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The U.S. Supreme Court is poised to issue a landmark ruling in FS Credit Opportunities v. Saba Capital Master Fund, a case that stems from a dispute involving activist shareholder Saba Capital and a number of closed-end funds and focuses on the interpretation of the Investment Company Act of 1940 (the 1940 Act). The closed-end fund industry is monitoring the case closely, as it has the potential to reshape the landscape of closed-end fund activism, shareholder litigation and fund governance.

A Circuit Split: 1940 Act Violations

At the heart of the Saba case is whether Section 47(b) of the 1940 Act gives shareholders like Saba an implied private right of action to bring lawsuits against funds in federal court for alleged violations of the 1940 Act where there is not a related express right of action provided in the statute. This question has divided the federal courts of appeals: The U.S. Court of Appeals for the Second Circuit has allowed such claims, while the Third and Ninth circuits have denied them, creating a circuit split that the Supreme Court agreed to resolve.

The Saba litigation began in the U.S. District Court for the Southern District of New York, where Saba challenged the funds’ opting into Maryland’s Control Share Acquisition Act — a statute that restricts voting rights for shares in excess of certain ownership thresholds (such as 10% of a fund’s shares). Saba argued that these anti-takeover protections violated Section 18(i) of the 1940 Act. Both the district court and the Second Circuit sided with Saba, setting the stage for the Supreme Court’s review. The Supreme Court heard arguments in the case on December 10.

Shareholder Power and Fund Governance

The case involves more than mere legal technicalities — it strikes at the core of fund governance, shareholder rights, and the balance of power between activist investors and fund boards. The outcome will determine whether shareholders can bring implied claims under the 1940 Act in federal court or if such claims must be explicitly authorized by the 1940 Act.

If the Supreme Court sides with Saba, the decision could empower activist investors to sue funds for rescission under Section 47(b) for alleged violations of the 1940 Act, even where the 1940 Act does not expressly provide shareholders the right to sue. Such a ruling could unleash a wave of new litigation against closed-end funds (and potentially even open-end funds), exposing funds and their boards to increased litigation risk and threatening a chilling effect on effective fund governance.

Conversely, a ruling in favor of the funds would restrict shareholder litigation to only those claims expressly authorized by the 1940 Act or those brought under state law, where fund board decisions generally are scrutinized under the business judgment rule. This would reinforce a fund board’s ability to adopt protective governance measures that are in the best interests of the fund and shareholders without fear of federal court challenges and would promote stability in the closed-end fund market by curtailing aggressive activist litigation strategies.

Control Share Statutes and Activism

Control share statutes, such as those adopted in Maryland and Delaware, allow a fund to restrict voting rights of shareholders who acquire a significant stake in a fund, to the extent they purchase additional shares over the established limits, with the aim to protect both the fund’s long-term strategy and other shareholders from hostile takeovers or activist disruptions.

The specter of litigation from activist investors already causes substantial disruption in the closed-end fund space, with fund boards negotiating settlements with activists or refraining from implementing or enforcing governance protections they otherwise believe are in the best interests of fund shareholders, due to fear of costly and distracting litigation. The Supreme Court’s decision will have the result of either making it easier for activist investors to end-run state law governance provisions designed to promote stability and protect the interests of long-term shareholders or preventing activist investors from using the federal courts to pursue self-serving agendas.

Potential Outcomes and Industry Impact

If the Supreme Court rules for Saba:

• Activist investors may gain a powerful tool to challenge fund governance and other provisions as alleged violations of the 1940 Act in federal courts, even where there is no explicit statutory authorization.
• Closed-end funds would continue to face increased litigation risk, which would potentially impact the frequency of closed-end fund initial public offerings (IPOs), which already declined significantly.
• The ruling could extend beyond closed-end funds, theoretically opening the door for broader 1940 Act litigation against open-end funds and their boards.
• Funds might need to reconsider certain governance mechanisms designed to protect long-term shareholders to mitigate litigation exposure.

If the Supreme Court rules for the funds:

• The existence of an implied right of action under Section 47(b) would be denied, restricting shareholder lawsuits to claims expressly authorized by the 1940 Act or state law claims.
• Closed-end funds would retain greater control to adopt governance provisions deemed to be in the best interests of shareholders, such as control share statutes, potentially encouraging more IPOs and investor interest.
• Activist investors’ aggressive federal litigation strategies may be curtailed, though state court actions would still be possible.
• The closed-end fund industry might see greater stability and predictability in fund governance and shareholder relations.

Next Steps

Whether the Supreme Court sides with Saba or the funds, the ruling will have lasting implications for fund boards, shareholders and the broader investment community. Funds and investors alike should prepare for the outcome because it will be impactful no matter how the Supreme Court rules.