coverage requirement that applies in
respect of the Applicants' APS Shares, rather than the asset coverage of 300%
ordinarily required.(16) Specifically, the Applicants seek such relief for a
temporary period from the date on which the Order is granted until October 31,
2010 (the "Exemption Period"). The Applicants' Boards, in determining to seek
this relief, considered, among other things, information regarding the nature of
the holders of the Applicants' APS Shares, information regarding the benefits of
existing leverage to the holders of the Applicants' common shares, the
advantages to shareholders of holding preferred stock rather than common stock
(i.e., increased dividends), Flaherty & Crumrine's views of the potential
availability of additional appropriate debt financing and the anticipated cost
----------
(15) Section 18(g) of the 1940 Act provides, among other things, that a
promissory note or other evidence of indebtedness issued in consideration
of any loan, extension or renewal thereof, made by a bank or other person
and privately arranged, and not intended to be publicly distributed, is not
a "senior security" for purposes of Section 18(a)(1)(B).
(16) Except as permitted under the requested Order, if issued, the Applicants
would meet all of the asset coverage requirements of Section 18(a) of the
1940 Act during the Exemption Period.
22
thereof and the ongoing efforts of Flaherty & Crumrine to create and facilitate
the issuance of alternate forms of senior securities that are equity-based, as
described above, market conditions and the disruptions such conditions have
caused to the Applicants in meeting asset maintenance tests with respect to
their APS Shares.
Each Applicant proposes that it would either pay down or refinance the debt
within the Exemption Period so that, upon expiration of the Exemption Period,
and thereafter, it will have asset coverage of at least 300% for each class of
senior security representing indebtedness to the extent required by the 1940
Act.
Subject to reasonable availability of sufficient collateral, the costs at
the time of borrowing, the current conditions in the credit market, the market
conditions in preferred shares of financial institutions (see below) and general
market conditions, potential benefits to Applicants' shareholders, and other
practical considerations, each Applicant intends to take reasonable and measured
steps to gradually increase its borrowings to replace all or a portion of its
remaining APS Shares under any of its existing credit facilities. The Applicants
submit that the Exemption Period is an appropriate period of time for the
proposed relief from Sections 18(a)(l)(A) and 18(a)(1)(B). The Applicants
believe that the gradual reduction of leverage through the use of proceeds of
any common share issuances, or the development by the industry of an alternative
form of preferred stock that provides liquidity at liquidation value might take
several months, if at all, after the Order has been issued. It is not possible
to predict when, or if, the securities and capital markets will return to
conditions that would enable the Applicants to achieve compliance with
applicable asset coverage requirements in the absence of the Order,
23
consistent with the best interests of the Applicants and their common
shareholders. Given the uncertainty and the current and continuing unsettled
state of the securities and capital markets, the Applicants believe that the
Exemption Period is reasonable and appropriate.
The proposed replacement of the leverage represented by the Applicants' APS
Shares with debt is expected to be favorable to both holders of the common
shares and the APS Shares of the Applicants. The proposed replacement of the
aggregate liquidation preference of each Applicant's APS Shares outstanding as
of the Order Date with debt would potentially provide liquidity to all of the
Applicants' current APS shareholders. Furthermore, although there can be no
certainty regarding financing costs under future market conditions, the proposed
replacement is also expected to benefit the common shareholders to the extent
that the debt, over time, is a lower cost form of leverage than the cost of
leveraging with APS Shares based on their Maximum Rates. The refinancings for
FFC and FLC, completed earlier this year, were done at financing terms that
compared favorably with the cost of the APS Shares at the Maximum Rate at the
time of those refinancings, and Flaherty & Crumrine believes that it is
currently possible to obtain financing terms during the Exemption Period that
compare favorably with the cost of the existing APS Shares at their Maximum
Rates, particularly as the underlying benchmarks for those rates increase over
time; further, Flaherty & Crumrine is cautiously optimistic that longer term
solutions that also compare favorably may be found. Due to the extremely
volatile and declining market conditions, the Applicants have been required to
sell portfolio securities at inopportune times to maintain their 300% asset
coverage requirements. As contemplated, the replacement of the aggregate
liquidation preference
24
of the APS Shares outstanding as of the Order Date with debt would avoid the
need for the Applicants to further and significantly deleverage over a short
period of time, purely due to the differences between the asset coverage
requirements for debt and stock in the 1940 Act, allowing Applicants to maintain
positions and fulfill investment strategies advantageous to common shareholders.
With respect to the existing APS Shares, a forced, significant deleveraging over
a short period of time for this reason would likely be detrimental to the common
shareholders in terms of portfolio disruption, transaction costs, possible tax
recognition events and reduced investment return over a potentially extended
period of time. Under current market conditions that may continue, this dynamic
is exacerbated to a great degree.
Although FFC and FLC were able to obtain secured financing earlier this
year and Flaherty & Crumrine has had preliminary discussions with a variety of
possible lenders regarding the replacement of the APS Shares of the Applicants
with debt, Flaherty & Crumrine has found that lenders generally are less willing
to devote significant effort or attention to such a possible transaction unless
and until there is a degree of certainty that the Order would be issued. The
specific terms of such a transaction, the economic attractiveness of the
transaction to the Applicants and the benefits and costs of the transaction to
the Applicants' common shareholders and the holders of the APS Shares will
depend upon circumstances that exist at the time such a transaction is
negotiated, and cannot be predicted with any degree of certainty. The terms of
any such transaction, once known, will be submitted to the Boards for
consideration, along with any alternative courses of action that may then be
available. (As with the terms of the possible
25
borrowing, the alternative courses that may be available for consideration by
the Boards will depend upon circumstances as they then exist, and cannot be
predicted with any degree of certainty.)
In considering any incurrence of debt to replace the APS Shares, the
members of each Applicant's Board owe fiduciary duties to the holders of both
the common shares and the APS Shares and will weigh carefully the benefits and
costs of the proposals to the common shareholders and the APS shareholders.(8)
Each Applicant's Board will consider, in connection with the proposed borrowing
by that Applicant, among other things, the expected costs of the debt, the
availability and terms of financing (including matters such as fees and lenders'
requirements related to the grant of a security interest in all or a portion of
an Applicant's assets), credit market conditions, and the investment return
expected to be potentially available on portfolio assets that have been or may
be acquired using leverage (all of which are generally highly unpredictable and
may vary significantly from one point in time to another). Each Applicant's
Board will also consider any alternative courses of action that, in the Board's
judgment, might be in the best interests of that Applicant, its common
shareholders and its APS shareholders. The additional specific borrowing
transactions, if any, in reliance on the Order that the Board may consider, the
specific information that the Board may receive, request or consider in
connection therewith, the specific alternatives that the Board may consider and
the
----------
(8) The Applicants do not believe that the proposed borrowings will require a
change to their fundamental investment policies that would require a
shareholder vote.
26
specific factors that may lead the Board to approve or disapprove a proposed
borrowing, or some alternative course of action, are not yet known.
The Board of any Applicant that borrows in reliance on the Order will
receive and review, no less frequently than quarterly during the Exemption
Period, detailed progress reports prepared by management (or other parties
selected by the Directors who are not "interested persons" (as defined in
Section 2(a)(19) of the 1940 Act) ("Independent Directors")) regarding and
assessing the efforts that the Applicant has undertaken, and the progress that
the Applicant has made, towards achieving compliance with the appropriate asset
coverage requirements under Section 18 by the expiration of the Exemption
Period. The regular meetings of the Board of any such Applicant, until such time
as compliance with such asset coverage requirements has been achieved, will
include time for the presentation and discussion of such reports and of the
progress that such Applicant has made towards achieving compliance with the
asset coverage requirements. To the extent that the Board deems appropriate,
these matters will also be scheduled for discussion at other meetings of the
Board or relevant committees thereof, and during executive sessions of the
Independent Directors.
III. ANALYSIS
A. APPLICABLE SECTIONS OF THE 1940 ACT
SECTION 18(a)(1)(A) of the 1940 Act provides that it is unlawful for any
registered closed-end management investment company to issue any class of senior
security, or to sell such security of which it is the issuer, unless, if such
class of senior security
27
represents an INDEBTEDNESS, immediately after such issuance or sale, it will
have an asset coverage of at least 300%.
SECTION 18(a)(2)(A) of the 1940 Act provides that it is unlawful for any
registered closed-end management investment company to issue any class of senior
security, or to sell any such security of which it is the issuer, unless, if
such class of senior security is a STOCK, immediately after such issuance or
sale it will have an asset coverage of at least 200%.
SECTION 18(a)(1)(B) of the 1940 Act provides that it is unlawful for any
registered closed-end management investment company to issue any class of senior
security that represents an INDEBTEDNESS unless it has made provision to
prohibit the declaration of any dividend (except a dividend payable in stock of
the company) or other distribution on any class of its capital stock, and the
purchase of any class of its capital stock, unless, at the time of the
declaration or purchase (after deducting the amount of the dividend,
distribution, or purchase price) it will have an asset coverage of at least
300%, except that dividends may be declared on any preferred stock if the senior
security representing indebtedness has an asset coverage of at least 200% at the
time of declaration after deducting the amount of the dividend.
SECTION 18(a)(2)(B) of the 1940 Act provides that it is unlawful for any
registered closed-end management investment company to issue any class of senior
security that is a STOCK unless it has made provision to prohibit the
declaration of any dividend (except a dividend payable in common stock of the
company) or other distribution on its common
28
stock, and the purchase of any of its common stock, unless, at the time of the
declaration or purchase (after deducting the amount of the dividend,
distribution or purchase price) it will have an asset coverage of at least 200%.
SECTION 18(g) of the 1940 Act provides, among other things, that "senior
security," for purposes of Section 18(a)(1)(B), does not include any promissory
note or other evidence of indebtedness issued in consideration of any loan,
extension or renewal thereof, made by a bank or other person and privately
arranged, and not intended to be publicly distributed.
SECTION 18(h) of the 1940 Act defines "asset coverage" of a class of senior
security representing an INDEBTEDNESS of an issuer to mean the ratio which the
value of the total assets of such issuer, less all liabilities and indebtedness
not represented by senior securities, bears to the aggregate amount of senior
securities representing indebtedness of such issuer. Section 18(h) of the 1940
Act defines "asset coverage" of a class of senior security of an issuer which is
a STOCK to mean the ratio which the value of the total assets of such issuer,
less all liabilities and indebtedness not represented by senior securities,
bears to the aggregate amount of senior securities representing indebtedness of
such issuer plus the aggregate of the involuntary liquidation preference of such
class of senior security which is a stock. The involuntary liquidation
preference of a class of senior security which is a stock is deemed to mean the
amount to which such class of senior security would be entitled on involuntary
liquidation of the issuer in preference to a security junior to it.
29
SECTION 6(c) of the 1940 Act provides, in relevant part, that the
Commission, by order upon application, may conditionally or unconditionally
exempt any person, security or transaction, or any class or classes of persons,
securities or transactions from any provision of the 1940 Act, if and to the
extent necessary or appropriate in the public interest and consistent with the
protection of investors and the purposes fairly intended by the policy and
provisions of the 1940 Act. The Applicants submit that their request for the
exemptive temporary relief described above meets the standards of Section 6(c).
B. STATEMENT IN SUPPORT OF APPLICATION
1. TEMPORARY EXEMPTIVE RELIEF IS NECESSARY, APPROPRIATE AND IN THE PUBLIC
INTEREST
The Applicants believe that the requested temporary exemptive relief is
necessary, appropriate and in the public interest because, as noted above in
Section I under the heading THE HARM TO HOLDERS OF APS SHARES, the illiquidity
of auction preferred securities, including the Applicants' APS Shares, still
causes hardship to holders that require liquidity in light of the ongoing
dormancy of the auction rate market. The proposed replacement of the APS Shares
with debt would provide liquidity for the Applicants' APS shareholders, while
the Applicants continue their diligent efforts to obtain a more permanent form
of financing (such as through the issuance of a new type of senior security that
is equity, as described above) that fully complies with the asset coverage
requirements of Section 18. Even if the retail holders have their APS Shares
repurchased by the broker-dealer entities from whom they purchased their APS
Shares, the agreements in principle between the Commission and the broker-dealer
entities do not
30
guarantee that the broker-dealer entities will repurchase shares held by
institutional investors, which are also experiencing liquidity problems.
In addition, the Applicants believe that the requested temporary exemptive
relief is necessary, appropriate and in the public interest because under
current market conditions, managing the portfolios to comply with the 300% asset
coverage limits has caused (for FFC and FLC) and may cause (for all the
Applicants) significant portfolio disruptions that Applicants believe is harmful
to common shareholders. The Applicants' portfolios have declined in value,
sometimes rapidly and significantly. The refinancing by FFC and FLC from APS
Shares to borrowings, and sales of portfolio securities to redeem APS Shares by
the Applicants, was a direct result of the APS Shares liquidity crisis.
Applicants believe that it is necessary and appropriate to permit application of
the 200% asset coverage test to future borrowings in order to protect the
interests of the Applicants and their common shareholders under current market
circumstances.
Also, the Order would permit the Applicants to continue to provide their
common shareholders with the enhanced returns that leverage may provide, without
disrupting the declaration of dividends or other distributions the Applicants
have historically made with respect to their common shares,(18) and to avoid the
potential harm to the common
----------
(18) The Applicants believe that their common shareholders expect regular
distributions. Each of the Applicants has declared and paid dividends on
its common shares on a monthly basis since shortly after commencing
operations. In addition, for the Applicants to continue to qualify as
regulated investment companies under the Internal Revenue Code of 1986, as
amended, and to receive favorable tax treatment thereunder, it is
necessary, among other things, for each Applicant to distribute at least 90
percent of its investment company taxable income and net tax-exempt
interest income (if any) during each taxable year. By permitting each
Applicant to declare dividends and distributions, on a temporary basis,
subject to a 200% asset coverage requirement under Section 18(a)(1)(B), it
is expected that the Applicant will be able to refinance APS Shares as
31
shareholders that could result if the Applicants were to continue to
significantly deleverage their portfolios in the current difficult market
environment over a short period of time. Each Fund's portfolio consists
primarily of preferred securities. To further delever, the Applicants may be
forced to sell portfolio holdings into a market that may be characterized by an
imbalance between buyers and sellers and a consequent lack of a depth of
liquidity. All the Applicants have been forced to delever and to sell portfolio
holdings into the current market. In addition, each of FFC and FLC has been
forced to consider ways to keep the portfolios in compliance with their 300%
asset coverage test for their current borrowings, including most notably selling
portfolio securities. Further significant deleveraging would potentially further
disadvantage the Applicants' common shareholders by reducing their investment
return, which, in turn, may reduce the market price of the common shares. In
determining that further develeraging would not be appropriate under current
market conditions, Flaherty & Crumrine considered the following factors, among
others:
----------
described in this Application without putting at risk the Applicant's
ability to maintain its status as a regulated investment company.
It is possible that, in connection with a borrowing incurred to refinance
outstanding APS Shares, the Applicants will issue a senior security
constituting indebtedness that is in consideration of a loan, made by a
bank or other person and privately arranged, and not intended to be
publicly distributed. Under Section 18(g), such a borrowing would not
require the Applicants to make the provision referred to in Section
18(a)(1)(B). However, the Applicants cannot rule out the possibility that
they will incur borrowings that do not meet the Section 18(g) criteria, and
are thus requesting relief from Section 18(a)(1)(B).
32
- Its detailed knowledge, based on its long experience managing
portfolios of investments of the kinds held by the Applicants, of the
market for these investments.
- Its belief that the preferred securities market suffered its worst
year in history in 2008, and continues to face pressure.
- That although all companies have felt some strain from the recession
and credit crunch, the financial issuers that make up the vast
majority of the preferred market (e.g., banks, finance companies,
broker-dealers and insurance companies) have been most affected, given
their direct and indirect exposure initially to the problems in
housing and subsequently to financial markets.
- That the pressure on preferred security valuations, especially those
of financial issuers, intensified in early September 2008, when over a
ten day period, the government placed Fannie Mae and Freddie Mac into
conservatorship, Lehman Brothers filed for bankruptcy and AIG required
the first of two massive doses of government assistance, and that the
forced selling that resulted from this collapse in financial services
preferreds continues to reverberate through the markets.
- Its own analysis (published in early January as PREFERRED VALUATION
AFTER THE TARP) which concluded that preferred securities were
significantly undervalued and traded at historically wide spreads to
benchmark fixed-income asset classes, and that the Funds' portfolios
could withstand default rates in excess of those that occurred during
the Great Depression and still generate positive returns.
33
- The adverse effects that deleveraging would have on the net income
that the Applicants earn for the benefit of their common shareholders,
given the historical positive spread between the portfolio return that
the Applicants can earn and the cost of leverage.
For the foregoing reasons, the Applicants do not believe further
deleveraging, in the current market environment, is a reasonable method to
provide liquidity to the Applicants' remaining APS shareholders. Nor do the
Applicants believe that it is beneficial to an Applicant or its shareholders to
continuously have to adjust portfolio holdings in volatile and declining market
circumstances to remain in compliance with 300% asset coverage requirements.
The Applicants' refinancing of their outstanding APS Shares through
borrowings under the Order would be subject to the Applicants' negotiating
agreements with acceptable counterparties and approval of such arrangements by
the Board, among other factors. The Applicants can provide no assurance that if
the Commission grants the Order, the Applicants will be able to redeem any of
their outstanding APS Shares using the proceeds of borrowings.
The Applicants submit that the current state of the credit markets, which
has affected APS Shares of all types, including the Applicants' APS Shares, is
an historic event of unusual severity and requires a creative and flexible
response on the part of both the private and public sectors. The Applicants
believe that these issues have created an urgent need for limited, prompt,
thoughtful and responsive solutions and believe that the requested temporary
relief is necessary, appropriate and in the public interest.
34
2. TEMPORARY EXEMPTIVE RELIEF IS CONSISTENT WITH THE PROTECTION OF
INVESTORS AND THE PURPOSES FAIRLY INTENDED BY THE POLICY AND
PROVISIONS OF THE 1940 ACT (AND SECTION 18 IN PARTICULAR)
The 1940 Act was adopted following a series of reports regarding investment
trusts and investment companies prepared by the Commission at the direction of
Congress, and extensive Congressional hearings. In Section 1(b) of the 1940 Act,
Congress declared that the national public interest and the interest of
investors are adversely affected by eight specifically enumerated business
practices of investment companies and their operators, several of which
apparently relate to the capital structure of investment companies. These
include:
"(2) when investment companies are organized, operated, managed, or
their portfolio securities are selected ... in the interest of special
classes of their security holders, .. . rather than in the interest of
all classes of such companies' security holders;
"(3) when investment companies issue securities containing inequitable
or discriminatory provisions, or fail to protect the preferences and
privileges of the holders of their outstanding securities;
"(4) when the control of investment companies is unduly concentrated
through pyramiding or inequitable methods of control, or is
inequitably distributed ...;
* * *
"(7) when investment companies by excessive borrowing and the issuance
of excessive amounts of senior securities increase unduly the
speculative character of their junior securities; or
"(8) when investment companies operate without adequate assets or
reserves."
35
In THE REGULATION OF MONEY MANAGERS, Professor Tamar Frankel summarizes the
extensive record of Congressional concerns relating to investment company
capital structures that emerged from the hearings that led to the adoption of
the 1940 Act:
Congressional hearings in 1940 revealed that some investment companies
borrowed heavily from the public without adequate assets and reserves.
The companies' capital structures were very complex, composed of many
classes of securities with various dividends, and liquidation and
voting rights. Furthermore, before 1940, investment companies were
free to borrow funds for securities speculation, whereas broker
dealers were restricted in the extent to which they could provide
loans for customers to finance securities transactions. The unequal
regulation of investment companies and broker dealers in securing
loans for securities transactions was not justified. The economic
effect of borrowing by investment companies was similar to the
economic effect of borrowing by broker dealers' customers. Both use
the loans to trade in securities. Furthermore, the existence of senior
securities conflicted with the theory of mutuality of risk, which
provided one of the justifications for investment company utility. In
addition, senior securities gave the misleading impression of safety
from risk and increased the speculative nature of both the common
stock and senior securities.
Complex capital structures induced controlling common stockholders to
invest in risky securities to produce income necessary to cover the
high cost of money: this complexity enabled insiders to manipulate the
allocation of expenses and profits among the various companies; it
facilitated control without equity investment or any other investment;
and it made it difficult for investors to value the securities of
investment companies. Section 18 was designed to ameliorate these
problems.
The original bill flatly prohibited investment companies from issuing
and selling senior securities. After extensive hearings, a minor
exception was given to open-end investment companies, and a few
exceptions were carved
36
out for closed-end investment companies and face-amount certificate
companies ....(19)
Reviewing the requested temporary exemptive relief for the Applicants in
light of the foregoing recitation of policy concerns leads to the conclusion in
these unique, exigent circumstances that the protection of investors and the
purposes fairly intended by the policy and provisions of the 1940 Act would be
served by granting a limited exemption permitting the refinancing of APS Shares
outstanding as of the Order Date with indebtedness having the same 200% minimum
asset coverage as currently applies to the APS Shares.(20) Specifically:
1) In the view of the Applicants' Boards, including the Applicants'
Independent Directors, and as explained above, the interests of both
classes of the Applicants' current investors would be well served by
the proposal -- the APS shareholders because they would achieve the
liquidity that the market currently is not providing, as well as full
recovery of the
----------
(19) T. FRANKEL, The Regulation of Money Managers (2008), Section 21.05;
citations omitted. Despite the abundance of information and commentary
regarding the abuses that prompted Congress to adopt Section 18 of the 1940
Act, the record is quite sparse as to the reason for the differential
levels of asset coverage provided for closed-end fund senior securities
that represent, respectively, indebtedness (300%) and stock (200%).
Professor Frankel cites testimony from David Schenker at a 1940 Senate
hearing to the effect that "debentures should be protected because they
sacrifice return for security of investment." Hearings on S. 3580 before a
Subcommittee of the Committee on Banking and Currency, U.S. Senate, at
1116-17 (1940). It perhaps stands to reason that, if a closed-end fund
chooses to exercise its ability to issue both debt and preferred equity, a
higher level of protection against the risk of default should be afforded
to the debt than to the preferred stock. But protection of that kind is
provided automatically by the mere fact that the debt ranks senior in the
capital structure to any outstanding preferred stock.
(20) The Small Business Incentive Act of 1980 (the "1980 Act") made the same
accommodation when it amended the 1940 Act to impose a lower level of asset
coverage for debt to 200% for business development companies ("BDCs"). See
15 U.S.C.S. Section 80a-61(a)(1). The legislative history of the 1980 Act
indicates that Congress considered the "special needs of such companies,
while at the same time preserving important investor protections." (H.R.
No. 96-1341, at 4804 (1980)). One of the "special needs" that may have led
Congress to allow BDCs to issue debt with only 200% asset coverage is that
the securities they purchase are "not readily marketable" and "are illiquid
and may remain so for several years." (R. Thomas and P. Roye, REGULATION OF
BUSINESS DEVELOPMENT COMPANIES UNDER THE INVESTMENT COMPANY ACT, 55 S. Cal.
L. Rev. 895, 904, 905 (1982)).
37
liquidation value of their shares; and the common shareholders because
(1) the Applicants' investment return would be enhanced to the extent
that the cost of borrowing for leverage is, over time, lower than that
of the total cost of APS Shares based on their Maximum Rates without
disruption to the declarations of dividends and other distributions
that common shareholders may expect and (2) the adverse consequences
of deleveraging and/or continuously needing to adjust to fluctuating
markets in maintaining asset coverage, including the selling of
portfolio securities at inopportune times, would be avoided.
2) The proposed additional borrowings would be short-term, rolling
renewable, or extendible loans and would be made with sophisticated
financial institutions. (Each of the participating financial
institutions will be a bank (as defined in Section 2(a)(5) of the 1940
Act), an insurance company (as defined in Section 2(a)(17) of the 1940
Act), or a qualified institutional buyer (as defined in Rule
144A(a)(1) under the Securities Act of 1933)). These financial
institutions would be (a) willing to make loans on the basis of 200%
asset coverage; (b) capable of assessing the risk associated with the
transactions; and (c) capable of determining what limitations, if any,
they wished to impose upon the payment of dividends to the common
shareholders or to impose on the redemption of the capital stock of
the Applicants; such a lender would not need the additional protection
that Congress in 1940 might have believed retail purchasers of
investment company debentures required or expected. In addition, the
short-term, rolling renewable or extendible nature of the loans would
allow these sophisticated lenders to choose not to renew the loans and
to recall their principal with any accrued interest.
3) The proposed borrowings solution does not "fail to protect the
preferences and privileges of the holders of [the Applicants']
outstanding securities" (1940 Act Section 1(b)(3)); the redemption of
the existing APS Shares would be effected in full accordance with the
relevant provisions of the Applicants' Articles Supplementary relating
to the terms, rights, preferences and privileges of the APS
Shares.(21) The 200% asset coverage requirement applicable to the
declaration of dividends or distributions and the repurchase of an
Applicant's capital stock, including APS Shares, would limit the
ability of the common shareholders to obtain assets of the Applicants
to the detriment of the debt holders in accordance with the underlying
purposes of Section 18(a)(1)(B) of the 1940 Act. In addition,
----------
(21) Any Applicant that has debt outstanding, at the time of any borrowing by
such Applicant in reliance on the Order, will obtain any consents to such
borrowing that may be required under the terms of any such outstanding
debt.
38
the lenders who participate in the borrowings will all be
sophisticated financial institutions who are capable of understanding
and weighing the risks inherent in such lowered asset coverage limits.
The common shareholders would continue to have the same rights and
preferences that they have always had; after the APS Shares have been
redeemed, the total amount of leverage and the concomitant risk of a
senior call on assets or claim on dividends will be the same as it was
when the Applicants' capital structure was comprised of APS Shares and
common shares.
4) The proposed borrowings solution would not "by excessive borrowing and
the issuance of excessive amounts of senior securities increase unduly
the speculative character of [the Applicants] junior securities" (1940
Act Section 1(b)(7)). The Applicants would be no more highly leveraged
if they replace the APS Shares with borrowing in an amount up to the
aggregate liquidation preference of the APS Shares as of the Order
Date, and so there would be no increase in the risk to the common
shareholders other than the risk that the borrowing cannot be renewed
or refinanced on favorable terms when it matures.(22) The Applicants
note that the proposed borrowings solution is temporary and that by
the end of the Exemption Period the Applicants would be in compliance
with the relevant asset coverage requirements. Accordingly, to the
extent the 1940 Act's asset coverage requirements were aimed at
limiting leverage because of its potential to magnify losses as well
as gains, the proposed borrowings solution would not unduly increase
the speculative nature of the Applicants' common shares because the
relief is temporary, and the Applicants would be no more highly
leveraged if they replace the APS Shares with borrowing. On no less
than a quarterly basis during the term of the Exemption Period, each
Applicant's Independent Directors would review the status of the
borrowings in excess of the 300% asset coverage and would determine
whether the maintenance of such borrowings
----------
(22) The Applicants acknowledge that the perpetual nature of the APS Shares
makes them in that respect a more attractive source of leverage than
borrowing, which by its terms must be repaid or refinanced at or before a
stated maturity date. The Applicants further acknowledge that managing any
portfolio that relies on borrowing for leverage entails the risk that, when
the borrowing matures and must be repaid or refinanced, an economically
attractive form of replacement leverage may not be available in the capital
markets. For that reason, any portfolio that relies on borrowing for
leverage is subject to the risk that it may have to deleverage. As
explained above, depending upon the circumstances, deleveraging could be
disadvantageous to the holders of the leveraged portfolio's common equity,
insofar as it may disrupt portfolio management, reduce portfolio investment
returns and potentially reduce the value of the common shares. The
Applicants thus regard leveraging through borrowing as potentially a
temporary, interim step, with the issuance of a new type of preferred
equity, as a possible longer-term replacement source of portfolio leverage.
39
continued to benefit the common shareholders. If they were to
determine that such borrowings no longer benefited the common
shareholders of a particular Applicant, that Applicant would take
prompt steps to increase its asset coverage to at least 300% through
orderly reduction of its level of borrowings.
5) The proposed borrowings solution would not make the Applicants'
capital structure more complex, opaque or hard to understand. Each
Applicant that replaces its APS Shares with senior securities
representing indebtedness would, as a result, have two classes of
outstanding securities, one senior and one junior, as was the case
prior to those Applicants' redemption of a portion of their APS
Shares. The proposed borrowings solution would actually simplify the
capital structure of FFC and FLC, which currently consists of senior
securities representing indebtedness, the remaining senior securities
which are stock (I.E., the APS Shares), and common stock.
6) The proposed borrowings solution would not result in undue
concentration of the control of investment companies through
"pyramiding," or inequitable methods or distribution of control (1940
Act Section 1(b)(4)).(23) The Order would not apply to the Applicant's
obligations under Section 12(d)(1) of the 1940 Act, and as such the
pyramiding of control that was typically present with complex capital
structures prior to the enactment of the 1940 Act would not be
present, or possible.
The proposed liquidity solution would not result in the Applicants'
maintaining a lower level of reserves, in relation to the amount of their
outstanding obligations to senior security holders, than they have historically
been required to maintain (1940 Act Section l(b)(8)). For the aforementioned
reasons, the Applicants believe that the request for the Applicants to be
allowed to substitute on a temporary basis a 200% asset coverage requirement for
the 300% asset coverage requirement, in the present, exigent
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(23) It appears that, prior to the adoption of the 1940 Act, voting power in
many investment companies was concentrated in the hands of insiders who
held the only voting shares in complex, multi-layered capital structures.
One of the reasons for limiting the amount and complexity of closed-end
fund capital structures was to eliminate the possibility that (absent
default on a senior security) voting control would rest other than with the
common shareholders.
circumstances, meets the standards for exemption under Section 6(c) of the 1940
Act. The Applicants also believe that the requested temporary, emergency relief
from Sections 18(a)(1)(A) and 18(a)(1)(B) is necessary, appropriate and in the
public interest and that such relief is consistent with the protection of
investors and the purposes intended by the policy and provisions of Section 18
of the 1940 Act.
3. APPLICABLE PRECEDENTS
There is precedent for the relief that the Applicants seek. The Commission
recently granted similar relief to other closed-end funds whose auction rate
securities holders were similarly affected by the failure of the auction rate
markets. Most notably and recently, on January 14, 2009, Commission noticed a
request for similar exemptive relief by Calamos Convertible Opportunities and
Income Fund, Calamos Convertible and High Income Fund, Calamos Strategic Total
Return Fund, and Calamos Global Dynamic Income Fund (the "Calamos Funds") for an
order under Section 6(c) of the 1940 Act for an exemption from Sections
18(a)(1)(A) and (B) of the 1940 Act for a two-year period immediately following
the date of the order (the "Calamos Order"). Pursuant to the Calamos Order, each
Calamos Fund will be permitted to issue debt securities subject to asset
coverage of 200% that would be used to refinance all of such Calamos Funds'
issued and outstanding APS Shares. The Calamos Order also will permit each
Calamos Fund to declare dividends and any other distributions on, or purchase,
shares of capital stock, during the term of the order, provided that any class
of senior securities representing indebtedness has asset coverage of at least
200% after deducting the amount
40
of such transaction. An order granting the Calamos application was issued on
February 10, 2009.
Prior to this, on October 2, 2008, the Commission noticed a request for
similar exemptive relief by Eaton Vance Floating-Rate Income Trust, Eaton Vance
Senior Floating-Rate Trust, Eaton Vance Senior Income Trust, Eaton Vance Credit
Opportunities Fund and Eaton Vance Limited Duration Income Fund (the "Eaton
Vance Funds") for an order under Section 6(c) of the 1940 Act for an exemption
from Sections 18(a)(1)(A) and (B) of the 1940 Act for a two-year period
immediately following the date of the order (the "Eaton Vance Notice").(24)
Pursuant to the Eaton Vance Notice, each Eaton Vance Fund will be permitted to
issue additional debt for the purpose of using the proceeds to redeem their
outstanding auction rate preferred shares and to issue dividends subject to the
new debt using the 200% asset coverage requirement for stock as opposed to the
300% asset coverage requirement for debt. The relief granted to Eaton Vance was
limited to debt incurred subsequent to the issuance of the order for the purpose
of redeeming auction rate preferred shares that were issued prior to February 1,
2008 and still outstanding at the time such post-order debt was incurred (and
the refinancing of such post-order debt until the expiration of the order). An
order granting the Eaton Vance application was issued on October 23, 2008.
The facts underlying the Calamos Order and the Eaton Vance Order are
materially similar to the facts of the Applicants. The Applicants are requesting
the same exemptive
----------
(24) SEE Eaton Vance Management, SEC No-Action Letter (June 13, 2008).
41
relief from the 1940 Act as the relief granted to Eaton Vance and Calamos. The
Applicants submit that the policy arguments supporting relief for the Eaton
Vance and Calamos applicants equally support the Applicants' request for similar
relief.
The Applicants are seeking relief that is identical to that granted in
Calamos, and as discussed infra, they are willing to agree that any order of the
Commission granting their requested relief would be subject to conditions that
are identical to those contained in the Calamos application. The Applicants
submit that the policy arguments supporting relief for the Calamos applicants
equally support the Applicant's request for similar relief.
IV. CONDITIONS
For the reasons set forth herein, the Applicants request that the
Commission issue an order pursuant to Section 6(c) for an exemption from the
provisions of Section 18(a)(1)(A) and Section 18(a)(1)(B) on a temporary basis.
The Applicants agree that any order of the Commission granting the requested
temporary relief shall be subject to the following conditions:
1. Each Applicant that borrows subject to 200% asset coverage under the
Order will do so only if such Applicant's Board, including a majority of
the Independent Directors, shall have determined that such borrowing is in
the best interests of such Applicant, its common shareholders and its APS
shareholders. Each Applicant shall make and preserve for a period of not
less than six years from the date of such determination, the first two
years in an easily accessible place, minutes specifically describing the
deliberations by the Board and the information and documents supporting
those deliberations, the factors considered
42
by the Board in connection with such determination, and the basis of such
determination.
2. Upon expiration of the Exemption Period, and thereafter, each Applicant
will have asset coverage of at least 300% for each class of senior security
representing indebtedness.
3. The Board of any Applicant that has borrowed in reliance on the Order
shall receive and review, no less frequently than quarterly during the
Exemption Period, detailed progress reports prepared by management (or
other parties selected by the Independent Directors) regarding and
assessing the efforts that the Applicant has undertaken, and the progress
that the Applicant has made, towards achieving compliance with the
appropriate asset coverage requirements under Section 18 by the expiration
of the Exemption Period. The Board, including a majority of the Independent
Directors, will make such adjustments as it deems necessary or appropriate
to ensure that the Applicant comes into compliance with Section 18 of the
1940 Act within a reasonable period of time, not to exceed the expiration
of the Exemption Period. Each Applicant will make and preserve minutes
describing these reports and the Board's review, including copies of such
reports and all other information provided to or relied upon by the Board,
for a period of not less than six years, the first two years in an easily
accessible place.
V. ADDITIONAL INFORMATION
Pursuant to Rule 0-2 under the 1940 Act, each Applicant declares that this
Application for a Commission order is signed by Donald F. Crumrine as Chief
Executive
43
Officer of each Applicant pursuant to the general authority vested in him as
such by the Articles of Incorporation and By-laws of each Applicant, and by
resolution of the Applicants' Boards.
The verifications required by Rule 0-2(d) and the authorizations required
by Rule 0-2(c) under the 1940 Act are attached hereto as Exhibits A and B.
Applicants request that any questions regarding this Application be
directed to the persons listed on the facing page hereof.
A copy of the Articles of Incorporation, as amended, including the Articles
Supplementary, as amended, of each of the Applicants is on file with the
Maryland State Department of Assessments and Taxation and notice is given that
this Application is executed on behalf of each of these Applicants separately by
an officer of each of these Applicants as an officer and not individually and
the obligations of each Applicant under or arising out of this Application are
not binding upon any of the Trustees or shareholders of any Applicant
individually but are binding only upon the assets and property of such
Applicant.
[The rest of this page is left intentionally blank.]
44
FLAHERTY & CRUMRINE PREFERRED INCOME FUND INCORPORATED
FLAHERTY & CRUMRINE PREFERRED INCOME OPPORTUNITY FUND INCORPORATED
FLAHERTY & CRUMRINE/CLAYMORE PREFERRED SECURITIES INCOME FUND INCORPORATED
FLAHERTY & CRUMRINE/CLAYMORE TOTAL RETURN FUND INCORPORATED
By: /s/ Donald F. Crumrine
--------------------------
Name: Donald F. Crumrine
Title: Chief Executive Officer
Dated: March 23, 2009
45
EXHIBIT A
Application pursuant to
Section 6(c) of the
Investment Company Act of 1940
for an Order of the Commission
THE STATE OF CALIFORNIA )
) ss:
LOS ANGELES COUNTY )
The undersigned, being duly sworn, deposes and says that he has duly executed
the attached First Amended and Restated Application for an Order of the
Securities and Exchange Commission pursuant to Section 6(c) of the Investment
Company Act of 1940, as amended ("1940 Act"), for and on behalf of Flaherty &
Crumrine Preferred Income Fund Incorporated, Flaherty & Crumrine Preferred
Income Opportunity Fund Incorporated, Flaherty & Crumrine/Claymore Preferred
Securities Income Fund Incorporated and Flaherty & Crumrine/Claymore Total
Return Fund, each a Maryland corporation and closed-end management investment
company registered under the 1940 Act, that he is the Chief Executive Officer of
each of the aforementioned investment companies, and that all actions by the
members and other bodies necessary to authorize the deponent to execute and file
such instrument have been taken. The deponent further says that he is familiar
with such instrument, and the contents thereof, and that the facts therein set
forth are true to the best of his knowledge, information and belief.
The undersigned certifies under PENALTY OF PERJURY under the laws of the State
of California that the foregoing paragraph is true and correct.
/s/ Donald F. Crumrine
----------------------------------------
Name: Donald F. Crumrine
Title: Chief Executive Officer
March 23, 2009
Page A-1
EXHIBIT B
Authorization for
Flaherty & Crumrine Preferred Income Fund Incorporated,
Flaherty & Crumrine Preferred Income Opportunity Fund Incorporated,
Flaherty & Crumrine/Claymore Preferred Securities Income Fund Incorporated
and
Flaherty & Crumrine/Claymore Total Return Fund Incorporated
The undersigned hereby certifies that he is the Secretary of each of Flaherty &
Crumrine Preferred Income Fund Incorporated, Flaherty & Crumrine Preferred
Income Opportunity Fund Incorporated, Flaherty & Crumrine/Claymore Preferred
Securities Income Fund Incorporated and Flaherty & Crumrine/Claymore Total
Return Fund Incorporated (each a "Fund" and collectively the "Funds"); that with
respect to the attached application for an order of exemption (the
"Application") from certain provisions of the Investment Company Act of 1940, as
amended (the "1940 Act"), all actions necessary to authorize the execution and
filing of the Application under the respective Articles of Incorporation of the
Funds have been taken and the person filing the Application on behalf of the
Funds is fully authorized to do so; and that the Funds duly adopted the
following resolutions on October 6, 2008:
RESOLVED: that the proper officers of the Fund be, and each of them hereby is,
authorized to prepare and file with the Securities and Exchange
Commission on behalf of the Fund, as such officers deem appropriate,
an application for an order, and any amendment thereto, pursuant to
Section 6(c) of the Investment Company Act of 1940 (the "1940 Act")
granting an exemption (a) from Section 18(1)(a) thereof to the extent
necessary to permit the Fund to refinance all or a portion of its
auction preferred shares ("APS shares") outstanding as of April 29,
2008 by issuing or incurring a comparable amount of debt, including
any existing issuances or incurrences of debt made since April 29,
2008 (with the aggregate of all such issuances and incurrences by the
Fund subject to the Order not to exceed the aggregate liquidation
preference of the Fund's APS Shares outstanding as of April 29, 2008)
subject to "asset coverage" (as defined in Section 18(h) of the 1940
Act) of 200% (rather than the asset coverage of 300% ordinarily
applicable to a senior security constituting indebtedness under
Section 18(a)(1)(A) of the 1940 Act) and (b) from Section 18(a)(1)(B)
of the 1940 Act so that the Fund may, in connection with the
borrowings referred to above and to the extent compliance with
Section 18(a)(1)(B) is not excused in the circumstances by Section
18(g) of the 1940 Act, make provision to prohibit the declaration of
dividends or distributions and the purchase of its capital stock
(including its APS shares) unless, at the time of any declaration or
purchase, after deducting the amount of such dividend, distribution
or purchase price, it has an asset coverage of at least 200% (rather
than the
Page B-1
asset coverage of 300% ordinarily required for such declarations and
purchases under Section 18(a)(1)(B) of the 1940 Act; and be it
further
RESOLVED: that the proper officers of the Fund, with advice of counsel, be, and
each of them hereby is, authorized and directed to take any and all
such further action to execute any and all documents, agreements, and
instruments and to take any and all steps deemed by them necessary or
desirable to carry out the purpose and intent of the foregoing
resolutions.
/s/ Chad C. Conwell
----------------------------------------
Name: Chad C. Conwell
Title: Secretary
Page B-2