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.
With the repeal of the preferential dividend rule, DRIPs investors do not have to be treated the same. Let's take a look at how Cornerstone is applying the new rules.
If the shares are trading at a discount to net asset value on the payment date, shares will be purchased on the open market and allocated to the reinvesting shareholders based on the average cost of those purchases. This has not changed from before, and we believe it is a good practice, as investors are receiving the lower price (at a discount, the share price is lower than the net asset value).
If the shares are trading at a premium to net asset value on the payment date, the funds issue new shares to reinvesting investors at either the last reported net asset value or at a price equal to the fund's average closing share price over the five-trading days preceding the payment date, whichever is lower.
This new policy is beneficial to shareholders of funds trading at large premiums, so a rare kudos to Cornerstone for interpreting and applying the RIC Modernization Act in this manner. Cornerstone's interpretation benefits its shareholders. We do not believe, however, that the RIC Modernization Act mandates that DRIPs be modified in this way. Only time will tell how other funds apply the new rules. This should become clear when annual reports begin being filed over the coming months.
How It Works
Let's look at Cornerstone Strategic Value CLM for an example of how the new DRIP policy works, and let's consider three scenarios. Under each scenario, the investors purchased 1,000 shares on Sept. 1 for the closing price of $9.35. This is an investment of $9,350, and our scenarios do not consider transaction costs or tax consequences. Also, we assume that residual (or partial) shares from the distribution are invested. Investor A is not enrolled in the DRIP and receives the monthly distributions in cash. Investor B is enrolled in the DRIP and holds onto the reinvested shares. Investor C is enrolled in the DRIP but sells the new shares immediately. For this third scenario, we assume the shares are available immediately for sale, which may not be a fair assumption; often, DRIPs explain that the shares will be available in the shareholders' accounts within 30 days of the payable date.
The Sept. 30 distribution of $0.1278 per share occurred. Each investor was entitled to $127.80. Investor A received this amount in cash. Because the shares were trading at a premium, we need to determine the price for the DRIP participants. The last published NAV was $5.97, and the average of the preceding five days' closing share prices was $8.924. The NAV was lower, so that was the price used for reinvestment. Investors B and C each received 21.4 shares. Investor B held on to these shares and then had 1,021.4 shares. Investor C sold the shares at the Oct. 3 open for $9.09 each, or a total of $194.53: Note that Investor C took advantage of the premium pricing, having received the shares for the NAV--pretty crafty.
The Oct. 31 distribution of $0.1278 per share occurred. Investor A again received $127.80 in cash. The shares continued to trade at a premium. The last published NAV was $6.34, and the average of the preceding five days' closing share prices was $9.174. The NAV was lower, so that was the price used for reinvestment. Investor B had 1,021.4 shares, entitling him or her to $130.53 in distribution; with this distribution, the investor received 20.6 shares for a total of 1,042 shares. Investor C still had 1,000 shares, having sold the reinvestment from September, so he or she received 20.2 shares from this distribution and sold them at the market open on Nov. 1 for $9.20 each, or a total of $185.84.
The Nov. 30 distribution of $0.1278 per share occurred. Investor A once again received $127.80 in cash. The shares were still at a premium. The last published NAV was $6.18, and the average of the preceding five days' closing share prices was $7.396. The NAV was lower, so that was the price used for reinvestment. Investor B had 1,042 shares, entitling him or her to $133.17 in distribution; with this distribution, the investor received 21.5 shares and now has 1,063.5 shares. Investor C, still holding only the initial 1,000 shares, received 20.7 shares from this distribution and sold them at the market open on Dec. 1 for $7.49 each, or a total of $155.04.
Investor A invested $9,350 for 1,000 shares. At the close on Dec. 1, these shares were worth $7,630 ($7.63 closing price). This investor had also received $383.40 in cash because of the distributions. The total return is negative 14.3% (($7,630 + $383.40)/$9,350 - 1).
Investor B invested $9,350 for 1,000 shares. The distributions were reinvested and held, so the investor now owns 1,063.5 shares worth $8,114.51. The total return is negative 13.2% ($8,114.51/$9,350 - 1). For the opportunity to own more shares, the investor is risking his or her capital in a fund with a deteriorating net asset value.
Investor C invested $9,350 for 1,000 shares. At the close on Dec. 1, the investor still has 1,000 shares worth $7,630, because he or she sold the reinvested shares. The proceeds from those sales totaled $535.41, ignoring the tax consequences. The total return is negative 12.7% (($7,630 + $535.41)/$9,350 - 1).
Although all three investors have negative total returns, the benefits of participating in the DRIP are clear, as Investors B and C outperformed Investor A. Investor C, though, is the winner, as he or she immediately sold the shares received for net asset value into the market at a premium. Compare the $535.41 gained from selling reinvested shares to the $383.40 gained from taking the distributions in cash. As long as a greater fool emerges to purchase the shares at a premium, this will be the case. It's free money, due solely to the RIC Modernization Act.
The passage of most bills into law unleashes unintended consequences. As the case of Cornerstone's revised DRIPs show, the RIC Modernization Act rewards investors in funds trading at a premium, especially if those investors participate in the fund's DRIP and sell the shares immediately at the premium price. It will be interesting to see how other fund families interpret the new law and change their DRIPs, if they change them at all. It is possible that Cornerstone's revision to the DRIP will give directors at other funds another mechanism with which to control discounts. After all, the potential to receive shares at net asset value and sell them at a premium could convince more investors to hold on to shares, eventually causing marginal prices to increase (fewer sellers) and leading to premium pricing. Widespread adoption of Cornerstone's policy could cause discounts for all CEFs to narrow. It could also cause funds trading at wide premiums to persist at those levels.
Whatever ramification of the RIC Modernization Act emerges, CEF investors should review their fund's DRIP and consider enrolling. Over time, it helps to compound the distributions' returns.