The RIC Modernization Act could give free money to CEF investors participating in Distribution Reinvestment Plans.
In the past couple of weeks, I've written articles (click here and here) on Cornerstone Progressive Return Fund CFP and Cornerstone Total Return Fund CRF. In each article, I noted updated language in the fund's semiannual reports related to their distribution reinvestment plans. Curious about the change, I did some digging. It turns out that the Regulated Investment Company Modernization Act, or RIC Modernization Act, of 2009 is behind the change. This act went into effect on Dec. 22, 2010, for funds with tax years beginning after that date. Most funds have not yet had to update their operations to incorporate this act. One area sure to receive increased scrutiny in light of the RIC Modernization Act is the reinvestment plan offered by most closed-end funds, or CEFs.
Distribution Reinvestment Plans
These are actually referred to as dividend reinvestment plans, or DRIPs, but because we eschew the term dividend in favor of the term distribution, we do so here as well. Besides, they are commonly referred to by their acronym, which works under our version, too.
Most closed-end funds offer DRIPs. Depending on the plan, either investors are automatically enrolled or they can decide to opt in. Because most shares of CEFs, and equities for that matter, are held in "street name" (meaning by the brokerage firm) rather than directly registered in the individual investor's name at the fund, few shareholders are actually in DRIPs. It may take extra paperwork to get into a DRIP, but we recommend enrolling. The implications of the RIC Modernization Act make this even more imperative in some cases.
Once investors are enrolled in a DRIP, their distributions are reinvested into shares of the fund rather than being sent to investors in the form of cash. Over time, having more shares in the fund increases the payout. Effectively, it increases the compounding of returns. Typical language for how many shares investors received, prior to the RIC Modernization Act, went something like this.
If the shares were selling for a discount to net asset value, shares were purchased in the market. Each reinvesting shareholder then received the shares at the average price they were purchased for.
If the shares were selling for a premium to net asset value, shares were issued by the fund at either the fund's net asset value or at a steep percentage (usually about 95%) of the fund's market share price on the payment date, whichever was greater. For funds trading at a premium, the fund keeps the distribution as an asset, in exchange for issuing new shares.
DRIPS Modified Under RIC Modernization Act
The RIC Modernization Act repeals something known as the preferential dividend rule. One of the upshots of this rule was that it prohibited investors in DRIPs to benefit from their "dividends" more than investors not enrolled in the DRIPs. As a result, at the time of the distribution payments, if the shares were selling at a discount, DRIP investors got the share price (which was good) that other investors could get. And if the shares were selling at a premium, DRIP investors got close to the market price. In this manner, DRIP investors were receiving the prices (by and large) that any investor could have received.
This is about to change, depending on how fund families interpret and apply the new rules.